CH-21 The Statement of Cash Flows Revisited – Intermediate Accounting : Book Guide

Chapter 21 The Statement of Cash Flows Revisited 1 Chapter 21 The Statement of Cash Flows Revisited QUESTIONS FOR REVIEW OF KEY TOPICS Question 21-1 Every cash flow eventually affects the balance of one or more accounts on the balance sheet, and the cash flows related to income-producing activities also are represented on the income statement. The cash flows, though, are not necessarily reported in the period the cash flows occur. This is because the income statement measures activities on an accrual basis rather than a cash basis. The Statement of Cash Flows fills the information gap by reporting the cash flows directly and in the period the cash flows occur. Question 21-2 No. Although the Statement of Cash Flows has been a required financial statement only since 1988, the relatively recent requirement completes a "full-cycle" movement of accounting thought back to cash flow reporting, which was common practice several decades ago. Prior to the mid-1930s, the preparation of financial statements on a cash basis was common although today’s cash flow reporting requirements are quite different from the cash flow reporting practiced during that earlier period (when emphasis was placed on cash-based income determination). Later, in 1971, APB Opinion 19 required a Statement of Changes in Financial Position that reported “funds flows” that could be defined as either cash or working capital. Question 21-3 No, an investment in treasury bills need not always be classified as a cash equivalent. A guideline – not a rule – for cash equivalents is that these investments must have a maturity date not longer than three months from the date of purchase. However, flexibility is permitted and each company must establish a policy regarding which short-term, highly liquid investments it classifies as cash equivalents. The designation must be consistent with the company's customary motivation for acquiring various investments and the policy should be described in disclosure notes. Question 21-4 Transactions that involve merely transfers from cash to cash equivalents such as the purchase of a three-month treasury bill, or from cash equivalents to cash such as the sale of a treasury bill, should not be reported on the Statement of Cash Flows. A dollar amount is simply transferred from one “cash” account to another “cash” account so that the total of cash and cash equivalents is not altered by such transactions. An exception is the sale of a cash equivalent at a gain or loss. In this case, the total of cash and cash equivalents actually increases or decreases. The increase or decrease is reported as a cash flow from operating activities. 2 Answers to Questions (continued) Question 21-5 "Cash flows from operating activities" are both inflows and outflows of cash that result from the same activities that are reported on the income statement. However, the income statement reports the activities on an accrual basis (revenues earned during the reporting period, regardless of when cash is received, and the expenses incurred in generating those revenues, regardless of when cash is paid). Cash flows from operating activities, on the other hand, report those activities when the cash is exchanged (on a cash basis). Question 21-6 The generalization that "cash flows from operating activities" report all the elements of the income statement on a cash basis is not strictly true for all elements of the income statement. No cash effects are reported for depreciation and amortization neither of operational assets, nor for gains and losses from the sale of those assets. Cash outflows occur when operational assets are acquired, and cash inflows occur when the assets are sold. However, the acquisition and subsequent resale of operational assets are classified as investing activities, rather than as operating activities. Question 21-7 "Cash flows from investing activities" are both outflows and inflows of cash due to the acquisition and disposition of assets. This classification includes cash payments to acquire (1) property, plant and equipment and other productive assets (2) investments in securities, and (3) nontrade receivables. When these assets later are liquidated, any cash receipts from their disposition also are classified as investing activities. The four specific examples can come from any combination of these categories. Two exceptions are inventories and cash equivalents. The purchase and sale of inventories are not considered investing activities because inventories are purchased for the purpose of being sold as part of the firm's primary operations and are classified as operating activities. The purchase and sale of assets classified as cash equivalents are not reported on the Statement of Cash Flows unless the total of cash and cash equivalents changes from the sale of a cash equivalent at a gain or loss. Question 21-8 The payment of cash dividends to shareholders is classified as a financing activity, but paying interest to creditors is classified as an operating activity. This is because "cash flows from operating activities" should reflect the cash effects of items that enter into the determination of net income. Interest expense is a determinant of net income. A dividend, on the other hand, is a distribution of net income and not an expense. 3 Answers to Questions (continued) Question 21-9 A Statement of Cash Flows reports transactions that cause an increase or a decrease in cash. However, some transactions that do not increase or decrease cash, but which result in significant investing and financing activities, must be reported in related disclosures. Entering a significant investing activity and a significant financing activity as two parts of a single transaction does not limit the value of reporting these activities. Examples of noncash transactions that would be reported: 1. Acquiring an asset by incurring a debt payable to the seller. 2. Acquiring an asset by entering into a capital lease. 3. Converting debt into common stock or other equity securities. 4. Exchanging noncash assets or liabilities for other noncash assets or liabilities. Question 21-10 The acquisition of a building purchased by issuing a mortgage note payable in addition to a significant cash down payment is an example of a transaction involving an investing and financing activity that is part cash and part noncash. The cash portion would be reported under the caption "Cash flows from investing activities," and the noncash portion of the transaction would be reported as a "noncash investing and financing activity." Question 21-11 Perhaps the most noteworthy item reported on an income statement is net income–the amount by which revenues exceed expenses. The most noteworthy item reported on a Statement of Cash Flows is not the amount of net cash flows. In fact, this may be the least important number on the statement. The increase or decrease in cash can be seen easily on comparative balance sheets. The purpose of the Statement of Cash Flows is not to report that cash increased or decreased by a certain amount, but why cash increased or decreased by that amount. The individual cash inflows and outflows provide that information. Question 21-12 The spreadsheet entries shown in the two "changes" columns, which separate the beginning and ending balances, explain the increase or decrease in each account balance. Spreadsheet entries duplicate the actual journal entries used to record the transactions as they occurred during the year Recording spreadsheet entries simultaneously identifies and classifies the activities to be reported on the Statement of Cash Flows because in order for cash to increase or decrease, there must be a corresponding change in a noncash account. Thus, if we can identify the events and transactions that caused the change in each noncash account during the period, we will have identified all the operating, investing, and financing activities . 4 Answers to Questions (continued) Question 21-13 If sales revenue is $200,000, this does not necessarily mean that $200,000 cash was received from customers. Amounts reported on the income statement usually do not represent the cash effects of the items reported. By referring to the beginning and ending balances in accounts receivable, we see whether cash received from customers was more or less than $200,000. If accounts receivable increased during the year, some of the sales revenue earned must not yet have been collected. On the other hand, if accounts receivable decreased during the year, more must have been collected than the sales revenue earned. Question 21-14 When an asset is sold at a gain, the gain is not reported as a cash inflow from operating activities. A gain (or loss) is simply the difference between cash received in the sale of an asset and the book value of the asset – not a cash flow. The cash effect of the sale is reported as an investing activity. To report the gain as a cash flow from operating activities, in addition to reporting the entire cash flow from investing activities, would be to report the gain twice. Question 21-15 Whether or not a loss is extraordinary, it is not reported on the statement of cash flows, but the cash inflow from the sale is reported as an investing activity. However, the spreadsheet entry would be affected if the loss is extraordinary. The income tax effect of an extraordinary item is not reflected in income tax expense, but instead is separately reported as a reduction in the extraordinary item. For example, if a loss on the sale of an asset was due to an extraordinary event, the tax savings from that loss would be reported as a reduction in the extraordinary loss rather than as a reduction in income tax expense. This must be considered when determining the cash paid for income taxes. Question 21-16 When determining the amount of cash paid for income taxes, an increase in the deferred income tax liability account would indicate that less cash had been paid than the income tax expense reported. The difference represents the portion of the income tax expense whose payment is deferred to a later year. Notice that precisely the same analysis would apply for an increase in current income tax payable. Question 21-17 When using the indirect method of determining net cash flows from operating activities, the net cash increase or decrease from operating activities is derived indirectly by starting with reported net income and "working backwards" to convert that amount to a cash basis. Amounts that were subtracted in determining net income, but which did not reduce cash, are added back to net income to reverse the effect of the amounts having been subtracted. Bad debt expense is one example. Other examples are depreciation expense, amortization of other intangibles, depletion, and a loss on the sale of assets. 5 Answers to Questions (concluded) Question 21-18 When using the indirect method of determining net cash flows from operating activities, when components of net income increase or decrease cash, but by an amount different from that reported on the income statement, net income is adjusted for changes in the balances of related balance sheet accounts to convert the effects of those items to a cash basis. For components of net income that increase or decrease cash by an amount exactly the same as that reported on the income statement, no adjustment of net income is required. Question 21-19 Either the direct method or the indirect method is permitted, but the FASB strongly encourages companies to report "cash flows from operating activities" by the direct method. The direct method reports specific operating cash receipts and operating cash payments, consistent with the primary objective of the Statement of Cash Flows. This allows investors and creditors to gain additional insight into the specific sources of cash receipts and payments from operating activities. Users also can more easily interpret and understand the information presented because the direct method avoids the confusion caused by reporting noncash items and other reconciling adjustments under the caption "cash flows from operating activities.” Question 21-20 The direct and indirect methods are alternative approaches to deriving net cash flows from operating activities only. Regardless of which method is used for that purpose, the way cash flows from investing and financing activities are presented is precisely the same. 6 BRIEF EXERCISES Brief Exercise 21-1 Summary Entry ($ in millions) Cash (received from customers) 38 Accounts receivable 5 Sales revenue 33 Brief Exercise 21-2 Summary Entry ($ in millions) Cash (received from customers) 39 Accounts receivable 4 Bad debt expense 2 Allowance for uncollectible accounts 1 Sales revenue 44 Brief Exercise 21-3 Summary Entry ($ in millions) Cost of goods sold 25 Inventory 6 Accounts payable 5 Cash (paid to suppliers of goods) 26 Brief Exercise 21-4 Summary Entry ($ in millions) Salaries expense 17 Salaries payable 3 Cash (paid to employees) 14 7 Brief Exercise 21-5 ($ in millions) Interest expense (10% x 1/2 x $380) 19 Discount on bonds payable 1 Cash (paid to bondholders) (9% x 1/2 x $400) 18 Agee would report the cash inflow of $380 million from the sale of the bonds as a cash inflow from financing activities in its statement of cash flows. The $18 million cash interest paid is cash outflow from operating activities because interest is an income statement (operating) item. Brief Exercise 21-6 ($ in millions) Interest expense (10% x 1/2 x $380) 19 Discount on bonds payable 1 Cash (paid to bondholders) (9% x 1/2 x $400) 18 Agee would report the cash inflow of $380 million from the sale of the bonds as a cash inflow from financing activities in its statement of cash flows. The $1 million discount would be added back to net income as a noncash adjustment because the interest expense ($19 million) was subtracted in calculating net income and yet the cash interest paid was only $18 million. 8 Brief Exercise 21-7 Merit would report the cash inflow of $41 million from the borrowing as a cash inflow from financing activities in its statement of cash flows. Each installment payment includes both an amount that represents interest and an amount that represents a reduction of principal. In its statement of cash flows, then, Merit reports the interest portion ($2,870,000*) as a cash outflow from operating activities and the principal portion ($7,130,000*) as a cash outflow from financing activities. *December 31, 2006 Interest expense (7% x outstanding balance) ... 2,870,000 Note payable (difference) ........................... 7,130,000 Cash (given) .......................................... 10,000,000 Brief Exercise 21-8 ($ in millions) Cash ......................................................... 35 Gain on sale of land (difference) ............ 13 Land (cost) ........................................... 22 Morgan would report the cash inflow of $35 million from the sale as a cash inflow from investing activities in its statement of cash flows. The $13 million gain is not a cash flow and would not be reported when using the direct method. For that reason, when using the indirect method, the gain would be subtracted from net income (which includes the gain) to avoid double-counting it. 9 Brief Exercise 21-9 Cash Flows From Investing Activities: Proceeds from sale of marketable securities $30 Proceeds from sale of land 15 Purchase of equipment for cash (25) Purchase of patent (12) Net cash inflows from investing activities $ 8 Brief Exercise 21-10 Cash Flows From Financing Activities: Sale of common shares $40 Purchase of treasury stock (21) Net cash inflows from financing activities $19 10 Brief Exercise 21-11 Net income $90 Adjustments for noncash effects: Depreciation expense 3 Loss on sale of equipment 2 Increase in accounts receivable (1) Increase in accounts payable 4 Increase in inventory (3) Net cash flows from operating activities $95 Brief Exercise 21-12 Net income $60 Adjustments for noncash effects: Amortization expense 2 Gain on sale of equipment (1) Decrease in accounts receivable 2 Decrease in accounts payable (5) Decrease in inventory 4 Net cash flows from operating activities $62 11 EXERCISES Exercise 21-1 Example F 1. Sale of common stock I 2. Sale of land F 3. Purchase of treasury stock O 4. Merchandise sales F 5. Issuance of a long-term note payable O 6. Purchase of merchandise F 7. Repayment of note payable O 8. Employee salaries I 9. Sale of equipment at a gain F 10. Issuance of bonds I 11. Acquisition of bonds of another corporation O 12. Payment of semiannual interest on bonds payable F 13. Payment of a cash dividend I 14. Purchase of building I 15. Collection of nontrade note receivable (principal amount) I 16. Loan to another firm F 17. Retirement of common stock O 18. Income taxes F 19. Issuance of a short-term note payable I 20. Sale of a copyright 12 Exercise 21-2 Requirement 1 ($ in millions) Inventory _______________________________________ Beginning balance 90 Goods purchased 303 300 Cost of goods sold Ending balance 93 Accounts Payable _______________________________________ 14 Beginning balance Cash paid 301 303 Goods purchased 16 Ending balance Requirement 2 Summary Entry ($ in millions) Cost of goods sold 300 Inventory 3 Accounts payable 2 Cash (paid to suppliers of goods) 301 13 Exercise 21-3 ($ in millions) Situation Sales Accounts Bad debt Allowance for Cash received revenue receivable expense uncollectible from accounts customers increase increase (decrease) (decrease) 1 100 -0- -0- -0- 100 1. Summary Entry Cash (received from customers) 100 Sales revenue 100 2 100 5 -0- -0- 95 2. Summary Entry Cash (received from customers) 95 Accounts receivable 5 Sales revenue 100 3 100 (5) -0- -0- 105 3. Summary Entry Cash (received from customers) 105 Accounts receivable 5 Sales revenue 100 4 100 5 2 2 95 4. Summary Entry Cash (received from customers) 95 Accounts receivable 5 Bad debt expense 2 Allowance for uncollectible accounts 2 Sales revenue 100 14 Exercise 21-3 (concluded) Situation Sales Accounts Bad debt Allowance for Cash received revenue receivable expense uncollectible from accounts customers increase increase (decrease) (decrease) 5 100 (5) 2 1 104 5. Summary Entry Cash (received from customers) 104 Bad debt expense 2 Allowance for uncollectible accounts 1 Accounts receivable 5 Sales revenue 100 6 100 5 2 (1) 92 6. Summary Entry Cash (received from customers) 92 Bad debt expense 2 Allowance for uncollectible accounts 1 Accounts receivable 5 Sales revenue 100 15 Exercise 21-4 Situation Sales Accounts Bad debt Allowance for Cash received revenue receivable expense uncollectible from accounts customers increase increase (decrease) (decrease) 1 200 -0- -0- -0- 200 1. Summary Entry Cash (received from customers) 200 Sales revenue 200 2 200 10 -0- -0- 190 2. Summary Entry Cash (received from customers) 190 Accounts receivable 10 Sales revenue 200 3 200 10 4 4 190 3. Summary Entry Cash (received from customers) 190 Accounts receivable 10 Bad debt expense 4 Allowance for uncollectible accounts 4 Sales revenue 200 4 200 10 4 (2) 184 4. Summary Entry Cash (received from customers) 184 Accounts receivable 10 Bad debt expense 4 Allowance for uncollectible accounts 2 Sales revenue 200 16 Exercise 21-5 Cost of Accounts Cash paid to Situation goods sold Inventory payable suppliers increase (decrease) increase (decrease) 1 100 0 0 100 1. Summary Entry Cost of goods sold 100 Cash (paid to suppliers of goods) 100 2 100 3 0 103 2. Summary Entry Cost of goods sold 100 Inventory 3 Cash (paid to suppliers of goods) 103 3 100 (3) 0 97 3. Summary Entry Cost of goods sold 100 Inventory 3 Cash (paid to suppliers of goods) 97 4 100 0 7 93 4. Summary Entry Cost of goods sold 100 Accounts payable 7 Cash (paid to suppliers of goods) 93 5 100 0 (7) 107 5. Summary Entry Cost of goods sold 100 Accounts payable 7 Cash (paid to suppliers of goods) 107 17 Exercise 21-5 (concluded) Cost of Accounts Cash paid to Situation goods sold Inventory payable suppliers increase (decrease) increase (decrease) 6 100 3 7 96 6. Summary Entry Cost of goods sold 100 Inventory 3 Accounts payable 7 Cash (paid to suppliers of goods) 96 7 100 3 (7) 110 7. Summary Entry Cost of goods sold 100 Inventory 3 Accounts payable 7 Cash (paid to suppliers of goods) 110 8 100 (3) (7) 104 8. Summary Entry Cost of goods sold 100 Accounts payable 7 Inventory 3 Cash (paid to suppliers of goods) 104 9 100 (3) 7 90 9. Summary Entry Cost of goods sold 100 Inventory 3 Accounts payable 7 Cash (paid to suppliers of goods) 90 18 Exercise 21-6 Cost of Accounts Cash paid to Situation goods sold Inventory payable suppliers increase increase (decrease) (decrease) 1 200 0 0 200 1. Summary Entry Cost of goods sold 200 Cash (paid to suppliers of goods) 200 2 200 6 0 206 2. Summary Entry Cost of goods sold 200 Inventory 6 Cash (paid to suppliers of goods) 206 3 200 0 14 186 3. Summary Entry Cost of goods sold 200 Accounts payable 14 Cash (paid to suppliers of goods) 186 4 200 6 14 192 4. Summary Entry Cost of goods sold 200 Inventory 6 Accounts payable 14 Cash (paid to suppliers of goods) 192 5 200 (6) (14) 208 5. Summary Entry Cost of goods sold 200 Accounts payable 14 Inventory 6 Cash (paid to suppliers of goods) 208 19 Exercise 21-7 Bond interest Bond interest Unamortized Cash paid Situation expense payable discount for interest increase increase (decrease) (decrease) 1 10 0 0 10 1. Summary Entry Bond interest expense 10 Cash (paid to bondholders) 10 2 10 2 0 8 2. Summary Entry Bond interest expense 10 Bond interest payable 2 Cash (paid to bondholders) 8 3 10 (2) 0 12 3. Summary Entry Bond interest expense 10 Bond interest payable 2 Cash (paid to bondholders) 12 4 10 0 (3) 7 4. Summary Entry Bond interest expense 10 Discount on bonds payable 3 Cash (paid to bondholders) 7 20 Exercise 21-7 (concluded) Bond interest Bond interest Unamortized Cash paid Situation expense payable discount for interest increase increase (decrease) (decrease) 5 10 2 (3) 5 5. Summary Entry Bond interest expense 10 Bond interest payable 2 Discount on bonds payable 3 Cash (paid to bondholders) 5 6 10 (2) (3) 9 6. Summary Entry Bond interest expense 10 Bond interest payable 2 Discount on bonds payable 3 Cash (paid to bondholders) 9 21 Exercise 21-8 Bond interest Bond interest Unamortized Cash paid Situation expense payable discount for interest increase increase (decrease) (decrease) 1 20 0 0 20 1. Summary Entry Bond interest expense 20 Cash (paid to bondholders) 20 2 20 4 0 16 2. Summary Entry Bond interest expense 20 Bond interest payable 4 Cash (paid to bondholders) 16 3 20 0 (6) 14 3. Summary Entry Bond interest expense 20 Discount on bonds payable 6 Cash (paid to bondholders) 14 4 20 (4) (6) 18 4. Summary Entry Bond interest expense 20 Bond interest payable 4 Discount on bonds payable 6 Cash (paid to bondholders) 18 22 Exercise 21-9 Income Deferred tax Income tax tax Cash paid Situation expense payable liability for taxes increase increase (decrease) (decrease) 1 10 0 0 10 1. Summary Entry Income tax expense 10 Cash (paid for income taxes) 10 2 10 3 0 7 2. Summary Entry Income tax expense 10 Income tax payable 3 Cash (paid for income taxes) 7 3 10 (3) 0 13 3. Summary Entry Income tax expense 10 Income tax payable 3 Cash (paid for income taxes) 13 4 10 0 2 8 4. Summary Entry Income tax expense 10 Deferred income tax liability 2 Cash (paid for income taxes) 8 5 10 0 (2) 12 5. Summary Entry Income tax expense 10 Deferred income tax liability 2 Cash (paid for income taxes) 12 23 Exercise 21-9 (concluded) Income Deferred tax Income tax tax Cash paid Situation expense payable liability for taxes increase increase (decrease) (decrease) 6 10 3 2 5 6. Summary Entry Income tax expense 10 Income tax payable 3 Deferred income tax liability 2 Cash (paid for income taxes) 5 7 10 3 (2) 9 7. Summary Entry Income tax expense 10 Deferred income tax liability 2 Income tax payable 3 Cash (paid for income taxes) 9 8 10 (3) (2) 15 8. Summary Entry Income tax expense 10 Income tax payable 3 Deferred income tax liability 2 Cash (paid for income taxes) 15 9 10 (3) 2 11 9. Summary Entry Income tax expense 10 Income tax payable 3 Deferred income tax liability 2 Cash (paid for income taxes) 11 24 Exercise 21-10 Income Deferred tax Income tax tax Cash paid Situation expense payable liability for taxes increase (decrease) increase (decrease) 1 10 0 0 10 1. Summary Entry Income tax expense 10 Cash (paid for income taxes) 10 2 10 3 0 7 2. Summary Entry Income tax expense 10 Income tax payable 3 Cash (paid for income taxes) 7 3 10 0 (2) 12 3. Summary Entry Income tax expense 10 Deferred income tax liability 2 Cash (paid for income taxes) 12 4 10 3 2 5 4. Summary Entry Income tax expense 10 Income tax payable 3 Deferred income tax liability 2 Cash (paid for income taxes) 5 5 10 (3) (2) 15 5. Summary Entry Income tax expense 10 Income tax payable 3 Deferred income tax liability 2 Cash (paid for income taxes) 15 25 Exercise 21-11 Most would report the cash inflow of $566,589,440 from the sale of the bonds as a cash inflow from financing activities in its statement of cash flows. The $64,000,000 cash interest paid *, ** is a cash outflow from operating activities because interest is an income statement (operating) item. June 30, 2006* Interest expense (6% x $566,589,440) .................. 33,995,366 Discount on bonds payable (difference) ......... 1,995,366 Cash (5% x $640,000,000) ............................... 32,000,000 December 31, 2006** Interest expense (6% x [$566,589,440 + 1,995,366])34,115,088 Discount on bonds payable (difference) ......... 2,115,088 Cash (5% x $640,000,000) ............................... 32,000,000 26 Exercise 21-12 National would report the cash inflow of $4 million from the borrowing as a cash inflow from financing activities in its statement of cash flows. Each installment payment includes both an amount that represents interest and an amount that represents a reduction of principal. In its statement of cash flows, then, National reports the interest portion ($400,000*) as a cash outflow from operating activities and the principal portion ($861,881*) as a cash outflow from financing activities. *December 31, 2006 Interest expense (10% x outstanding balance) 400,000 Note payable (difference) .......................... 861,881 Cash (given) ......................................... 1,261,881 27 Exercise 21-13 Requirement 1 Cash Flows From Investing Activities: Proceeds from sale of land $ 12 Purchase of Microsoft common stock (160) Net cash outflows from investing activities $(148) Requirement 2 Cash Flows From Financing Activities: Payment for the early extinguishment of long-term bonds (carrying amount: $97 million) $(102) Proceeds from the sale of treasury stock (cost: $17 million) 22 Distribution of cash dividends declared in 2005 (40) Net cash outflows from financing activities $(120) 28 Exercise 21-14 Requirement 1 Cash Flows From Investing Activities: Proceeds from sale of equipment $ 8 Acquisition of building for cash (7) Purchase of marketable securities (not a cash equivalent) (5) Collection of note receivable with interest (principal amount) 11 Net cash inflows from investing activities $ 7 Requirement 2 Cash Flows From Financing Activities: Payment for the early extinguishment of long-term notes (book value: $50 million) $ (54) Sale of common shares 176 Retirement of common shares (122) Issuance of short-term note payable for cash 10 Distribution of cash dividends declared in 2005 (30) Net cash outflows from financing activities $ (20) 29 Exercise 21-15 Wilson would report the $3,000,000* investment in the commercial food processor and its financing with a capital lease as a significant noncash investing and financing activity in the disclosure notes to the financial statements. The $391,548 ($195,774 x 2) cash lease payments *, ** are divided into the interest portion and the principal portion. The interest portion, $84,127, is reported as cash outflows from operating activities. The principal portion, $195,774 + 111,647, is reported as cash outflows from financing activities. Note: By the indirect method of reporting cash flows from operating activities, Wilson would add back to net income the $150,000 depreciation expense since it didn’t actually reduce cash. The $84,127 interest expense that reduced net income actually did reduce cash [the interest portion of the $391,548 ($195,774 x 2) cash lease payments], so for it, no adjustment to net income is necessary. Calculations: September 30, 2006* Leased equipment (calculated below) ..................... 3,000,000 Lease payable (calculated below) ....................... 3,000,000 Lease payable ..................................................... 195,774 Cash (rental payment) ....................................... 195,774 Note: $195,774 x 15.3238t = $3,000,000 t present value of an annuity due of $1: n=20, i=3% December 31, 2006** Interest expense (3% x [$3 million – 195,774]) .......... 84,127 Lease payable (difference) ....................................... 111,647 Cash (lease payment) ......................................... 195,774 Depreciation expense ($3 million / 5 years x ¼ year) ... 150,000 Accumulated depreciation .............................. 150,000 30 Exercise 21-16 Investing Activities: Beilich would report the $600 million investment as a cash outflow among investing activities in its statement of cash flows. Operating Activities: By the direct method of reporting cash flows from operating activities, Beilich would report the $12 million cash dividend as a cash inflow from operating activities. By the indirect method of reporting cash flows from operating activities, Beilich would subtract from net income the $60 million investment revenue since it didn’t actually provide cash but would add the $12 million cash dividend. Alternatively, the company might just subtract the $48 million difference. 31 Exercise 21-17 RECONCILIATION OF NET INCOME TO NET CASH FLOWS FROM OPERATING ACTIVITIES Net income $50,000 Adjustments for noncash effects: Depreciation expense 7,000 Increase in inventory (1,500) Decrease in salaries payable (800) Decrease in accounts receivable 2,000 Amortization of patent 500 Decrease in bond premium (1,000) Increase in accounts payable 4,000 Net cash flows from operating activities $60,200 32 Exercise 21-18 ($ in millions) Net income closed to retained earnings Income summary ..................................................................................... 75 Retained earnings (given) ................................................ 75 The operating activities summarized by this transaction are identified individually when we explain the changes in the components of net income. But including the entry on the spreadsheet is helpful in partially explaining the change in retained earnings. Cash dividend Retained earnings (given) .................................................... 25 Cash ............................................................................................................ 25 This transaction identifies a $25 million cash outflow from financing activities. Stock dividend Retained earnings (given) .................................................... 16 Common stock (1 million shares at $1 par per share) ................ 1 Paid-in capital – excess of par (remainder) ........................ 15 This transaction does not represent a significant investing or financing activity, but including the entry on the spreadsheet is helpful in partially explaining changes in the balances of the three accounts affected. Property dividend Retained earnings (given) .................................................... 12 Short-term investments.................................................................... 12 This noncash transaction identifies both a $12 million financing activity (distribution of a dividend to shareholders) and a $12 million investing activity (disposition of an investment). Both are reported on the Statement of Cash Flows. 33 Exercise 21-18 (concluded) Sale of treasury shares Cash (difference)* .................................................................. 43 Retained earnings (given) .................................................... 10 Treasury stock (at cost, given) ............................................ 53 *This transaction identifies a $43 million cash inflow from financing activities. 34 Exercise 21-19 Income Statement Sales $600a Cost of goods sold 360b Salaries expense 78c Depreciation expense 18f Insurance expense 42d Loss on sale of land 12f Income tax expense 54e (564) Net Income $ 36 a Summary Entry Cash (received from customers) 612 Accounts receivable 12 Sales revenue 600 b Summary Entry Cost of goods sold 360 Inventory 24 Accounts payable 36 Cash (paid to suppliers of goods) 420 c Summary Entry Salaries expense 78 Salaries payable 12 Cash (paid to employees) 66 d Summary Entry Insurance expense 42 Prepaid insurance 18 Cash (paid for insurance) 24 e Summary Entry Income tax expense 54 Income tax payable 12 Cash (paid for income taxes) 42 f Depreciation expense and the loss on sale of land are noncash reductions in income. 35 Exercise 21-20 RECONCILIATION OF NET INCOME TO NET CASH FLOWS FROM OPERATING ACTIVITIES Net income $ 26 Adjustments for noncash effects: Increase in accounts receivable (54) Increase (decrease) in inventory 0 Increase in accounts payable 13 Increase in salaries payable 4 Decrease in prepaid insurance 6 Depreciation expense 11 Depletion expense 5 Decrease in bond discount 1 Gain on sale of equipment (25) Loss on sale of land 8 Increase in income tax payable 12 Net cash flows from operating activities $ 7 36 Exercise 21-21 Requirement 1: a. Summary Entry Cash (received from customers) 311 Accounts receivable 6 Sales revenue 305 b. Summary Entry Cost of goods sold 185 Inventory 13 Accounts payable 8 Cash (paid to suppliers of goods) 206 c. Summary Entry Salaries expense 41 Salaries payable 5 Cash (paid to employees) 36 d. Summary Entry Insurance expense 19 Prepaid insurance 9 Cash (paid for insurance) 10 e. Summary Entry Income tax expense 22 Income tax payable 20 Cash (paid for income taxes) 2 Depreciation expense and the loss on sale of land are not cash outflows. Requirement 2: Cash Flows from Operating Activities: Cash received from customers $311 Cash paid to suppliers (206) Cash paid to employees (36) Cash paid for insurance (10) Cash paid for income taxes (2) Net cash flows from operating activities $57 37 Exercise 21-22 RECONCILIATION OF NET INCOME TO NET CASH FLOWS FROM OPERATING ACTIVITIES Net loss $ (5,000) Adjustments for noncash effects: Depreciation expense 6,000 Increase in salaries payable 500 Decrease in accounts receivable 2,000 Increase in inventory (2,300) Amortization of patent 300 Reduction in discount on bonds 200 Net cash flows from operating activities $1,700 Exercise 21-23 Direct Method Cash Flows from Operating Activities: Cash received from customers $672 Cash paid to suppliers (234) Cash paid to employees (116) Cash paid for interest (15) Cash decrease from sale of cash equivalents (3) Cash paid for income taxes (81) Net cash flows from operating activities $223 38 Exercise 21-24 Indirect Method Cash Flows from Operating Activities: Net income $ 86 Adjustments for noncash effects: Decrease in accounts receivable 12 Decrease in inventory 10 Increase in accounts payable 6 Decrease in salaries payable (6) Increase in interest payable 5 Depreciation expense 90 Patent amortization expense 5 Extraordinary loss (earthquake damage) 10 Increase in income tax payable 5 Net cash flows from operating activities $223 39 Exercise 21-25 Direct Method Cash Flows from Operating Activities: Cash received from customers $1,332 a Cash decrease from sale of cash equivalents (6) Cash paid to suppliers (484)b Cash paid to employees (226)c Cash paid for interest (35)d Cash paid for income taxes (187)e Net cash flows from operating activities $ 394 Calculations using spreadsheet entries: a. Summary Entry Cash (received from customers) 1,332 Accounts receivable 12 Sales revenue 1,320 b. Summary Entry Cost of goods sold 500 Inventory 10 Accounts payable 6 Cash (paid to suppliers of goods) 484 c. Summary Entry Salaries expense 220 Salaries payable 6 Cash (paid to employees) 226 d. Summary Entry Interest expense 40 Interest payable 5 Cash (paid for interest) 35 e. Summary Entry Income tax expense 182 Tax on E.O. gain 10 Income tax payable 5 Cash (paid for income taxes) 187 Depreciation expense, patent amortization, and the gain on early extinguishment of debt are not cash flows. 40 Exercise 21-26 Indirect Method Cash Flows From Operating Activities: Net income $192 Adjustments for noncash effects: Depreciation expense 180 Patent amortization expense 10 Extraordinary gain (sale of subsidiary) (20) Decrease in accounts receivable 12 Decrease in inventory 10 Increase in accounts payable 6 Decrease in salaries payable (6) Increase in interest payable 5 Increase in income tax payable 5 Net cash flows from operating activities $394 41 Exercise 21-27 Red, Inc. Spreadsheet for the Statement of Cash Flows Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Balance Sheet Assets: Cash 110 (11) 86 24 Accounts receivable 132 (1) 46 178 Prepaid insurance 3 (4) 4 7 Inventory 175 (2) 110 285 Buildings and equipment 350 (6) 230 (7) 180 400 Less: Acc. depreciation (240) (7) 171 (3) 50 (119) 530 775 Liabilities: Accounts payable 100 (2) 13 87 Accrued expenses payable 11 (4) 5 6 Notes payable 0 (8) 50 50 Bonds payable 0 (10) 160 160 Shareholders' Equity: Common stock 400 400 Retained earnings 19 (9) 50 (5) 103 72 530 775 Income Statement Revenues: Sales revenue (1) 2,000 2,000 Expenses: Cost of goods sold (2) 1,400 1,400 Depreciation expense (3) 50 50 Operating expenses (4) 447 447 Net income (5) 103 103 42 Exercise 21-27 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Cash Flows Operating activities: Cash inflows: From customers (1) 1,954 Cash outflows: To suppliers of goods (2) 1,523 For operating expenses (4) 456 Net cash flows (25) Investing activities: Purchase of equipment (6) 230 Sale of equipment (7) 9 Net cash flows (221) Financing activities: Issuance of note payable (8) 50 Payment of cash dividends (9) 50 Issuance of bonds payable (10) 160 Net cash flows 160 Net decrease in cash (11) 86 (86) Totals 4,888 4,888 43 Exercise 21-27 (concluded) Red, Inc. Statement of Cash Flows For year ended December 31, 2006 ($ in millions) Cash flows from operating activities: Cash inflows: From customers $1,954 Cash outflows: To suppliers of goods (1,523) For operating expenses (456) Net cash flows from operating activities $(25) Cash flows from investing activities: Purchase of equipment (230) Sale of equipment 9 Net cash flows from investing activities (221) Cash flows from financing activities: Issuance of note payable 50 Issuance of bonds payable 160 Payment of cash dividends (50) Net cash flows from financing activities 160 Net decrease in cash (86) Cash balance, January 1 110 Cash balance, December 31 $ 24 44 Exercise 21-28 Pension expense (given) 82 Prepaid (accrued) pension cost (difference between beginning credit balance and ending debit balance) 6 Cash (paid to the pension trustee) 88 Exercise 21-29 1. c 2. a 3. d 45 Exercise 21-30 Red, Inc. Spreadsheet for the Statement of Cash Flows Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Balance Sheet Assets: Cash 110 (13) 86 24 Accounts receivable 132 (3) 46 178 Prepaid insurance 3 (4) 4 7 Inventory 175 (5) 110 285 Buildings and equipment 350 (8) 230 (9) 180 400 Less: Acc. depreciation (240) (9) 171 (2) 50 (119) 530 775 Liabilities: Accounts payable 100 (6) 13 87 Accrued expenses payable 11 (7) 5 6 Notes payable 0 (10) 50 50 Bonds payable 0 (11) 160 160 Shareholders' Equity: Common stock 400 400 Retained earnings 19 (12) 50 (1) 103 72 530 775 46 Exercise 21-30 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Cash Flows Net income (1) 103 Adjustments for noncash effects: Depreciation expense (2) 50 Increase in accounts receivable (3) 46 Increase in prepaid insurance (4) 4 Increase in inventory (5) 110 Decrease in accounts payable (6) 13 Decrease in accrued expenses (7) 5 Net cash flows (25) Investing activities: Purchase of equipment (8) 230 Sale of equipment (9) 9 Net cash flows (221) Financing activities: Issuance of note payable (10) 50 Issuance of bonds payable (11) 160 Payment of cash dividends (12) 50 Net cash flows 160 Net decrease in cash (13) 86 (86) Totals 1,087 1,087 47 Exercise 21-30 (concluded) Red, Inc. Statement of Cash Flows For year ended December 31, 2006 ($ in millions) Cash flows from operating activities: Net income $ 103 Adjustments for noncash effects: Depreciation expense 50 Increase in accounts receivable (46) Increase in prepaid insurance (4) Increase in inventory (110) Decrease in accounts payable (13) Decrease in accrued expenses payable (5) Net cash flows from operating activities $ (25) Cash flows from investing activities: Purchase of equipment (230) Sale of equipment 9 Net cash flows from investing activities (221) Cash flows from financing activities: Issuance of note payable 50 Issuance of bonds payable 160 Payment of cash dividends (50) Net cash flows from financing activities 160 Net decrease in cash (86) Cash balance, January 1 110 Cash balance, December 31 $ 24 48 Exercise 21-31 1. d. Under SFAS 95, a statement of cash flows should report as operating activities all transactions and other events not classified as investing or financing activities. In general, the cash flows from transactions and other events that enter into the determination of income are to be classified as operating. Distributions to owners (cash dividends on a company’s own stock) are cash flows from financing, not operating, activities. 2. a. Investing activities include the lending of money and the collecting of those loans, and the acquisition, sale, or other disposal of securities that are not cash equivalents and of productive assets that are expected to generate revenue over a long period of time. Investing activities include the purchase of machinery and the sale of a building. The net inflow from these activities is $700,000 ($1,200,000 - $500,000). Financing activities include the issuance of preferred stock and the payment of dividends. The net inflow is $3,600,000 ($4,000,000 - $400,000). The conversion of bonds into common stock and the stock dividend do not affect cash. 3. c. Net operating cash flow may be determined by adjusting net income. Depreciation is an expense not directly affecting cash flows that should be added back to net income. The increase in accounts payable is added to net income because it indicates that an expense has been recorded but not paid. The gain on the sale of land is an inflow from an investing, not an operating, activity and should be subtracted from net income. The dividends paid on preferred stock are cash outflows from financing, not operating, activities and do not require an adjustment. Thus, net cash flow from operations is $4,600,000 ($3,000,000 + $1,500,000 - $200,000 + $300,000). 49 Exercise 21-32 BALANCE SHEET ACCOUNTS Cash (Statement of Cash Flows ) ______________________________________________________ 86 Operating Activities: From customers (1) 1,954 1,523 (2) To suppliers 456 (4) For expenses Investing Activities: 230 (6) Purchase of equipment Sale of equipment (7) 9 Financing Activities: Issuance of notes (8) 50 50 (9) Payment of dividends Issuance of bonds (10) 160 Accounts Receivable Prepaid Insurance ______________________ ______________________ 46 4 ________ ________ (1) 46 (4) 4 Inventory Buildings and Equipment ______________________ ______________________ 110 50 ________ ________ (2) 110 (6) 230 180 (7) Accumulated Depreciation Accounts Payable ______________________ ______________________ 121 13 ________ ________ (7) 171 50 (3) (2) 13 50 Exercise 21-32 (continued) Accrued Expenses Payable Notes Payable ______________________ ______________________ 5 50 ________ ________ (4) 5 50 (8) Bonds Payable Retained Earnings ______________________ ______________________ 160 53 ________ ________ 160 (10) (9) 50 103 (5) INCOME STATEMENT ACCOUNTS Sales Cost of Goods Sold ______________________ ______________________ 2,000 1,400 2,000 (1) (2) 1,400 Depreciation Expense Operating Expenses ______________________ ______________________ 50 447 ________ ________ (3) 50 (4) 447 Net Income (Income Summary) ______________________ 103 ________ (5) 103 51 Exercise 21-32 (concluded) Red, Inc. Statement of Cash Flows For year ended December 31, 2006 ($ in millions) Cash flows from operating activities: Cash inflows: From customers $1,954 Cash outflows: To suppliers of goods (1,523) For operating expenses (456) Net cash flows from operating activities $(25) Cash flows from investing activities: Purchase of equipment (230) Sale of equipment 9 Net cash flows from investing activities (221) Cash flows from financing activities: Issuance of note payable 50 Issuance of bonds payable 160 Payment of cash dividends (50) Net cash flows from financing activities 160 Net decrease in cash (86) Cash balance, January 1 110 Cash balance, December 31 $ 24 52 PROBLEMS Problem 21-1 Classifications + I Investing activity (cash inflow) – I Investing activity (cash outflow + F Financing activity (cash inflow) – F Financing activity (cash outflow) N Noncash investing and financing activity X Not reported as an investing and/or a financing activity Transactions Example + I 1. Sale of land + F 2. Issuance of common stock for cash - F 3. Purchase of treasury stock N 4. Conversion of bonds payable to common stock N 5. Lease of equipment by capital lease + I 6. Sale of patent - I 7. Acquisition of building for cash N 8. Issuance of common stock for land + I 9. Collection of note receivable (principal amount) + F 10. Issuance of bonds X 11. Issuance of stock dividend N 12. Payment of property dividend - F 13. Payment of cash dividends + F 14. Issuance of short-term note payable for cash + F 15. Issuance of long-term note payable for cash - I 16. Purchase of marketable securities (not cash equivalent) - F 17. Payment of note payable X 18. Cash payment for 5-year insurance policy + I 19. Sale of equipment N 20. Issuance of note payable for equipment - I 21. Acquisition of common stock of another corporation N 22. Repayment of long-term debt by issuing common stock X 23. Appropriation of retained earnings for plant expansion X 24. Payment of semiannual interest on bonds payable - F 25. Retirement of preferred stock - I 26. Loan to another firm X 27. Sale of inventory to customers X 28. Purchase of marketable securities (cash equivalents) 53 Problem 21-2 Wright Company Spreadsheet for the Statement of Cash Flows Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Balance Sheet Assets: Cash 30 (15) 12 42 Accounts receivable 75 (1) 2 73 Short-term investment 15 (9) 25 40 Inventory 70 (2) 5 75 Land 60 (6) 10 50 Buildings and equipment 400 (10) 150 550 Less: Acc. depreciation (75) (4) 40 (115) 575 715 Liabilities: Accounts payable 35 (2) 7 28 Salaries payable 5 (3) 3 2 Interest payable 3 (5) 2 5 Income tax payable 12 (7) 3 9 Notes payable 30 (11) 30 0 Bonds payable 100 (12) 60 160 Shareholders' Equity: Common stock 200 (13) 50 250 Paid-in capital-ex. of par 100 (13) 26 126 Retained earnings 90 (14) 35 (8) 80 135 575 715 Statement of Income Revenues: Sales revenue (1) 380 380 Expenses: Cost of goods sold (2) 130 (130) Salaries expense (3) 45 (45) Depreciation expense (4) 40 (40) Interest expense (5) 12 (12) Loss on sale of land (6) 3 (3) Income tax expense (7) 70 (70) Net income (8) 80 80 54 Problem 21-2 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Cash Flows Operating activities: Cash inflows: From customers (1) 382 Cash outflows: To suppliers of goods (2) 142 To employees (3) 48 For interest expense (5) 10 For income taxes (7) 73 Net cash flows 109 Investing activities: Sale of land (6) 7 Purchase of ST investment (9) 25 Purchase of equipment (10) 150 Net cash flows (168) Financing activities: Repayment of notes payable (11) 30 Sale of bonds payable (12) 60 Sale of common stock (13) 76 Payment of cash dividends (14) 35 Net cash flows 71 Net increase in cash (15) 12 12 Totals 1,175 1,175 55 Problem 21-2 (concluded) Wright Company Statement of Cash Flows For year ended December 31, 2006 (in $000) Cash flows from operating activities: Cash inflows: From customers $382 Cash outflows: To suppliers of goods (142) To employees (48) For interest expense (10) For income taxes (73) Net cash flows from operating activities $109 Cash flows from investing activities: Sale of land 7 Purchase of short-term investment (25) Purchase of equipment (150) Net cash flows from investing activities (168) Cash flows from financing activities: Repayment of notes payable (30) Sale of bonds payable 60 Sale of common stock 76 Payment of cash dividends (35) Net cash flows from financing activities 71 Net increase in cash 12 Cash balance, January 1 30 Cash balance, December 31 $ 42 56 Problem 21-3 National Intercable Company Spreadsheet for the Statement of Cash Flows Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Balance Sheet Assets: Cash 55 (18) 17 72 Accounts receivable 170 (1) 11 181 Less: Allowance (6) (1) 2 (8) Prepaid insurance 12 (8) 5 7 Inventory 165 (4) 5 170 Long-term investment 90 (2) 6 (3) 30 66 Land 150 150 Buildings and equipment 270 (13) 80 X (11) 60 290 Less: Acc. depreciation (75) (11) 15 (6) 25 (85) Trademark 25 (7) 1 24 856 867 Liabilities: Accounts payable 45 (4) 15 30 Salaries payable 8 (5) 5 3 Deferred tax liability 15 (10) 3 18 Lease liability 0 X (13) 80 80 Bonds payable 275 (14) 130 145 Less: Discount (25) (9) 3 (22) Shareholders' Equity: Common stock 290 (15) 20 310 Paid-in capital-ex of par 85 (15) 10 95 Preferred stock 0 (16) 50 50 Retained earnings 163 (17) 30 (12) 25 158 856 867 X Noncash investing and financing activity 57 Problem 21-3 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Income Revenues: Sales revenue (1) 320 320 Investment revenue (2) 15 15 Gain on sale of investments (3) 5 5 Expenses: Cost of goods sold (4) 125 (125) Salaries expense (5) 55 (55) Depreciation expense (6) 25 (25) Trademark amortization (7) 1 (1) Bad debt expense (1) 7 (7) Insurance expense (8) 13 (13) Bond interest expense (9) 30 (30) Income tax expense (10) 38 (38) Extraordinary loss (tornado) (11) 42 (42) Less: Tax savings (10) 21 21 Net income (12) 25 25 58 Problem 21-3 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Cash Flows Operating activities: Cash inflows: From customers (1) 304 From investment revenue (2) 9 Cash outflows: To suppliers of goods (4) 145 To employees (5) 60 For insurance expense (8) 8 For bond interest expense (9) 27 For income taxes (10) 14 Net cash flows 59 Investing activities: Sale of long-term investment (3) 35 Sale of building parts (11) 3 Net cash flows 38 Financing activities: Retirement of bonds payable (14) 130 Sale of common stock (15) 30 Sale of preferred stock (16) 50 Payment of cash dividends (17) 30 Net cash flows (80) Net increase in cash (18) 17 17 ____ ____ Totals 1,106 1,106 59 Problem 21-3 (concluded) National Intercable Company Statement of Cash Flows For year ended December 31, 2006 ($ in millions) Cash flows from operating activities: Cash inflows: From customers $304 From investment revenue 9 Cash outflows: To suppliers of goods (145) To employees (60) For insurance expense (8) For bond interest expense (27) For income taxes (14) Net cash flows from operating activities $ 59 Cash flows from investing activities: Sale of building parts 3 Sale of long-term investment 35 Net cash flows from investing activities 38 Cash flows from financing activities: Retirement of bonds payable (130) Sale of common stock 30 Sale of preferred stock 50 Payment of cash dividends (30) Net cash flows from financing activities (80) Net increase in cash 17 Cash balance, January 1 55 Cash balance, December 31 $ 72 Noncash investing and financing activities: Acquired $80 million of equipment by 7-year capital lease. 60 Problem 21-4 Dux Company Spreadsheet for the Statement of Cash Flows Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Balance Sheet Assets: Cash 20 (17) 13 33 Accounts receivable 50 (1) 2 48 Less: Allowance (3) (1) 1 (4) Dividends receivable 2 (2) 1 3 Inventory 50 (3) 5 55 Long-term investment 10 (10) 5 15 Land 40 (11) 30 X 70 Buildings and equipment 250 (12) 15 (7) 40 225 Less: Acc. depreciation (50) (7) 30 (5) 5 (25) 369 420 Liabilities: Accounts payable 20 (3) 7 13 Salaries payable 5 (4) 3 2 Interest payable 2 (6) 2 4 Income tax payable 8 (8) 1 7 Notes payable 0 X (11) 30 30 Bonds payable 70 (13) 25 95 Less: Discount on bonds (3) (6) 1 (2) Shareholders' Equity: Common stock 200 (14) 10 210 Paid-in capital-ex. of par 20 (14) 4 24 Retained earnings 47 (14) 14 (15) 13 (9) 25 45 Less: Treasury stock 0 (16) 8 (8) 369 420 X Noncash investing and financing activity 61 Problem 21-4 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Income Revenues: Sales revenue (1) 200 200 Dividend revenue (2) 3 3 Expenses: Cost of goods sold (3) 120 (120) Salaries expense (4) 25 (25) Depreciation expense (5) 5 (5) Bad debt expense (1) 1 (1) Interest expense (6) 8 (8) Loss on sale of building (7) 3 (3) Income tax expense (8) 16 (16) Net income (9) 25 25 Statement of Cash Flows Operating activities: Cash inflows: From customers (1) 202 From dividends received (2) 2 Cash outflows: To suppliers of goods (3) 132 To employees (4) 28 For interest expense (6) 5 For income taxes (8) 17 Net cash flows 22 Investing activities: Sale of building (7) 7 Purchase of LT investment (10) 5 Purchase of equipment (12) 15 Net cash flows (13) Financing activities: Sale of bonds payable (13) 25 Payment of cash dividends (15) 13 Purchase of treasury stock (16) 8 Net cash flows 4 Net increase in cash (17) 13 13 Totals 584 584 62 Problem 21-4 (concluded) Dux Company Statement of Cash Flows For year ended December 31, 2006 ($ in 000s) Cash flows from operating activities: Cash inflows: From customers $202 From dividends received 2 Cash outflows: To suppliers of goods (132) To employees (28) For interest expense (5) For income taxes (17) Net cash flows from operating activities $22 Cash flows from investing activities: Sale of building 7 Purchase of long-term investment (5) Purchase of equipment (15) Net cash flows from investing activities (13) Cash flows from financing activities: Sale of bonds payable 25 Payment of cash dividends (13) Purchase of treasury stock (8) Net cash flows from financing activities 4 Net increase in cash 13 Cash balance, January 1 20 Cash balance, December 31 $33 Noncash investing and financing activities: Acquired $30,000 of land by issuing a 13%, 7-year note. $30 63 Problem 21-5 Metagrobolize Industries Spreadsheet for the Statement of Cash Flows Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Balance Sheet Assets: Cash 375 (14) 225 600 Accounts receivable 450 (1) 150 600 Inventory 525 (4) 375 900 Land 600 (2) 150 X (3) 75 675 Building 900 900 Less: Acc. depreciation (270) (5) 30 (300) Equipment 2,250 (11) 900 (7) 300 2,850 Less: Acc. depreciation (480) (7) 270 (6) 315 (525) Patent 1,500 (8) 300 1,200 5,850 6,900 Liabilities: Accounts payable 450 (4) 300 750 Accrued expenses 225 (9) 75 300 Lease liability – land 0 X (2) 150 150 Shareholders' Equity: Common stock 3,000 (12) 150 3,150 Paid-in capital-ex. of par 675 (12) 75 750 Retained earnings 1,500 (12) 225 (10) 975 (13) 450 1,800 5,850 6,900 Income Statement Revenues: Sales revenue (1) 2,645 2,645 Gain on sale of land (3) 90 90 Expenses: Cost of goods sold (4) 600 (600) Depreciation expense-build. (5) 30 (30) Depreciation expense-equip. (6) 315 (315) Loss on sale of equipment (7) 15 (15) Amortization of patent (8) 300 (300) Operating expenses (9) 500 (500) Net income (10) 975 975 64 Problem 21-5 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Cash Flows Operating activities: Cash inflows: From customers (1) 2,495 Cash outflows: To suppliers of goods (4) 675 For operating expenses (9) 425 Net cash flows 1,395 Investing activities: Purchase of equipment (11) 900 Sale of land (3) 165 Sale of equipment (7) 15 Net cash flows (720) Financing activities: Payment of cash dividends (13) 450 Net cash flows (450) Net increase in cash (14) 225 225 Totals 8,155 8,155 X Noncash investing and financing activity 65 Problem 21-5 (concluded) Metagrobolize Industries Statement of Cash Flows For year ended December 31, 2006 ($ in 000) Cash flows from operating activities: Cash inflows: From customers $2,495 Cash outflows: To suppliers of goods (675) For operating expenses (425) Net cash flows from operating activities $1,395 Cash flows from investing activities: Purchase of equipment (900) Sale of land 165 Sale of equipment 15 Net cash flows from investing activities (720) Cash flows from financing activities: Payment of cash dividends (450) Net cash flows from financing activities (450) Net increase in cash 225 Cash balance, January 1 375 Cash balance, December 31 $ 600 Noncash investing and financing activities: Land acquired by capital lease $150 66 Problem 21-6 Requirement 1 a. Summary Entry Cash (received from customers) 153 Bad debt expense 2 Accounts receivable 3 Allowance for uncollectible accts. 2 Sales revenue 150 b. Summary Entry Cost of goods sold 90 Inventory 6 Accounts payable 9 Cash (paid to suppliers of goods) 87 c. Summary Entry Salaries expense 20 Salaries payable 3 Cash (paid to employees) 17 d. Summary Entry Interest expense 6 Discount on bonds payable 3 Cash (paid for interest) 3 e. Summary Entry Insurance expense 10 Prepaid insurance 2 Cash (paid for insurance ) 8 f. Summary Entry Income tax expense 13 Income tax payable 6 Cash (paid for income taxes) 7 Depreciation expense, bad debt expense, the gain on sale of equipment, and the loss on sale of land are not cash outflows. 67 Problem 21-6 (concluded) Requirement 2 Cash Flows From Operating Activities: Cash received from customers $153 Cash paid to suppliers (87) Cash paid to employees (17) Cash paid for interest (3) Cash paid for insurance (8) Cash paid for income taxes (7) Net cash flows from operating activities $ 31 68 Problem 21-7 Cash Flows from Operating Activities: Cash received from customers $316a Cash increase from sale of cash equivalents 2b Cash paid to suppliers (114)c Cash paid to employees (34)d Cash paid for interest (11)e Cash paid for insurance (16)f Cash paid for income taxes (52)g Net cash flows from operating activities $ 91 a. Summary Entry Cash (received from customers) 316 Accounts receivable 6 Sales revenue 310 b. The gain on sale of cash equivalents indicates that total cash increased as a result of converting cash in one form (say a $10 million treasury bill) to cash in another form (checking account)*: Summary Entry Cash [checking account] 12 Gain on sale of cash equivalents 2 Cash [treasury bill] 10 [*Any other example you think of that involves a gain on sale of cash equivalents would work as well.] c. Summary Entry Cost of goods sold 120 Inventory 12 Accounts payable 18 Cash (paid to suppliers of goods) 114 d. Summary Entry Salaries expense 40 Salaries payable 6 Cash (paid to employees) 34 e. Summary Entry Interest expense 12 Discount on bonds payable 1 Cash (paid for interest) 11 69 Problem 21-7 (concluded) f. Summary Entry Insurance expense 20 Prepaid insurance 4 Cash (paid for insurance ) 16 g. Summary Entry Income tax expense [on ordinary income] 50 Income tax expense - on extraordinary gain 12 Income tax payable 10 Cash (paid for income taxes) 52 Depreciation expense, patent amortization expense, the loss on sale of land, and the gain are neither cash inflows nor outflows. 70 Problem 21-8 Direct Method Cash Flows From Operating Activities: Cash received from customers $692 Cash paid to suppliers (103) Cash paid to employees (111) Cash paid for insurance (18) Cash paid for interest (40) Cash paid for income taxes (70) Net cash flows from operating activities $350 Indirect Method Cash Flows From Operating Activities: Net income $ 88 Adjustments for noncash effects: Increase in accounts receivable (108) Decrease in inventory 104 Increase in accounts payable 93 Increase in salaries payable 9 Decrease in prepaid insurance 22 Depreciation expense 123 Decrease in bond discount 10 Gain on sale of buildings (11) Loss on sale of machinery 12 Deferred income tax liability 8 Net cash flows from operating activities $350 71 Problem 21-9 Direct Method Cash Flows From Operating Activities: Cash received from customers $914 Cash increase from sale of cash equivalents 4 Cash paid to suppliers (384) Cash paid to employees (228) Cash paid for interest (35) Cash paid for income taxes (54) Net cash flows from operating activities $217 Indirect Method Cash Flows From Operating Activities: Net income $ 40 Adjustments for noncash effects: Decrease in accounts receivable 14 Increase in inventory (10) Decrease in accounts payable (24) Decrease in salaries payable (8) Increase in interest payable 5 Depreciation expense 190 Bad debt expense 12 Extraordinary loss (flood damage) 12 Decrease in income tax payable (14) Net cash flows from operating activities $217 Problem 21-10 1. Cash received from customers $306 2. Cost of goods sold $180 3. ? in salaries payable Increase 4. Cash paid for depreciation 0 [Not reported – no cash effect] 5. Interest expense $12 6. Cash paid for insurance $12 7. Increase in income tax payable $6 8. Net income $27 72 Problem 21-11 Arduous Company Spreadsheet for the Statement of Cash Flows Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Balance Sheet Assets: Cash 81 (21) 35 116 Accounts receivable 202 (1) 2 200 Less: Allowance (8) (1) 2 (10) Investment rev. receivable 4 (2) 2 6 Inventory 200 (4) 5 205 Prepaid insurance 8 (8) 4 4 Long-term investment 125 (2) 6 (13) 25 156 Land 150 (14) 46 X 196 Buildings and equipment 400 (15) 82 X (11) 70 412 Less: Acc. depreciation (120) (11) 35 (6) 12 (97) Patent 32 (7) 2 30 1,074 1,218 Liabilities: Accounts payable 65 (4) 15 50 Salaries payable 11 (5) 5 6 Bond interest payable 4 (9) 4 8 Income tax payable 14 (10) 2 12 Deferred tax liability 8 (10) 3 11 Notes payable 0 X (14) 23 23 Lease liability 0 X (15) 82 82 Bonds payable 275 (16) 60 215 Less: Discount (25) (9) 3 (22) Shareholders' Equity: Common stock 410 (17) 20 430 Paid-in capital-ex. of par 85 (17) 10 95 Preferred stock 0 (18) 75 75 Retained earnings 227 (17) 30 (19) 22 (12) 67 242 Less: Treasury stock 0 (20) 9 (9) 1,074 1,218 73 Problem 21-11 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Income Revenues: Sales revenue (1) 410 410 Investment revenue (2) 11 11 Gain on sale of treasury bills (3) 2 2 Expenses: Cost of goods sold (4) 180 (180) Salaries expense (5) 65 (65) Depreciation expense (6) 12 (12) Patent amortization expense (7) 2 (2) Bad debt expense (1) 8 (8) Insurance expense (8) 7 (7) Bond interest expense (9) 28 (28) Income tax expense (10) 45 (45) Extraordinary loss (flood) (11) 18 (18) Less: Tax savings (10) 9 9 Net income (12) 67 67 X Noncash investing and financing activity 74 Problem 21-11 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Cash Flows Operating activities: Cash inflows: From customers (1) 406 From investment revenue (2) 3 From sale of cash equivalents (3) 2 Cash outflows: To suppliers of goods (4) 200 To employees (5) 70 For insurance expense (8) 3 For bond interest expense (9) 21 For income taxes (10) 35 Net cash flows 82 Investing activities: Sale of machine components (11) 17 Purchase of LT investment (13) 25 Purchase of land (14) 23 Net cash flows (31) Financing activities: Retirement of bonds payable (16) 60 Sale of preferred stock (18) 75 Payment of cash dividends (19) 22 Purchase of treasury stock (20) 9 Net cash flows (16) Net increase in cash (21) 35 35 Totals 1,314 1,314 75 Problem 21-11 (concluded) Arduous Company Statement of Cash Flows For year ended December 31, 2006 ($ in millions) Cash flows from operating activities: Cash inflows: From customers $406 From investment revenue 3 From sale of cash equivalents 2 Cash outflows: To suppliers of goods (200) To employees (70) For insurance expense (3) For bond interest expense (21) For income taxes (35) Net cash flows from operating activities $ 82 Cash flows from investing activities: Sale of machine components 17 Purchase of long-term investment (25) Purchase of land (23) Net cash flows from investing activities (31) Cash flows from financing activities: Retirement of bonds payable (60) Sale of preferred stock 75 Payment of cash dividends (22) Purchase of treasury stock (9) Net cash flows from financing activities (16) Net increase in cash 35 Cash balance, January 1 81 Cash balance, December 31 $116 Noncash investing and financing activities: Acquired $82 million building by 15-year capital lease. Acquired $46 million of land by issuing cash and a 15%, 4-year note as follows: Cost of land $46 Cash paid 23 76 Note issued $23 77 Problem 21-12 Requirement 1 Retirement of common shares ($ in millions) Common stock (5 million shares x $1 par per share) .............................. 5 Paid-in capital – excess of par ($22 – 5 – 2) .................................. 15 Retained earnings (given) ............................................................ 2 Cash (given)* ........................................................................... 22 *This transaction identifies a $22 million cash outflow from financing activities. Net income closed to retained earnings Income summary ............................................................................................... 88 Retained earnings (given) ........................................................ 88 *The operating activities summarized by this transaction are identified individually when we explain the changes in the components of net income. But including the entry on the spreadsheet is helpful in partially explaining change in retained earnings. Declaration of a cash dividend Retained earnings (given) ............................................................ 33 Cash ...................................................................................................................... 33 *This transaction identifies a $33 million cash outflow from financing activities. Declaration of a stock dividend Retained earnings (given) ............................................................ 20 Common stock ([105-5] x 4%) million shares at $1 par per share) ........... 4 Paid-in capital – excess of par (difference) ................................ 16 *This transaction does not represent a significant investing nor financing activity, but including the entry on the spreadsheet is helpful in partially explaining changes in the balances of the two accounts affected. 78 Problem 21-12 (concluded) Requirement 2 Brenner-Jude Corporation Statements of Retained Earnings FOR THE YEAR ENDED DECEMBER 31, 2006 ($ in millions) Balance at January 1 $ 90 Net income for the year 88 Deductions: Retirement of common stock (2) Cash dividends of $.33 per share (33) 4% stock dividend (20) Balance at December 31 $123 79 Problem 21-13 Amount Category 1. Cash collections from customers (direct method). $145,0001 O 2. Payments for purchase of property, plant, and equipment. $ 50,0002 I 3. Proceeds from sale of equipment. $ 31,0003 I 4. Cash dividends paid. $ 12,0004 F 5. Redemption of bonds payable. $ 17,0005 F 1 Summary Entry Cash (received from customers) 145,000 Accounts receivable ($34,000 - 24,000) 10,000 Sales revenue (given) 155,000 2P, P, & E _______________________________________________________________ Beginning balance 247 Acquired with B/P 20 40 Equipment sold Purchased ? ____________ Ending balance 277 $277,000 + 40,000 - 247,000 - 20,000 = $50,000 3 Summary Entry Cash (sale of equipment) 31,000 Accumulated depreciation (determined below) 22,000 P, P, & E (given) 40,000 Gain on sale of equipment (given) 13,000 Accumulated Depreciation _______________________________________________________________ 167 Beginning balance 33 Depreciation expense Equipment sold ? ____________ 178 Ending balance $167,000 + 33,000 - 178,000 = $22,000 80 Problem 21-13 (concluded) 4 Summary Entry Retained earnings (determined below) 15,000 Dividends payable ($8,000 - 5,000) 3,000 Cash (paid for dividends) 12,000 Retained Earnings _______________________________________________________________ 91 Beginning balance 28 Net income Dividends declared ? ____________ 104 Ending balance $91,000 + 28,000 - 104,000 = $15,000 5 Summary Entry Bonds payable (determined below) 17,000 Cash 17,000 Bonds payable _______________________________________________________________ 46 Beginning balance 20 Issued for P, P, & E Bonds redeemed ? ____________ 49 Ending balance $46,000 + 20,000 - 49,000 = $17,000 81 Problem 21-14 Surmise Company Spreadsheet for the Statement of Cash Flows Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Balance Sheet Assets: Cash 40 (16) 5 45 Accounts receivable 96 (5) 4 92 Less: Allowance (4) (3) 8 (12) Prepaid expenses 5 (8) 3 8 Inventory 130 (6) 15 145 Long-term investment 40 (10) 40 80 Land 100 100 Buildings and equip. 300 (11) 111 X 411 Less: Acc. depreciation (120) (2) 22 (142) Patent 17 (4) 1 16 604 743 Liabilities: Accounts payable 32 (7) 15 17 Accrued liabilities 10 (9) 12 (2) Notes payable 0 (12) 35 35 Lease liability 0 X (11) 111 111 Bonds payable 125 (13) 60 65 Shareholders' Equity: Common stock 50 (14) 10 60 Paid-in capital-ex. of par 205 (14) 40 245 Retained earnings 182 (15) 20 (1) 50 212 604 743 X Noncash investing and financing activity 82 Problem 21-14 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Cash Flows Operating activities: Net income (1) 50 Adjustments for noncash effects: Depreciation expense (2) 22 Bad debt expense (3) 8 Patent amortization expense (4) 1 Decrease in accounts receivable (5) 4 Increase in inventory (6) 15 Decrease in accounts payable (7) 15 Increase in prepaid expenses (8) 3 Decrease in accrued liabilities (9) 12 Net cash flows 40 Investing activities: Purchase of LT investment (10) 40 Net cash flows (40) Financing activities: Issuance of note payable (12) 35 Retirement of bonds payable (13) 60 Sale of common stock (14) 50 Payment of cash dividends (15) 20 Net cash flows 5 Net increase in cash __ (16) 5 5 Totals 451 451 83 Problem 21-14 (concluded) Surmise Company Statement of Cash Flows For year ended December 31, 2006 ($ in millions) Cash flows from operating activities: Net income $ 50 Adjustments for noncash effects: Depreciation expense 22 Bad debt expense 8 Patent amortization expense 1 Decrease in accounts receivable 4 Increase in inventory (15) Decrease in accounts payable (15) Increase in prepaid expenses (3) Decrease in accrued liabilities (12) Net cash flows from operating activities $40 Cash flows from investing activities: Purchase of long-term investment (40) Net cash flows from investing activities (40) Cash flows from financing activities: Issuance of note payable 35 Retirement of bonds payable (60) Sale of common stock 50 Payment of cash dividends (20) Net cash flows from financing activities 5 Net increase in cash 5 Cash balance, January 1 40 Cash balance, December 31 $45 Noncash investing and financing activities: Acquired buildings by capital lease $111 84 Problem 21-15 Dux Company Spreadsheet for the Statement of Cash Flows Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Balance Sheet Assets: Cash 20 (20) 13 33 Accounts receivable 50 (5) 2 48 Less: Allowance (3) (6) 1 (4) Dividends receivable 2 (7) 1 3 Inventory 50 (8) 5 55 Long-term investment 10 (13) 5 15 Land 40 (14) 30 X 70 Buildings and equipment 250 (15) 15 (4) 40 225 Less: Acc. depreciation (50) (4) 30 (2) 5 (25) 369 420 Liabilities: Accounts payable 20 (9) 7 13 Salaries payable 5 (10) 3 2 Interest payable 2 (11) 2 4 Income tax payable 8 (12) 1 7 Notes payable 0 X (14) 30 30 Bonds payable 70 (16) 25 95 Less: Discount on bonds (3) (3) 1 (2) Shareholders' Equity: Common stock 200 (17) 10 210 Paid-in capital-ex. of par 20 (17) 4 24 Retained earnings 47 (17) 14 (18) 13 (1) 25 45 Less: Treasury stock 0 (19) 8 (8) 369 420 X Noncash investing and financing activity 85 Problem 21-15 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Cash Flows Net income (1) 25 Adjustments for noncash effects: Depreciation expense (2) 5 Amortization of discount (3) 1 Loss on sale of building (4) 3 Decrease in accounts receivable (5) 2 Increase in allowance (6) 1 Increase in dividends receivable (7) 1 Increase in inventory (8) 5 Decrease in accounts payable (9) 7 Decrease in salaries payable (10) 3 Increase in interest payable (11) 2 Decrease in income tax payable (12) 1 Net cash flows 22 Investing activities: Sale of building (4) 7 Purchase of LT investment (13) 5 Purchase of equipment (15) 15 Net cash flows (13) Financing activities: Sale of bonds payable (16) 25 Payment of cash dividends (18) 13 Purchase of treasury stock (19) 8 Net cash flows 4 Net increase in cash (20) 13 13 ___ ___ Totals 216 216 86 Problem 21-15 (concluded) Dux Company Statement of Cash Flows For year ended December 31, 2006 ($ in 000s) Cash flows from operating activities: Net income $25 Adjustments for noncash effects: Depreciation expense 5 Amortization of discount 1 Loss on sale of building 3 Decrease in accounts receivable 2 Increase in allowance for uncollectibles 1 Increase in dividends receivable (1) Increase in inventory (5) Decrease in accounts payable (7) Decrease in salaries payable (3) Increase in interest payable 2 Decrease in income tax payable (1) Net cash flows from operating activities $22 Cash flows from investing activities: Sale of building 7 Purchase of long-term investment (5) Purchase of equipment (15) Net cash flows from investing activities (13) Cash flows from financing activities: Sale of bonds payable 25 Payment of cash dividends (13) Purchase of treasury stock (8) Net cash flows from financing activities 4 Net increase in cash 13 Cash balance, January 1 20 Cash balance, December 31 $33 Noncash investing and financing activities: Acquired $30,000 of land by issuing a 13%, 7-year note. $30 87 Problem 21-16 Metagrobolize Industries Spreadsheet for the Statement of Cash Flows Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Balance Sheet Assets: Cash 375 (15) 225 600 Accounts receivable 450 (7) 150 600 Inventory 525 (8) 375 900 Land 600 (11) 150 X (2) 75 675 Building 900 900 Less: Acc. depreciation (270) (3) 30 (300) Equipment 2,250 (12) 900 (5) 300 2,850 Less: Acc. depreciation (480) (5) 270 (4) 315 (525) Patent 1,500 (6) 300 1,200 5,850 6,900 Liabilities: Accounts payable 450 (9) 300 750 Accrued expenses 225 (10) 75 300 Lease liability–land 0 X (11) 150 150 Shareholders' Equity: Common stock 3,000 (13) 150 3,150 Paid-in capital-ex. of par 675 (13) 75 750 Retained earnings 1,500 (13) 225 (1) 975 (14) 450 1,800 5,850 6,900 X Noncash investing and financing activity 88 Problem 21-16 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Cash Flows Operating activities: Net income (1) 975 Adjustments for noncash effects: Gain on sale of land (2) 90 Depreciation expense-build (3) 30 Depreciation expense-equip (4) 315 Loss on sale of equipment (5) 15 Amortization of patent (6) 300 Increase in accounts receivable (7) 150 Increase in inventory (8) 375 Increase in accounts payable (9) 300 Increase in accrued expenses (10) 75 Net cash flows 1,395 Investing activities: Purchase of equipment (12) 900 Sale of land (2) 165 Sale of equipment (5) 15 Net cash flows (720) Financing activities: Payment of cash dividends (14) 450 Net cash flows (450) Net increase in cash (15) 225 225 Totals 4,935 4,935 89 Problem 21-16 (concluded) Metagrobolize Industries Statement of Cash Flows For year ended December 31, 2006 ($ in 000s) Cash flows from operating activities: Net income $ 975 Adjustments for noncash effects: Gain on sale of land (90) Depreciation expense – building 30 Depreciation expense – equipment 315 Loss on sale of equipment 15 Amortization of patent 300 Increase in accounts receivable (150) Increase in inventory (375) Increase in accounts payable 300 Increase in accrued expenses 75 Net cash flows from operating activities $1,395 Cash flows from investing activities: Purchase of equipment (900) Sale of land 165 Sale of equipment 15 Net cash flows from investing activities (720) Cash flows from financing activities: Payment of cash dividends (450) Net cash flows from financing activities (450) Net increase in cash 225 Cash balance, January 1 375 Cash balance, December 31 $ 600 Noncash investing and financing activities: Land acquired by capital lease $150 90 Problem 21-17 Arduous Company Spreadsheet for the Statement of Cash Flows Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Balance Sheet Assets: Cash 81 (25) 35 116 Accounts receivable 202 (5) 2 200 Less: Allowance (8) (6) 2 (10) Investment rev. receivable 4 (7) 2 6 Inventory 200 (10) 5 205 Prepaid insurance 8 (9) 4 4 Long-term investment 125 (8) 6 (17) 25 156 Land 150 (18) 46 X 196 Buildings and equipment 400 (19) 82 X (16) 70 412 Less: Acc. depreciation (120) (16) 35 (2) 12 (97) Patent 32 (3) 2 30 1,074 1,218 Liabilities: Accounts payable 65 (11) 15 50 Salaries payable 11 (12) 5 6 Bond interest payable 4 (13) 4 8 Income tax payable 14 (14) 2 12 Deferred tax liability 8 (15) 3 11 Notes payable 0 X (18) 23 23 Lease liability 0 X (19) 82 82 Bonds payable 275 (20) 60 215 Less: Discount (25) (4) 3 (22) Shareholders' Equity: Common stock 410 (21) 20 430 Paid-in capital-ex. of par 85 (21) 10 95 Preferred stock 0 (22) 75 75 Retained earnings 227 (21) 30 (23) 22 (1) 67 242 Less: Treasury stock 0 (24) 9 (9) 1,074 1,218 91 Problem 21-17 (continued) Spreadsheet for the Statement of Cash Flows (continued) Dec.31 Changes Dec. 31 2005 Debits Credits 2006 Statement of Cash Flows Operating activities: Net income (1) 67 Adjustments for noncash effects: Depreciation expense (2) 12 Patent amortization expense (3) 2 Amortization of discount (4) 3 Decrease in accounts receivable (5) 2 Increase in allowance (6) 2 Increase in investment rev. rec. (7) 2 Equity method income (8) 6 Decrease in prepaid insurance (9) 4 Increase in inventory (10) 5 Decrease in accounts payable (11) 15 Decrease in salaries payable (12) 5 Increase in interest payable (13) 4 Decrease in tax payable (14) 2 Increase in deferred tax liability (15) 3 Loss on flood (extraordinary) (16) 18 Net cash flows 82 Investing activities: Sale of machine components (16) 17 Purchase of LT investment (17) 25 Purchase of land (18) 23 Net cash flows (31) Financing activities: Retirement of bonds payable (20) 60 Sale of preferred stock (22) 75 Payment of cash dividends (23) 22 Purchase of treasury stock (24) 9 Net cash flows (16) Net increase in cash (25) 35 35 Totals 588 588 92 Problem 21-17 (continued) Arduous Company Statement of Cash Flows For year ended December 31, 2006 ($ in millions) Cash flows from operating activities: Net income $67 Adjustments for noncash effects: Depreciation expense 12 Patent amortization expense 2 Amortization of discount 3 Decrease in accounts receivable 2 Increase in allowance for uncollectible accounts 2 Increase in investment revenue receivable (2) Increase in investment due to equity method income (6) Decrease in prepaid insurance 4 Increase in inventory (5) Decrease in accounts payable (15) Decrease in salaries payable (5) Increase in interest payable 4 Decrease in income tax payable (2) Increase in deferred tax liability 3 Loss on flood (extraordinary) 18 Net cash flows from operating activities $ 82 Cash flows from investing activities: Sale of machine components 17 Purchase of long-term investment (25) Purchase of land (23) Net cash flows from investing activities (31) Cash flows from financing activities: Retirement of bonds payable (60) Sale of preferred stock 75 Payment of cash dividends (22) Purchase of treasury stock (9) Net cash flows from financing activities (16) Net increase in cash 35 Cash balance, January 1 81 Cash balance, December 31 $116 93 Problem 21-17 (concluded) Noncash investing and financing activities: Acquired $82 million building by 15-year capital lease. Acquired $46 million of land by issuing cash and a 15%, 4-year note as follows: Cost of land $46 Cash paid 23 Note issued $23 X Noncash investing and financing activity 94 The following problems use the technique learned in Appendix 21-B. Problem 21-18 BALANCE SHEET ACCOUNTS Cash (Statement of Cash Flows ) _____________________________________________________________ 13 Operating Activities: From customers (1) 202 132 (3) To suppliers of goods From dividends received (2) 2 28 (4) To employees 5 (6) For interest 17 (8) For income taxes Investing Activities: Sale of building (7) 7 5 (10) Purchase of LT investment 15 (12) Purchase of equipment Financing Activities: Sale of bonds payable (13) 25 13 (15) Payment of dividends 8 (16) Purchase of treasury stock Accounts Receivable Allowance for Uncollectibles ______________________ _______________________________ 2 1 _________________ 2 (1) 1 (1) Inventory Dividends Receivable ______________________ _______________________________ 5 1 _________________ (3) 5 (2) 1 95 Problem 21-18 (continued) Long-term Investments Land ______________________ _______________________________ 5 30 _________________ (10) 5 X (11) 30 Buildings and Equipment Accumulated Depreciation ______________________ _______________________________ 25 25 _________________ (12) 15 40 (7) (7) 30 5 (5) Accounts Payable Salaries Payable ______________________ _______________________________ 7 3 _________________ (3) 7 (4) 3 Interest Payable Income Tax Payable ______________________ _______________________________ 2 1 _________________ 2 (6) (8) 1 Notes Payable Bonds Payable ______________________ _______________________________ 30 25 _________________ 30 (11) X 25 (13) Discount on Bonds Common Stock ______________________ _______________________________ 1 10 _________________ 1 (6) 10 (14) 96 Problem 21-18 (continued) Paid-in Capital Retained Earnings ______________________ _______________________________ 4 2 _________________ 4 (14) (14) 14 25 (9) (15) 13 Treasury Stock ______________________ 8 _________________ (16) 8 X Noncash investing and financing activity 97 Problem 21-18 (continued) INCOME STATEMENT ACCOUNTS Sales Dividend Revenue ______________________ _______________________________ 200 3 _________________ 200 (1) 3 (2) Cost of Goods Sold Salaries Expense ______________________ _______________________________ 120 25 _________________ (3) 120 (4) 25 Depreciation Expense Bad Debts Expense ______________________ _______________________________ 5 1 _________________ (5) 5 (1) 1 Interest Expense Loss on Sale of Building ______________________ _______________________________ 8 3 _________________ (6) 8 (7) 3 Income Tax Expense Net Income (Income Summary) ______________________ _______________________________ 16 25 _________________ (8) 16 (9) 25 98 Problem 21-18 (concluded) Dux Company Statement of Cash Flows For year ended December 31, 2006 ($ in 000s) Cash flows from operating activities: Cash inflows: From customers $202 From dividends received 2 Cash outflows: To suppliers of goods (132) To employees (28) For interest expense (5) For income taxes (17) Net cash flows from operating activities $22 Cash flows from investing activities: Sale of building 7 Purchase of long-term investment (5) Purchase of equipment (15) Net cash flows from investing activities (13) Cash flows from financing activities: Sale of bonds payable 25 Payment of cash dividends (13) Purchase of treasury stock (8) Net cash flows from financing activities 4 Net increase in cash 13 Cash balance, January 1 20 Cash balance, December 31 $33 Noncash investing and financing activities: Acquired $30,000 of land by issuing a 13%, 7-year note. $30 99 Problem 21-19 BALANCE SHEET ACCOUNTS Cash (Statement of Cash Flows ) _____________________________________________________________ 225 Operating Activities: From customers (1) 2,495 675 (4) To suppliers 425 (9) For expenses Investing Activities: Sale of land (3) 165 900 (11) Purchase of equipment Sale of equipment (7) 15 Financing Activities: 450 (13) Payment of div. Accounts Receivable Inventory ______________________ _______________________________ 150 375 _________________ (1) 150 (4) 375 Land Accumulated Depr.-Buildings ______________________ _______________________________ 75 30 _________________ X (2) 150 75 (3) 30 (5) Equipment Accumulated Depr.-Equipment ______________________ _______________________________ 600 45 _________________ (11) 900 300 (7) (7) 270 315 (6) 100 Problem 21-19 (continued) Patent Accounts Payable ______________________ _______________________________ 300 300 _________________ 300 (8) 300 (4) Accrued Expenses Payable Lease Liability-Land ______________________ _______________________________ 75 150 _________________ 75 (9) 150 (2) X Common Stock Paid-in Capital ______________________ _______________________________ 150 75 _________________ 150 (12) 75 (12) Retained Earnings ______________________ 300 _________________ (12) 225 975 (10) (13) 450 X Noncash investing and financing activity 101 Problem 21-19 (continued) INCOME STATEMENT ACCOUNTS Sales Gain on Sale of Land ______________________ _______________________________ 2,645 90 _________________ 2,645 (1) 90 (3) Cost of Goods Sold Depreciation Expense-Build. ______________________ _______________________________ 600 30 _________________ (4) 600 (5) 30 Depreciation Expense-Equip. Loss on Sale of Equipment ______________________ _______________________________ 315 15 _________________ (6) 315 (7) 15 Amortization of Patent Operating Expenses ______________________ _______________________________ 300 500 _________________ (8) 300 (9) 500 Net Income (Income Summary) ______________________ 975 _________________ (10) 975 102 Problem 21-19 (concluded) Metagrobolize Industries Statement of Cash Flows For year ended December 31, 2006 ($ in 000s) Cash flows from operating activities: Cash inflows: From customers $2,495 Cash outflows: To suppliers of goods (675) For operating expenses (425) Net cash flows from operating activities $1,395 Cash flows from investing activities: Purchase of equipment (900) Sale of land 165 Sale of equipment 15 Net cash flows from investing activities (720) Cash flows from financing activities: Payment of cash dividends (450) Net cash flows from financing activities (450) Net increase in cash 225 Cash balance, January 1 375 Cash balance, December 31 $ 600 Noncash investing and financing activities: Land acquired by capital lease $150 103 Problem 21-20 BALANCE SHEET ACCOUNTS Cash (Statement of Cash Flows ) _______________________________________________________________ 35 Operating Activities: From customers (1) 406 200 (4) To suppliers of goods From investment revenue (2) 3 70 (5) To employees From sale of cash equivalents (3) 2 3 (8) For insurance 21 (9) For bond interest 35 (10) For income taxes Investing Activities: Sale of machine components (11) 17 25 (13) Purchase of LT invest. 23 (14) Purchase of land Financing Activities: Sale of preferred stock (18) 75 60 (16) Retirement of bonds 22 (19) Payment of dividends 9 (20) Purch. of treas. stock Accounts Receivable Allowance for Uncollectibles ______________________ _______________________________ 2 2 _________________ 2 (1) 2 (1) Prepaid Insurance Inventory ______________________ _______________________________ 4 5 _________________ 4 (8) (4) 5 104 Problem 21-20 (continued) Investment Revenue Receivable Long-term Investments ______________________ _______________________________ 2 31 _________________ (2) 2 (2) 6 (13) 25 Land Buildings and Equipment ______________________ _______________________________ 46 12 _________________ X (14) 46 X (15) 82 70 (11) Accumulated Depreciation Patent ______________________ _______________________________ 23 2 _________________ (11) 35 12 (6) 2 (7) Accounts Payable Salaries Payable ______________________ _______________________________ 15 5 _________________ (4) 15 (5) 5 Bond Interest Payable Income Tax Payable ______________________ _______________________________ 4 2 _________________ 4 (9) (10) 2 X Noncash investing and financing activity 105 Problem 21-20 (continued) Deferred Tax Payable Notes Payable ______________________ _______________________________ 3 23 _________________ 3 (10) 23 (14) X Lease Liability Bonds Payable ______________________ _______________________________ 82 60 _________________ 82 (15) X (16) 60 Discount on Bonds Common Stock ______________________ _______________________________ 3 20 _________________ 3 (9) 20 (17) Paid-in Capital Preferred Stock ______________________ _______________________________ 10 75 _________________ 10 (17) 75 (18) Retained Earnings Treasury Stock ______________________ _______________________________ 15 9 _________________ (17) 30 67 (12) (20) 9 (19) 22 X Noncash investing and financing activity 106 Problem 21-20 (continued) INCOME STATEMENT ACCOUNTS Sales Investment Revenue ______________________ _______________________________ 410 11 _________________ 410 (1) 11 (2) Gain on Sale of Treasury Bills Cost of Goods Sold ______________________ _______________________________ 2 180 _________________ 2 (3) (4) 180 Salaries Expense Depreciation Expense ______________________ _______________________________ 65 12 _________________ (5) 65 (6) 12 107 Problem 21-20 (continued) Patent Amortization Expense Bad Debts Expense ______________________ _______________________________ 2 8 _________________ (7) 2 (1) 8 Insurance Expense Bond Interest Expense ______________________ _______________________________ 7 28 _________________ (8) 7 (9) 28 Income Tax Expense Extraordinary Loss (Flood) ______________________ _______________________________ 45 18 _________________ (10) 45 (11) 18 Tax Savings Net Income (Income Summary) ______________________ _______________________________ 9 67 _________________ 9 (10) (12) 67 108 Problem 21-20 (concluded) Arduous Company Statement of Cash Flows For year ended December 31, 2006 ($ in millions) Cash flows from operating activities: Cash inflows: From customers $406 From investment revenue 3 From sale of cash equivalents 2 Cash outflows: To suppliers of goods (200) To employees (70) For insurance expense (3) For bond interest expense (21) For income taxes (35) Net cash flows from operating activities $ 82 Cash flows from investing activities: Sale of machine components 17 Purchase of long-term investment (25) Purchase of land (23) Net cash flows from investing activities (31) Cash flows from financing activities: Retirement of bonds payable (60) Sale of preferred stock 75 Payment of cash dividends (22) Purchase of treasury stock (9) Net cash flows from financing activities (16) Net increase in cash 35 Cash balance, January 1 81 Cash balance, December 31 $116 Noncash investing and financing activities: Acquired $82 million building by 15-year capital lease. Acquired $46 million of land by issuing cash and a 15%, 4-year note as follows: Cost of land $46 Cash paid 23 109 Note issued $23 110 CASES Communication Case 21-1 Memorandum To: Mr. Robert James From: Your Name Date: Current Date RE: Discrepancy between profitability and cash flows Our operating results for the first half of the year demonstrate that it is possible for operating activities to simultaneously produce a positive net income and negative net cash flows. Net income was $5 million. Cash flow from operating activities for the period was negative $16 million. Generally accepted accounting principles permit us to report cash flows by either of two methods – the direct or the indirect approach as follows: ($ in millions) [Direct Method] Cash flows from operating activities: Cash inflows: From customers ($75 - 20) $55 Cash outflows: To suppliers of goods ($30 + 15 – 2) (43) For other expenses ($35 - 7) (28) Net cash flows from operating activities $(16) 111 Case 21-1 (concluded) [Indirect Method] Cash flows from operating activities: Net income $ 5 Adjustments for noncash effects: Depreciation expense 5 Increase in accounts receivable (20) Increase in inventory (15) Increase in accounts payable 2 Increase in accrued expenses payable 7 Net cash flows from operating activities $(16) The reason for the apparent discrepancy between cash flows and net income is due to the way the two items are measured. Net income (or loss) is the result of combining the revenues earned during the reporting period, regardless of when cash is received, and the expenses incurred in generating those revenues, regardless of when cash is paid. We refer to this as the “accrual concept” of accounting. On the other hand, "cash flows from operating activities" are both inflows and outflows of cash that result from the same activities that are reported on the income statement. In other words, this classification of cash flows includes the elements of net income, but reported on a cash basis. Let me know if I can provide you additional details. 112 Judgment Case 21-2 Daring Company Statement of Cash Flows For year ended December 31, 2006 ($ in 000s) Cash flows from operating activities: Cash inflows: From customers ($100 - 25) $75 Cash outflows: To suppliers of goods ($50 + 20 - 10) (60) For remaining expenses ($25 - 5) (20) Net cash flows from operating activities $ (5) Cash flows from investing activities: Purchase of operational assets (given) (55) Cash flows from financing activities: Issuance of note payable $ 45 Issuance of common stock 20 Net cash flows from financing activities 65 Net increase in cash $ 5 Cash balance, January 1 0 Cash balance, December 31 $5 Your concerns are justified in the sense that cash flows are insufficient to cover existing interest charges, not to mention additional charges from new debt. In fact, the principal on the debt of $45,000 will come due shortly in addition to additional interest. Although net income is positive, cash flows from operating activities are negative. A difference between cash flows and net income can exist due to the way the two items are measured. Net income, measured on an accrual basis, is the difference between the revenues earned during the reporting period, regardless of when cash is received, and the expenses incurred in generating those revenues, regardless of when cash is paid. Cash flows from operating activities are inflows and outflows of cash resulting from the same activities that are reported on the income statement. 113 Case 21-2 (concluded) On the other hand, the negative cash flow from operations is not reason, in and of itself, for rejecting the application. Profit is positive. The reason net income is measured on an accrual basis rather than a cash basis is that very often, net income is a better indication of performance, particularly long-term performance, than cash flow. However, many promising companies that have reported profits have failed due to cash shortages. Good business managers understand that bottom line net income has little to do with maintaining solvency. By being able to accurately predict the timing and amounts of cash flows, companies can remain afloat and also avoid financing charges caused by having to undertake emergency borrowing, as is the case here. The bottom line is that additional information is needed. One cause of the negative operating cash flows is the acquisition of a large amount of inventory that is unsold. If product demand is strong, this is favorable. Why are those inventories unsold? What is the projected growth rate in revenues? Another concern may be the rather high balance in accounts receivable. Cash collected from customers was only 75% of sales for the year. Is credit policy too lax? On the other hand, if the uncollected receivables arose primarily as a result of heavy year-end sales and are eminently collectible, the cash flow situation will benefit. Another practical consideration is the fact that the bank already has a $45,000 investment in this new company, an investment that likely will be lost if the company is denied the new funds it seeks. 114 Integrating Case 21-3 Requirement 1 Calculation of the present value of lease payments $391,548 x 15.32380Φ = $6,000,000 (rounded) Φ present value of an annuity due of $1: n=20, i=3% Richards would report the $6,000,000* investment in the protein analyzer and its financing with a capital lease as a significant noncash investing and financing activity in the disclosure notes to the financial statements. The $783,096 ($391,548 x 2) cash lease payments *, ** are divided into the interest portion and the principal portion. The interest portion, $168,254, is reported as cash outflows from operating activities. The principal portion, $391,548 + 223,294, is reported as cash outflows from financing activities. Note: By the indirect method of reporting cash flows from operating activities, we would add back to net income the $300,000 depreciation expense since it didn’t actually reduce cash. The $168,254 interest expense that reduced net income actually did reduce cash [the interest portion of the $783,096 ($391,548 x 2) cash lease payments], so for it, no adjustment to net income is necessary. Calculations: September 30, 2006* Leased equipment (calculated in req. 1) ........................... 6,000,000 Lease payable (calculated in req. 1) .............................. 6,000,000 Lease payable ................................................................. 391,548 Cash (rental payment) ................................................... 391,548 December 31, 2006** Interest expense (3% x [$6 million – 391,548]) ................ 168,254 Lease payable (difference) ............................................... 223,294 Cash (rental payment) ................................................... 391,548 Depreciation expense ($6 million / 5 years x ¼ year) ....... 300,000 Accumulated depreciation .......................................... 300,000 115 Case21-3 (continued) Requirement 2 Advanced would report the $6,000,000* direct financing lease of the protein analyzer as a significant noncash investing activity (acquiring one asset and disposing of another) in the disclosure notes to the financial statements. The $783,096 ($391,548 x 2) cash lease payments *, ** are divided into the interest portion and the principal portion. The interest portion, $168,254, is reported as cash inflows from operating activities. The principal portion, $391,548 + 223,294, is reported as cash inflows from investing activities. Note: By the indirect method of reporting cash flows from operating activities, the $168,254 interest revenue that increased net income actually did increase cash [the interest portion of the $783,096 ($391,548 x 2) cash lease payments], so for it, no adjustment to net income is necessary. Calculations: September 30, 2006* Lease receivable ($391,548 x 20) ..................................... 7,830,960 Unearned interest revenue ($7,830,960 – 6,000,000) ... 1,830,960 Inventory of equipment (lessor’s cost) ......................... 6,000,000 Cash (rental payment) ....................................................... 391,548 Lease receivable .......................................................... 391,548 December 31, 2006** Cash (rental payment) ....................................................... 391,548 Lease receivable .......................................................... 391,548 Unearned interest revenue ............................................. 168,254 Interest revenue (3% x [$6,000,000 – 391,548]) ........... 168,254 116 Case 21-3 (continued) Requirement 3 Makers would report the $6,000,000* sales-type lease of the protein analyzer as a significant noncash activity in the disclosure notes to the financial statements. The $783,096 ($391,548 x 2) cash lease payments *, ** are considered to be cash flows from operating activities. A sales-type lease differs from a direct financing lease in that we assume the lessor is actually selling its product, an operating activity. Thus, both the interest portion, $168,254, and the principal portion, $391,548 + 223,294, are reported as cash inflows from operating activities. Note: By the indirect method of reporting cash flows from operating activities, the $1,000,000 (Sales revenue: $6,000,000 – Cost of goods sold: $5,000,000) dealer’s profit must be deducted from net income because it is included in net income but won’t increase cash flows until the lease payments are collected over the next five years. This addition, however, occurs automatically as we make the usual adjustments for the change in receivables (to adjust sales to cash received from customers) and for the change in inventory (to adjust cost of goods sold to cash paid to suppliers). The $168,254 interest revenue that increased net income actually did increase cash [the interest portion of the $783,096 ($391,548 x 2) cash lease payments], so for it, no adjustment to net income is necessary. The principal portion, $391,548 + 223,294, must be added because it is not otherwise included in net income. This, too, though, occurs automatically as we make the usual adjustments for the change in receivables (to adjust sales to cash received from customers). Noncash adjustments to convert net income to cash flows from operating activities: Increase in lease receivable ........................... ($7,830,960) Increase in unearned interest (contra lease receivable) 1,830,960 Decrease in inventory of equipment .............. 5,000,000 Decrease in lease receivable, Sept. 30 ........... 391,548 Decrease in lease receivable, Dec. 31 ........... 391,548 Decrease in unearned interest (contra lease receivable), Dec. 31 (168,254) 117 Case 21-3 (concluded) Calculations: September 30, 2006* Lease receivable ($391,548 x 20) ..................................... 7,830,960 Cost of goods sold (lessor’s cost) ..................................... 5,000,000 Sales revenue (present value) ....................................... 6,000,000 Unearned interest revenue ($7,830,960 – 6,000,000) ... 1,830,960 Inventory of equipment (lessor’s cost) ......................... 5,000,000 Cash (rental payment) ....................................................... 391,548 Lease receivable .......................................................... 391,548 December 31, 2006** Cash (rental payment) ....................................................... 391,548 Lease receivable .......................................................... 391,548 Unearned interest revenue ............................................. 168,254 Interest revenue (3% x [$6,000,000 – 391,548]) ........... 168,254 118 Research Case 21-4 Requirement 1 From Microsoft’s disclosure note regarding unearned revenue: Unearned Revenue …. The percentage of revenue recorded as unearned due to undelivered elements ranges from approximately 15% to 25% of the sales price for Windows XP Home, approximately 5% to 15% of the sales price for Windows XP Professional, and approximately 1% to 15% of the sales price for desktop applications. ……. So, 5% to 15% of the sales price for Windows XP Professional is initially recorded as unearned revenue. Requirement 2 The statement of cash flows includes “unearned revenue” as an addition to net income in the operations section because this is the amount of revenue collected in cash but not included in the income statement. Conversely, “recognition of unearned revenue” is included as a deduction from net income because this amount previously recorded as unearned revenue when collected, now is being recognized – included in revenue. The recognition now does not increase cash, so subtracting this amount serves to convert net income to a cash basis. Microsoft reported these two items separately rather than just adjusting net income for the change in the unearned revenue account balance because, even though adjusting for the net change would produce the same net result, the dollar amounts are sufficiently large that separate reporting is deemed more informative. Requirement 3 Stock-based compensation is recorded as a fraction of the fair value of such compensation (restricted stock, stock options, SARs) on the date of grant. There is no cash flow associated with such compensation, so the expense is added back to net income to remove this noncash item from the determination of cash from operating activities. 119 Analysis Case 21-5 Requirement 1 (a) Cash _______________________________________________________________ Beginning balance ? Net increase (from SCF) 183 ____________ Ending balance 360 Beginning Cash + Net increase in cash = Ending Cash Beginning Cash + 183 = 360 Beginning Cash = 360 - 183 Beginning Cash = 177 (b) Accounts Receivable _______________________________________________________________ Beginning balance 252 Sales (from IS) 240 213 Collected from customers (from SCF) ____________ Ending balance ? Ending Accounts Receivable = Beginning Accounts Receivable + Sales – Cash collections = 252 + 240 – 213 = 279 120 Case 21-5 (continued) (c) Accounts Payable _______________________________________________________________ 90 Beginning balance ? Purchases Cash paid to suppliers 90 ____________ 120 Ending balance Beginning A/P + Purchases – Cash Paid = Ending A/P 90 + Purchases – 90 = 120. 90 + Purchases – 90 = 120. Therefore, Purchases = 120 Inventory _______________________________________________________________ Beginning balance ? Purchases (from above) 120 96 Cost of goods sold (from IS) ____________ Ending balance 180 Beginning Inventory + Purchases – Ending Inventory = Cost of goods sold Beginning Inventory + 120 – 180 = 96 Beginning Inventory = 96 – 120 + 180 Beginning Inventory = 156 121 Case 21-5 (continued) (d) Gain on sale of equipment was 45; Cash received was 120; therefore, book value of equipment was 75. Since the cost of equipment sold was 150 (600 - 450), accumulated depreciation must have been 75. Summary Entry Cash (from SCF) 120 Accumulated depreciation (to balance) 75 P, P, & E (450 - 600) 150 Gain on sale of equipment (from IS) 45 Accumulated Depreciation _______________________________________________________________ ? Beginning balance 30 Depreciation expense Equipment sold (from above) 75 ____________ 120 Ending balance Beginning Accumulated depreciation + Depreciation expense – Accumulated depreciation on equipment sold = Ending Accumulated depreciation Beginning Accumulated depreciation + 30 – 75 = 120 Beginning Accumulated depreciation = 120 – 30 + 75 = 165 (e) Income Taxes Payable _______________________________________________________________ ? Beginning balance 21 Income tax expense Cash paid (from SCF) 27 ____________ 66 Ending balance Beg. Inc. taxes payable + Inc. tax expense – Inc. taxes paid = Ending Inc. taxes payable Beg. Inc. taxes payable = Ending Inc. taxes payable + Taxes paid - Inc. tax expense Beg. Inc. taxes payable = 66 + 27 – 21 = 72 122 Case 21-5 (continued) (f) Retained Earnings _______________________________________________________________ 141 Beginning balance 84 Net income Dividends declared 9 ____________ ? Ending balance Ending R/E = Beginning R/E + Net income – Dividends = 141 + 84 – 9 = 216 Distinctive Industries Comparative Balance Sheets At December 31 2006 2005 Assets: Cash $ 360 $ 177 Accounts receivable (net) 279 252 Inventory 180 156 Property, plant & equipment 450 600 Less: Accumulated depreciation (120) (165) Total assets $1,149 $1,020 Liabilities and shareholders’ equity: Accounts payable $ 120 $ 90 General and administrative expenses payable 27 27 Income taxes payable 66 72 Common stock 720 690 Retained earnings 216 141 Total liabilities and shareholders’ equity $1,149 $1,020 123 Case 21-5 (concluded) Requirement 2 Distinctive Industries Statement of Cash Flows For the Year Ended December 31, 2006 ($ in millions) Cash flows from operating activities: Net income $ 84 Adjustments to net income: Depreciation expense 30 Gain on sale of equipment (45) Increase in accounts receivable (net) * (27) Increase in inventory ** (24) Increase in accounts payable *** 30 Decrease in income taxes payable **** (6) Net cash inflows from operating activities $42 * $279 – 252 = $27 ** $180 – 156 = $24 *** $120 – 90 = $30 **** $66 – 72 = $(6) 124 Real World Case 21-6 Requirement 1 In the three years, Cingular’s largest investing activity was construction and capital expenditures. Investments used a large amount of cash as well. In fact, the single largest expenditure was for the acquisition of AT&T in 2004. A look at financing activities reveals that funds from external financing were insufficient to fund these and other investments. In fact, in 2003, financing activities produced a decrease, not an increase, in cash. The bulk of the funds for investments came from cash provided by operations (internal financing) in each year. Requirement 2 Transactions that involve merely transfers from cash to “cash equivalents” such as the purchase of a CD should not be reported in the statement of cash flows. A dollar amount is simply transferred from one "cash" account to another "cash" account so that the total of cash and cash equivalents is not altered by such transactions. An exception is the sale of a cash equivalent at a gain or loss. In this case, the total of cash and cash equivalents actually increases or decreases. The increase or decrease is reported as a cash flow from operating activities. Requirement 3 The sale of debt and the sale of stock are reported as financing activities. Requirement 4 The payment of cash dividends to shareholders is classified as a financing activity, but paying interest to creditors is classified as an operating activity. This is because "cash flows from operating activities" should reflect the cash effects of items that enter into the determination of net income. Interest expense is a determinant of net income. A dividend, on the other hand, is a distribution of net income and not an expense. 125 Case 21-6 (concluded) Requirement 5 A statement of cash flows reports transactions that cause an increase or a decrease in cash. However, some transactions that do not increase or decrease cash, but which result in significant investing and financing activities, must be reported in related disclosures. Entering a significant investing activity and a significant financing activity as two parts of a single transaction does not limit the value of reporting these activities. Examples of noncash transactions that would be reported: • Acquiring an asset by incurring a debt payable to the seller. • Acquiring an asset by entering into a capital lease. • Converting debt into common stock or other equity securities. • Exchanging noncash assets or liabilities for other noncash assets or liabilities. 126 Ethics Case 21-7 Discussion should include these elements. The apparent situation: There seems to be at least superficial evidence that income is being artificially propped up by management practices that might not be healthy for the company in the long run. Ben apparently suspects the motivation may be partly due to management compensation tied to reported profits. Ethical Dilemma: Does Ben have an obligation to challenge the questionable practices? If his suspicions are confirmed, what action, if any, should he take? Who is affected?: Ben President, controller, and other managers Shareholders Potential shareholders The employees The creditors The company’s auditors 127 Real World Case 21-8 Requirement 1 Cash flows from operating activities are both inflows and outflows of cash that result from the same activities that are reported on the income statement. The income statement, however, reports the activities on an accrual basis. This means that the income statement reports revenues earned during the reporting period, regardless of when cash is received, and the expenses incurred in generating those revenues, regardless of when cash is paid. Cash flows from operating activities, on the other hand, report those activities when the cash is exchanged (i. e., on a cash basis). Requirement 2 Depreciation is the major contributor to the Northwest having positive cash flows from operating activities despite a net loss. When using the indirect method, the net cash increase or decrease from operating activities is derived indirectly by starting with reported net income, or net loss in this case, and "working backwards" to convert that amount to a cash basis. Amounts that were subtracted in determining net income or loss, but which did not reduce cash, are added back to net income to reverse the effect of the amounts having been subtracted. Depreciation and amortization expense is one example. In 2004, that was $731 million for Northwest. Requirement 3 When assets are sold at a gain, the gain is not reported as a cash inflow from operating activities. A gain (or loss) is simply the difference between cash received in the sale of an asset and the book value of the asset; it’s not a cash flow. The cash effect of the transaction is reported as an investing activity. To report the gain as a cash flow from operating activities, in addition to reporting the entire cash flow from investing activities, would be to report the gain twice. 128 Research Case 21-9 The results students report will vary depending on the companies chosen. It can be interesting to have students compare in class their findings with those of their classmates. Most companies use the indirect method to report operating activities. Adjustments to net income in reconciling net income and cash flows from operations are reported on the face of the statement of cash flows when the indirect method is used and in a separate reconciliation schedule when the direct method is used. The cash payments for interest and for taxes are reported on the face of the statement of cash flows when the direct method is used and in a separate disclosure note when the indirect method is used. Significant investing activities can point to new directions in which the company may be moving or perhaps may indicate that investment funds are being invested in passive peripheral activities for lack of profitable opportunities in mainstream operations. What combination of debt and equity does a company use to finance its activities? Significant financing activities in recent years can point to shifts in that combination. 129 Analysis Case 21-10 1. FedEx is expanding its business as evidenced by the investing activities. External financing need not be sufficient to fund those investments because of the substantial internal financing provided by operating activities. Notice that dividends to shareholders are relatively small, so most funds from operating activities are being reinvested in the business. 2. The six activities listed under financing activities for the 2004 fiscal year are ($ in millions): Financing Activities 2004 2003 2002 Principal payments on debt (319) (10) (320) Proceeds from debt issuances 1,599 -- -- Proceeds from stock issuances 115 81 88 Dividends paid (66) (60) -- Purchase of treasury stock (179) (186) (177) Other, net -- 1 3 --------- ---------- ---------- Cash from financing activities 1,150 (174) (406) The statement tells us that FedEx borrowed much more cash in 2004 than it paid to retire debt after not borrowing any the two previous years. Also noteworthy is that FedEx paid no dividends prior to 2003. A relatively small amount of cash also was received from sale of stock. [Reference to FedEx’s Statement of Changes in Common Stockholders’ Investment tells us that stock was sold or granted under employee benefit plans rather than being sold to the public.] 3. Companies are required to separately disclose cash payments for both interest and income taxes. When the direct method is used to report operating activities, those amounts automatically are shown. But when a company uses the indirect method as FedEx does, supplemental disclosure is needed. Note 14 in the disclosure notes serves this purpose: Note 14: Supplemental Cash Flow Information Cash paid for interest expense and income taxes for the years ended May 31 was as follows: In thousands 2004 2003 2002 Interest (net of capitalized interest) $151 $125 $146 Income taxes 364 53 312 Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482