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					Chapter 6
The Statement of Cash Flows

SOLUTIONS

1.   The two primary purposes of the statement of cash flows are to provide information about the
     firm’s operating cash receipts and cash payments and to provide information about the cash flows
     associated with the firm’s investing and financing activities.

2.   Cash equivalents are short-term, highly liquid investments such as treasury bills, commercial paper,
     and money market funds. These investments are readily convertible to known amounts of cash.

3.   The three cash flow categories included in the statement of cash flows are:
      Operating. Operating activities are those activities that enter into the calculation of net income.
        Net cash provided by operating activities is the “bottom line” of the cash flow statement.
      Investing. The primary investing activities are the purchase and sale of land, buildings,
        equipment, and investments involving securities of other entities.
      Financing. Financing activities involve the receipt of cash from and the repayment of cash to
        owners and lenders.

4.   A growing company might report negative cash from operating and investing activities as a sign of
     the cash that is being spent in business expansion. A growing company would also experience
     positive cash from financing activities in order to fund this growth. A mature company in a stable
     industry would probably have positive cash from operations, a small negative cash from investing
     activities in order to finance asset replacements, and negative cash from financing activities as loans
     are repaid and large dividends are paid to shareholders.

5.   Two significant non-cash activities that you might expect to find disclosed in the notes to the
     financial statements are assets acquired through a mortgage or in exchange for stock or a
     conversion of a debt obligation into an equity position such as conversion of bonds into stock.

6.   Conceptually, the statement of cash flows is the easiest financial statement to prepare because the
     preparation of a statement of cash flows is no more complicated than a simple three-way sorting of
     transactions into operating, investing, and financing transactions.

7.   The following transactions affect both net income and cash flows:
      Sale of merchandise (services) for cash
      Payment to suppliers for merchandise inventory that has been sold
      Payment to employees for salaries and wages
      Payment of income taxes

     The following transactions change net income but have no effect on cash flows from operations:
      Recording of depreciation expense
      Recognition of gains or losses on the sale of assets
      Recognition of a restructuring charge




                                               Chapter 6 – 1
8.    The six steps in the process for preparing a statement of cash flows using income statement and
      balance sheet data are:
      1. Compute the change in the cash balance.
      2. Convert the income statement from an accrual-basis to a cash-basis summary of operations.
      3. Analyze the long-term assets to identify the cash flow effects of investing activities.
      4. Analyze the long-term debt and stockholders’ equity accounts to determine the cash flow
          effects of any financing transactions.
      5. Prepare the formal statement of cash flows.
      6. Disclose any significant investing or financing transactions that did not involve cash.

9.    Depreciation is added back to net income in computing cash from operating activities using the
      indirect method because depreciation does not involve an outflow of cash. Since depreciation
      expense is initially subtracted to arrive at net income, adding it back effectively eliminates
      depreciation from the computation of cash from operations.

10.   Gains are subtracted and losses are added to compute cash flow from operations when using the
      indirect method in order to avoid double counting. For example, the cash flow effect of an
      equipment sale is shown in the investing activities section of the cash flow statement. To avoid
      double counting, any gain or loss on the sale of the equipment should be excluded from the
      operating activities section. In order to exclude a gain from the operating activities section, it must
      be subtracted from net income. A loss must be added back to net income in the operating activities
      section.

11.   In general, one should analyze the current assets and current liabilities in computing cash from
      operating activities. To analyze cash from investing activities, one should look at the long-term
      asset accounts. To analyze cash from financing activities, one should look at the long-term debt and
      the equity accounts.

12.   To find cash collected from customers (using the direct method):

      Beginning accounts receivable                                                     $220,000
      + Sales during the year                                                            270,000
      = Total amount to be collected                                                    $490,000
      – Ending accounts receivable (amount not yet collected)                           (160,000)
      = Cash collected from customers                                                   $330,000

13.   The direct method is favored by many users of financial statements because it is easy to understand.
      Even a financial statement novice can decipher operating cash flow information when it is
      presented using the direct method. On the other hand, the indirect method is favored and used by
      most companies because it is relatively easy to construct from existing balance sheet and income
      statement data. In addition, the indirect method highlights the reasons for the difference between
      net income and cash from operations.

14.   Depreciation is not a source of cash. Higher depreciation expense means lower net income.
      However, since the depreciation expense is added back in computing cash from operating activities,
      there is no net effect on operating cash flow. To repeat, depreciation is not a source of cash. Note:
      Depreciation tax deductions do reduce the amount of cash paid for income taxes.

15.   If the balance in a prepaid asset account increases during the year, this means that the cash paid for
      that item (to replenish the account) was more than the expense, or consumption, associated with
      that item.


                                                Chapter 6 – 2
16.   If the account Unearned Revenue increases during a period, this represents an additional inflow of
      cash for services that have not yet been performed With the direct method, this is shown as
      additional cash collected from customers. With indirect method, the increase in the liability
      Unearned Revenue is shown as an addition to operating cash flow.

17.   Increases in current assets result in a subtraction from net income to arrive at cash flow from
      operations when using the indirect method because an increase represents cash that otherwise
      would have been available for buying equipment or paying dividends that is tied up in the form of
      that current asset. A decrease is added in the computation of cash flow from operations because a
      decrease means cash has been freed for other purposes.

18.   With respect to the account Property, Plant & Equipment and the related Accumulated Depreciation
      account, the three most common events that can occur are purchases, sales, and depreciation. A
      purchase is shown as a cash outflow from investing activities. A sale is a cash inflow from
      investing activities. Depreciation expense is included in the computation of net income but, because
      it is a non-cash expense, is eliminated by adding it back in computing cash from operating
      activities.

19.   The Retained Earnings account increases because of net income, which is included in the
      computation of cash from operating activities. The Retained Earnings account decreases because of
      net losses which are also part of the computation of cash from operating activities. The Retained
      Earnings account also decreases because of cash dividends which are reported as part of financing
      activities.

20.   A forecasted statement of cash flows allows management to see the relationship between forecasted
      operating cash flow and the cash needed for investing activities. If there is an expected shortfall in
      available cash, a company can either use the forecasted information in obtaining additional
      financing or the company can scale back its expansion plans in order to reduce the drain on cash.

21.   Lenders can make use of a forecasted statement of cash flows to see whether it seems likely that a
      company can continue to meet its existing debt obligations. An investor can use the projected cash
      flow statement to evaluate the likelihood that a company will be able to continue making dividend
      payments.


EXERCISES

E 6-1 Transactions Affecting Cash Flows

                                                                           Effect on Cash
Transaction                                                        Increase    Decrease          No Effect
a.   Amortization of intangible asset                                                                X
b.   Conversion of preferred stock to common stock                                                   X
c.   Sales on account                                                                                X
d.   Purchase of inventory on account                                                                X
e.   Declaration of a dividend                                                                       X
f.   Payment of accounts payable                                                    X
g.   Collection of accounts receivable                                X
h.   Depreciation on factory building                                                                 X
i.   Sale of building at a loss                                       X
j.   Retirement of debt through issuance of common stock                                              X


                                               Chapter 6 – 3
E 6-2 Types of Activities Affecting Cash Flow

a.   Payment of federal income taxes                                         1       Operating
b.   Dividend payments to shareholders                                       3       Financing
c.   Repayment of short–term obligations                                     3       Financing
d.   Loans made to another company                                           2        Investing
e.   Payments made to acquire a business                                     2        Investing
f.   Salaries paid to employees                                              1       Operating
g.   Interest paid to lenders                                                1       Operating
h.   Dividends received from investments                                     1       Operating
i.   Cash paid to acquire treasury stock                                     3       Financing

E 6-3 Purpose and Format of the Statement of Cash Flows

1.   The two primary purposes of the cash flow statement are to provide information about the firm’s
     cash receipts and cash payments and to provide information about the investing and financing
     activities of the firm. This statement is useful to present and potential investors and creditors
     because it helps them assess:
     a. the firm’s ability to generate future cash flows.
     b. the firm’s ability to meet its obligations and pay dividends and its need for outside financing.
     c. the reasons for the differences between income and cash receipts and payments.
     d. both the cash and non-cash aspects of the firm’s investing and financing activities.

2.   The following methods are used to report cash flows from operations:
     a. The direct method, which involves reporting the major types of operating receipts and cash
        payments, such as receipts from the sale of goods and services and payments to suppliers of
        inventory. Cash flows from operating activities are the difference between the total operating
        receipts and the total operating payments.
     b. The indirect method, which involves presenting a reconciliation between net income and net
        cash flows from operations. Essentially, the accrual-based income statement is reconciled to a
        cash-basis statement.

3.   The following categories of activities must be disclosed on the statement of cash flows:
     a. Operating activities, which include all transactions that are not considered either investing or
        financing activities. Therefore, operating activities consist primarily of delivering or producing
        goods for sale and providing services. Cash flows from operating activities are really the cash
        effect of the transactions that enter into the determination of net income.
     b. Investing activities, which include cash inflows and outflows from lending money and
        collecting on loans and from acquiring and selling securities and productive assets such as
        property, plant, and equipment.
     c. Financing activities, which include obtaining resources from owners and providing them a
        return on their investment and obtaining borrowed resources from creditors and repaying those
        borrowings. Common examples include issuance of notes, bonds, mortgages, and other short-
        or long-term borrowings and the issuance of common and preferred stock.

4.   The FASB requires that information about the non-cash investing and financing activities be
     disclosed outside the formal statement of cash flows. These transactions should be clearly identified
     as not involving cash receipts or payments. An example of such a transaction is when a firm issues
     common stock in exchange for plant and equipment.




                                                Chapter 6 – 4
E 6-4 Accounts Used for Cash Flow Analysis

     Income Statement                                             Balance Sheet
a.   Sales                                                    Accounts Receivable
b.   Cost of Goods Sold                                       Inventory, Accounts Payable
c.   Depreciation Expense                                     Accumulated Depreciation
d.   Amortization Expense                                     Accumulated Amortization
                                                                or associated asset account
e.   Rent Expense                                             Prepaid Rent or Rent Payable
f.   Interest Expense                                         Interest Payable
g.   Insurance Expense                                        Prepaid Insurance
h.   Income Tax Expense                                       Income Taxes Payable, Prepaid Income tax

E 6-5 Classifying Cash Flow Activities

     a.   Financing activity, increase cash
     b.   Investing activity, increase cash
     c.   Financing activity, decrease cash
     d.   Operating activity, decrease cash
     e.   Investing activity, decrease cash
     f.   Investing and financing, non-cash transaction
     g.   Financing activity, decrease cash

E 6-6 Format of the Statement of Cash Flows

1.                                            Wilcox Inc.
                                       Statement of Cash Flows
                                For the Year Ended December 31, 2006

     Cash flows from operating activities:
         Receipts from customers                                        $276,000
         Payments for inventory                                         (211,200)
         Payments for operating expenses                                 (62,400)
         Payments for interest                                           (40,800)
         Payments for taxes                                              (37,800)
     Net cash used in operating activities                                                 $ (76,200)

     Cash flows from investing activities:
         Proceeds from sale of equipment                                $ 66,000
         Purchase of equipment                                          (276,000)
     Net cash used in investing activities                                                 (210,000)

     Cash flows from financing activities:
         Proceeds from loan                                             $240,000
         Sale of stock                                                   180,000
         Payment of dividends                                            (52,800)
     Net cash provided by financing activities                                              367,200
     Net Cash Increase for the Period                                                       $81,000




                                              Chapter 6 – 5
2.    The cash inflow and outflow summary report initially prepared by Wilcox Inc. obscures the fact
      that Wilcox’s operations consumed $76,200 in cash during 2006. Cash from operating activities is a
      key indicator of company performance. From the formal statement of cash flows, we can see that
      Wilcox needed to obtain $420,000 in financing in order to meet its cash needs for the year. The
      three-category statement of cash flows is much more informative than is the summary
      inflow/outflow statement prepared by Wilcox.

E 6-7 Understanding the Statement of Cash Flows

Looking at the cash flow statement, we see that the majority of the cash generated from operating and
financing activities was invested in KCA Company. If this investment was made with the intention of
acquiring (or merging with) KCA Company, then the financial statements of KCA Company must be
examined to assess the impact of this investment on the overall profitability of Potsie Company. We also
notice that Potsie Company retired bonds of $400,000, issued $500,000 of common stock, and issued
$800,000 of long-term debt. Further, the dividends paid totaled $200,000.

Even though there was a net increase in cash of $65,000, this is far less than the cash provided by
operations of $165,000. Further, the amount of investing and financing activities that took place indicates
that the company may be going through a major reorganization.

E 6-8 Determining Cash Payments for Inventory Purchases

Ending inventory                                                                           $ 265,000
+ Cost of goods sold during the year                                                          900,000
= Total amount of inventory needed during the year                                         $1,165,000
– Beginning inventory (inventory already on hand)                                            (232,500)
= Inventory purchased during the year                                                      $ 932,500
+ Beginning balance in accounts payable                                                       120,000
= Total amount owed for inventory purchases                                                $1,052,500
– Ending balance in accounts payable (amount not yet paid)                                   (100,000)
= Cash paid for inventory purchases                                                        $ 952,500

E 6-9 Determining Cash Payments for Inventory Purchases

Ending inventory                                                                           $ 60,000
+ Cost of goods sold during the year                                                        350,000
= Total amount of inventory needed during the year                                         $410,000
– Beginning inventory (inventory already on hand)                                           (40,000)
= Inventory purchased during the year                                                      $370,000
+ Beginning balance in accounts payable                                                      25,000
= Total amount owed for inventory purchases                                                $395,000
– Ending balance in accounts payable (amount not yet paid)                                  (20,000)
= Cash paid for inventory purchases                                                        $375,000




                                               Chapter 6 – 6
E 6-10 Determining Cash Flows from Operations

                                          Payne Company
                                 Cash Flows from Operating Activities

     Net cash flows from operating activities
         Net income                                                                         $275,000
         Depreciation expense                                                                  9,000
         Increase in accounts receivable                                                     (45,000)
         Increase in prepaid insurance                                                        (1,400)
         Decrease in supplies                                                                  2,000
         Decrease in accounts payable                                                         (8,000)
     Net cash provided by operating activities                                              $231,600

E 6-11 Determining Cash Flows from Operations

                                         Amulek Corporation
                                 Cash Flows from Operating Activities

     Net cash flows from operating activities
         Net income                                                                        $ 675,000
         Depreciation expense                                                                139,500
         Less: Gain on sale of land                                                          (25,500)
         Less: Increase in accounts receivable                                               (26,100)
         Plus: Decrease in inventory                                                          18,900
         Plus: Increase in accounts payable                                                   13,500
     Net cash provided by operating activities                                             $ 795,300

E 6-12 Cash Flow Impact of Gains and Losses

1.   If Pecan uses the direct method of reporting cash from operating activities, nothing with respect to
     the computer sale will be reported in the operating activities section. The $50,000 cash proceeds
     from the computer sale will be reported as a cash inflow from investing activities.

2.   The $50,000 cash proceeds from the computer sale will be reported as a cash inflow from investing
     activities. In addition, if Pecan uses the indirect method of reporting cash from operating activities,
     the impact of the $20,000 loss must be removed from net income. In order to do so, the $20,000
     loss is added back in computing cash from operating activities.




                                               Chapter 6 – 7
E 6-13 Complete Statement of Cash Flows: Indirect Method

                                           LaForge Company
                               Statement of Cash Flows (Indirect Method)
                                 For the Year Ended December 31, 2006
     Cash flows from operating activities:
        Net Income                                                                  $    70
        Adjustments:
             Depreciation                                                $    60
             Decrease in accounts receivable                                  50
             Increase in inventory                                           (30)
             Increase in prepaid general expenses                             (8)
             Increase in accounts payable                                     25
             Increase in interest payable                                      2
             Decrease in income taxes payable                                (17)      82
        Net cash provided by operating activities                                   $ 152

     Cash flows from investing activities:
        Sale of plant assets                                            $ 200
        Purchase of plant assets                                         (349)1
        Net cash used in investing activities                                           (149)

     Cash flows from financing activities:
        Issuance of bonds payable                                       $ 402
        Issuance of stock                                                  383
        Payment of cash dividends                                         (75)
        Net cash provided by financing activities                                          3

     Net increase in cash and cash equivalents                                      $     6
     Cash and cash equivalents at beginning of year                                      16
     Cash and cash equivalents at end of year                                       $    22

     COMPUTATIONS:
     1
         Beginning plant assets                                                     $ 1,000
         Less: Plant assets sold                                                        330
                                                                                    $ 670
         Add: Ending plant assets                                                     1,019
         Difference (plant assets purchased)                                        $ 349
     2
         Beginning bonds payable                                                    $  77
         Ending bonds payable                                                         117
         Increase (bonds payable issued)                                            $ 40
     3
         Beginning paid-in capital                                                  $ 300
         Ending paid-in capital                                                       338
         Increase (stock issued)                                                    $ 38




                                                Chapter 6 – 8
The following matrix can be used in computing cash from operating activities:
                                               Income           Adjustments             Cash Flows from
                                              Statement                                   Operations
           Sales                                1,300           A.       50                  1,350
           Cost of Goods Sold                    (880)          B.      (30)                  (885)
                                                                C.       25
           Depreciation Expense                  (60)           D.       60                      0
           General Expenses                     (240)           E.       (8)                  (248)
           Interest Expense                      (15)           F.        2                    (13)
           Income Tax Expense                    (35)           G.      (17)                   (52)
                                                  70                                           152
      A.    Decrease in accounts receivable
      B.    Increase in inventory
      C.    Increase in accounts payable
      D.    Amount of reported depreciation expense
      E.    Increase in prepaid general expenses
      F.    Increase in interest payable
      G.    Decrease in income taxes payable
E 6-14 Complete Statement of Cash Flows: Direct Method
                                             LaForge Company
                                  Statement of Cash Flows (Direct Method)
                                   For the Year Ended December 31, 2006
      Cash flows from operating activities:
              Cash receipts from customers                                                     $1,3501
              Cash payments for:
              Purchases of inventory                                        $ (885)2
              General expenses                                                 (248)3
              Interest expense                                                  (13)4
              Income tax expense                                                (52)5           (1,198)
              Net cash provided by operating activities                                        $ 152
      Cash flows from investing activities:
              Sale of plant assets                                           $ 200
              Purchase of plant assets                                       (349)
              Net cash used in investing activities                                                (149)
      Cash flows from financing activities:
              Issuance of bonds payable                                      $ 40
              Issuance of common stock                                         38
              Payment of cash dividends                                       (75)
              Net cash provided by financing activities                                                3
      Net increase in cash and cash equivalents                                                $       6
      Cash and cash equivalents at beginning of year                                                  16
      Cash and cash equivalents at end of year                                                 $      22
      COMPUTATIONS:
      1
        Sales                                                                                  $1,300
        + Beginning accounts receivable                                                            250
        – Ending accounts receivable                                                              (200)
        = Cash receipts from customers                                                         $ 1,350


                                               Chapter 6 – 9
      2
          Cost of goods sold                                                             $ 880
          – Beginning inventory                                                            (95)
          + Ending inventory                                                               125
          = Inventory purchases                                                          $ 910
          + Beginning accounts payable                                                      50
          – Ending accounts payable                                                        (75)
          = Cash payments for inventory purchases                                        $ 885
      3
          General expenses                                                               $ 240
          – Beginning prepaid general expenses                                             (10)
          + Ending prepaid general expenses                                                 18
          = Cash payments for general expenses                                           $ 248
      4
          Interest expense                                                               $ 15
          + Beginning interest payable                                                       8
          – Ending interest payable                                                        (10)
          = Cash payments for interest expense                                           $ 13
      5
          Income tax expense                                                             $ 35
          + Beginning income taxes payable                                                 107
          – Ending income taxes payable                                                    (90)
          = Cash payments for income tax expense                                         $ 52

The following matrix can be used in computing cash from operating activities:
                                             Income            Adjustments      Cash Flows from
                                            Statement                             Operations
           Sales                              1,300            A.     50             1,350
           Cost of Goods Sold                  (880)           B.    (30)             (885)
                                                               C.     25
           Depreciation Expense                 (60)           D.     60                 0
           General Expenses                    (240)           E.     (8)             (248)
           Interest Expense                     (15)           F.      2               (13)
           Income Tax Expense                   (35)           G.    (17)              (52)
                                                 70                                    152

      A.    Decrease in accounts receivable
      B.    Increase in inventory
      C.    Increase in accounts payable
      D.    Amount of reported depreciation expense
      E.    Increase in prepaid general expenses
      F.    Increase in interest payable
      G.    Decrease in income taxes payable

E 6-15 Cash Flow from Investing and Financing Activities

1.    Beginning long-term debt balance                                                $ 75,000
      + New long-term debt incurred during the year (computed)                          75,000
      = Ending long-term debt balance                                                 $150,000

      Beginning common stock balance                                                  $120,000
      + New common stock issued during the year (computed)                              30,000
      = Ending common stock balance                                                   $150,000



                                              Chapter 6 – 10
Cash inflow from financing activities is computed as follows:
New long-term debt                                                        $75,000
Common stock issued                                                        30,000
Cash dividends paid                                                       (30,000)
Total                                                                     $75,000
2.   Beginning equipment balance                                                         $150,000
     – Equipment sold during the year                                                         –0
     = Ending equipment WITHOUT purchase of new equipment                                $150,000
     + New equipment purchased during the year (computed)                                 174,000
     = Ending equipment balance                                                          $324,000
Cash outflow from investing activities was $174,000 for new equipment.
No additional land was purchased during the year.
E 6-16 Forecasted Income Statement and Statement of Cash Flows
1.                                                           Forecasted
Income Statement                                 2006          2007
      Sales                                          2,000       2,200    given
      Cost of Goods Sold                               700         770    35% of sales,
      Gross Profit                                   1,300       1,430    like last year
      Depreciation Expense                             120         160    20% of PPE, like last year
      Other Operating Expenses                       1,010       1,111    50.5% of sales,
                                                                          like last year
      Operating Profit                                 170         159
      Interest Expense                                  90          75    15% of bank loan,
                                                                          like last year
      Income before Taxes                               80          84
      Income Taxes                                      30          32    37.5% of pre-tax,
                                                                          like last year
      Net Income                                        50          52
2.    Cash flows from operating activities:
         Net Income                                                                           $ 52
         Adjustments:
              Depreciation                                               $ 160
              Increase in other current assets                             (50)
              Increase in accounts payable                                  20                 130
         Net cash provided by operating activities                                            $182
      Cash flows from investing activities:
         Purchase of property, plant, and equipment                      $(360)1
         Net cash used in investing activities                                                    (360)
      Cash flows from financing activities:
         Repayment of bank loans payable                                 $(100)2
         Issuance of common stock                                          2803
         Payment of cash dividends                                           (0)4
         Net cash provided by financing activities                                                180
      Net increase in cash and cash equivalents                                               $  2
      Cash and cash equivalents at beginning of year                                            20
      Cash and cash equivalents at end of year                                                $ 22


                                             Chapter 6 – 11
     COMPUTATIONS:
     1
         Beginning property, plant, and equipment                                              $ 600
         Less: Impact of depreciation expense                                                    160
                                                                                               $ 440
         Ending property, plant, and equipment                                                   800
         Difference (assets purchased)                                                         $ 360
     2
         Beginning bank loans payable                                                          $ 600
         Ending bank loans payable                                                               500
         Decrease (bank loans repaid)                                                          $ 100
     3
         Beginning stockholders’ equity                                                        $ 320
         Plus: Increase from forecasted net income                                                52
         Less: Decrease from forecasted cash dividends                                            (0)
         Total stockholders’ equity with no new stock                                          $ 372
         Ending stockholders’ equity                                                             652
         Increase (common stock issued)                                                        $ 280
     4
         It is assumed that cash dividends are $0.
E 6-17 Forecasted Balance Sheet, Income Statement, and Statement of Cash Flows
1.                                                            Forecasted
Balance Sheet                                    2006           2007

     Cash                                           20            30       50% natural increase
     Other Current Assets                          500           750       50% natural increase
     Property, Plant, and Equipment, net         1,600         1,600       more efficient, item (b)
     Total Assets                                2,120         2,380

     Accounts Payable                              200           300       50% natural increase
     Bank Loans Payable                          1,400         1,800       new loan of $400, item (c)
     Total Stockholders’ Equity                    520           280       to balance
     Total Liabilities and Equities              2,120         2,380
2.
Income Statement
     Sales                                       2,000         3,000       given, item (a)
     Cost of Goods Sold                          1,500         2,250       75% of sales,
                                                                           like last year
     Gross Profit                                    500         750
     Depreciation Expense                             80          80       5% of PPE,
                                                                           like last year
     Other Operating Expenses                        160         240       8% of sales,
                                                                           like last year
     Operating Profit                                260         430
     Interest Expense                                140         180       10% of bank loan,
                                                                           like last year
     Income before Taxes                             120         250
     Income Taxes                                     40          83       33.3% of pre-tax,
                                                                           like last year
     Net Income                                       80         167


                                             Chapter 6 – 12
3.   Cash flows from operating activities:
        Net Income                                                          $ 167
        Adjustments:
             Depreciation                                        $ 80
             Increase in other current assets                    (250)
             Increase in accounts payable                         100
                                                                             (70)
        Net cash provided by operating activities                           $ 97
     Cash flows from investing activities:
        Purchase of property, plant, and equipment               $ (80)1
        Net cash used in investing activities                                 (80)
     Cash flows from financing activities:
        New bank loans payable                                   $ 4002
        Repurchase of common stock                               (407)3
        Payment of cash dividends                                   (0)4
        Net cash provided by financing activities
                                                                              (7)
     Net increase in cash and cash equivalents                              $ 10
     Cash and cash equivalents at beginning of year                           20
     Cash and cash equivalents at end of year                               $ 30

COMPUTATIONS:
     1
         Beginning property, plant, and equipment                          $ 1,600
         Less: Impact of depreciation expense                                   80
                                                                           $ 1,520
         Ending property, plant, and equipment                               1,600
         Difference (assets purchased)                                      $ 80
     2
         Beginning bank loans payable                                      $ 1,400
         Ending bank loans payable                                           1,800
         Increase (new bank loans)                                          $ 400
     3
         Beginning stockholders’ equity                                    $ 520
         Plus: Increase from forecasted net income                            167
         Less: Decrease from forecasted cash dividends                         (0)
         Total stockholders’ equity with no new stock                      $ 687
         Ending stockholders’ equity                                          280
         Decrease (common stock repurchased)                               $ (407)
     4
         It is assumed that cash dividends are $0.




                                                Chapter 6 – 13
PROBLEMS
P 6-18 Types of Changes in Cash
1. Item                                               Operating    Investing     Financing      None
a. Net income for the year, $3,000                        X
b. Purchase of a new building through the
   issuance of a mortgage for the entire amount                                                  X
c. Issuance of capital stock in exchange for land
   valued at $20,000                                                                             X
d. Collection of accounts receivable, $12,000             X
e. Payment of interest on bond debt, $9,000               X
f. Payment of cash dividends, $12,000                                                X
g. Issuance of additional common stock, $300,000                                     X
h. Depreciation for year, $6,000                                                                 X
i. Purchase of equipment for cash, $12,000                             X
j. Sale of long-term investments, $25,000                              X
k. Sale of merchandise on account, $35,000                                                       X
l. Deposit of cash in a savings account, $5,000                                                  X

     Note: For item (l), the savings account would probably be considered to be a cash equivalent. As a
     result, this transaction merely results in changing cash from one form into another; there is no net
     financial statement effect.

2.   ANALYSIS: As seen in items (b) and (c), some very significant transactions can be excluded from
     the cash flow statement. The FASB’s position makes some sense because it restricts the cash flow
     statement to just those transactions involving cash. A compromise position might be to exclude the
     significant non-cash transactions from the formal cash flow statement, but to require that they be
     briefly mentioned at the bottom of the statement of cash flows and then more fully explained in the
     financial statement notes. In this way, financial statement users would be less likely to overlook
     these important non-cash transactions.

P 6-19 Determining Cash Flow from Operations

1.                                  The Laker Basketball Company
                          Partial Statement of Cash Flows—Indirect Method
                                   For the Year Ended June 30, 2006

     Cash from operating activities
         Net income                                                                      $50,000
         Adjustments to reconcile net income to net cash
             provided by operating activities:
             Depreciation expense                                        $12,000
             Loss on sale of investment securities                         1,000
             Restructuring charge                                        105,000
             Loss on sale of land                                         20,000
             Gain on early extinguishment of debt                        (70,000)
             Increase in accounts receivable                              (8,000)         60,000
     Net cash provided by operating activities                                          $110,000
     Note: Because the investment securities are NOT part of the Laker’s active trading portfolio, the
     purchases and sales of the investment securities are investing activities. As such, the loss is
     excluded from the calculation of cash from operating activities.


                                             Chapter 6 – 14
2.    ANALYSIS: Without the $70,000 gain from the early extinguishment of debt, The Laker
      Basketball Company would have reported a net loss of $20,000 ($50,000 – $70,000) for the year.
      Clearly, the company accelerated the extinguishment of the debt in order to avoid the
      embarrassment of reporting a net loss. However, because the company was preparing to extinguish
      the debt anyway, management can hardly be faulted for taking advantage of the timing to erase the
      potential net loss.
P 6-20 Determining Cash Flow from Operations
1.                                           Stevo Company
                             Partial Statement of Cash Flows—Direct Method
                                  For the Year Ended December 31, 2006
Cash from operating activities
    Cash received from customers
        Sales                                                        $ 400,000
        Decrease in accounts receivable                                 20,000         $420,000
    Cash received from rent
        Rental income                                                $   6,560
        Increase in rent receivable                                       (160)           6,400
    Cash paid to suppliers
        Cost of goods sold                                           $ 278,800
        Decrease in inventories                                         (4,000)
        Decrease in accounts payable                                     4,000         (278,800)
    Cash paid for supplies
        Supplies used                                                $   3,760
        Increase in supplies                                               640          (4,400)
    Cash paid for other accrued expenses
        Other accrued expenses                                      $ 61,600
        Increase in other accrued liabilities                          (2,400)          (59,200)
Net cash provided by operations                                                        $ 84,000
2.   The property, plant, and equipment was sold for $13,600, computed as follows:
     Historical cost of property, plant, and equipment sold                            $ 16,000
     Less: Accumulated depreciation                                                      (4,000)
     Book value of property, plant, and equipment sold                                 $ 12,000
     Plus: Gain on sale                                                                   1,600
     Proceeds from sale of property, plant, and equipment                              $ 13,600
3.   Property, plant, and equipment in the amount of $96,000 was purchased during the year, computed
     as follows:
      Beginning property, plant, and equipment (PP&E) balance                          $400,000
      – Historical cost of PP&E sold during the year                                   – 16,000
      = Ending PP&E WITHOUT purchase of new PP&E                                       $384,000
      + New PP&E purchased during the year (computed)                                    96,000
      = Ending PP&E balance                                                            $480,000
4.    A cash dividend of $27,840 was paid during the year, computed as follows:
      Beginning retained earnings balance                                               $72,000
      Plus: Net income for the year                                                      56,000
      = Ending retained earnings WITHOUT payment of dividends                          $128,000
      – Cash dividends paid during the year (computed)                                   27,840
      = Ending retained earnings balance                                               $100,160


                                                Chapter 6 – 15
5.   ANALYSIS: Stevo Company does not look like a young, start-up company. Both accounts
     receivable and inventory decreased during the year; these accounts are typically increasing for
     growing companies. In addition, cash dividends paid were almost half of net income. Dividends
     would probably be a much lower percentage of net income for a young company.

P 6-21 Analysis of Cash Flow Data

1.                                                                        2006              2005
     Net income                                                          $65,000          $57,000
     + Depreciation                                                       50,000           48,000
     – Increase in other current assets/
     + Decrease in other current assets                                  (50,000)         (30,000)
     + Increase in current liabilities/
     – Decrease in current liabilities                                    95,000          (10,000)
     Net cash from operating activities                                 $160,000          $65,000

2.                                                             2006            2005         2004
     Cash                                                    $75,000         $120,000     $60,000
     Other current assets                                    450,000          400,000     370,000
     Current liabilities                                     335,000          290,000     250,000

                                                                           2006              2005
     Net income                                                          $65,000          $57,000
     + Depreciation                                                       50,000           48,000
     – Increase in other current assets/
     + Decrease in other current assets                                  (50,000)         (30,000)
     + Increase in current liabilities/
     – Decrease in current liabilities                                    45,000          40,000
     Net cash from operating activities                                 $110,000        $115,000

3.                                                              2006           2005         2004
     Cash                                                    $ 75,000        $120,000     $ 60,000
     Other current assets                                     450,000         350,000     370,000
     Current liabilities                                      335,000         240,000     250,000

                                                                           2006              2005
     Net income                                                          $65,000           $57,000
     + Depreciation                                                       50,000            48,000
     – Increase in other current assets/
     + Decrease in other current assets                                 (100,000)           20,000
     + Increase in current liabilities/
     – Decrease in current liabilities                                    95,000          (10,000)
     Net cash from operating activities                                 $110,000         $115,000

4.   ANALYSIS: As the examples above illustrate, cash from operations can be manipulated easily by
     delaying payments or purchases past the end of the period. However, the examples also illustrate
     that total cash flow cannot be manipulated—total cash flow for the years 2006 and 2005 is
     $225,000 in all three examples. The manipulations just have the effect of shifting cash flow from
     one period to another.



                                            Chapter 6 – 16
P 6-22 Definitions of Cash Flow

1.                                                                2006       2005        2004       2003
     Net income                                                   $ 100      $ 100       $ 100      $ 100
     + Depreciation                                                  60         60          60         60
     ± Change in receivables                                        (20)         0         (40)       (30)
     ± Change in inventory                                          (30)        60           0         10
     ± Change in payables                                            40         50         (30)        20
     Net cash from operating activities                           $ 150      $ 270       $ 90       $ 160

2.   “Cash flow” (net income + depreciation) is $160 each year.

3.   ANALYSIS: When working capital (current assets – current liabilities) is relatively constant, the
     net cash from operations is about the same as the cash flow measure. This is the case in 2006 and in
     2003 in the example. Firms that are not growing would expect to have a stable level of working
     capital. For such firms, net income + depreciation is a reasonable approximation for cash flow from
     operations.

     If working capital is increasing, then part of the cash generated by operations must be used to
     finance the additional working capital. This will cause cash flow from operations to be less than net
     income + depreciation. This is the case in 2004 in the example. Working capital is often increasing
     in high-growth firms and also in firms that are having trouble collecting receivables or moving
     inventory.

     If working capital is decreasing, extra cash is freed up in addition to the cash generated by
     operations. This will cause cash flow from operations to be greater than net income + depreciation.
     This is the case in 2005 in the example. Working capital can be decreased by any combination of
     the following actions: increase receivable collection efforts, reduce inventory levels, allow payable
     levels to increase.

P 6-23 How to Generate Cash

     Examination of the operating activities section of a statement of cash flows reveals several other
     possible sources of cash. In general, it is often possible to free up cash by reducing working capital
     as follows:

        Reduce receivables. This can be done by increasing collection efforts. This strategy is
         particularly effective for businesses that have previously been lax and have allowed receivables
         to balloon. Of course, care must be taken not to alienate customers.
        Reduce inventories. When cash is short, many companies find that by more carefully
         monitoring inventory levels they can reduce the need to keep inventory on hand.
        Reduce prepaid expenses.
        Delay cash payment of payables. Care must be taken not to anger suppliers, and the advisability
         of losing cash discounts must be considered, but this is probably the most common strategy
         used by businesses with short-term cash shortages.

     Many businesses are less profitable than they could be because they have too large an investment in
     working capital. Often it requires a cash shortage to make this fact apparent.




                                              Chapter 6 – 17
P 6-24 Comparison of Indirect and Direct Methods

1.
                                            Riker Company
                            Partial Statement of Cash Flows (Direct Method)
                                 For the Year Ended December 31, 2006

     Cash flows from operating activities:
        Cash receipts from customers                                                       $803,7501
        Cash payments for:
             Inventory                                                  $489,4902
             Operating expenses                                           98,8003
             Interest                                                     22,5004
             Income taxes                                                 37,9305           648,720
        Net cash flow provided by operating activities                                     $155,030

COMPUTATIONS:
     1
         Sales                                                                             $812,350
         – Increase in accounts receivable                                                    8,600
         = Cash receipts from customers                                                    $803,750
     2
         Cost of goods sold                                                                $500,000
         – Decrease in inventory                                                            (12,430)
         + Decrease in accounts payable (80%)                                                 1,920
         = Cash payments for inventory                                                     $489,490
     3
         Operating expenses                                                                $100,000
         + Decrease in accounts payable (20%)                                                   480
         – Decrease in prepaid operating expenses                                            (1,680)
         = Cash payments for operating expenses                                            $ 98,800
     4
         Interest expense                                                                  $ 23,000
         – Increase in interest payable                                                         500
         = Cash payments for interest                                                      $ 22,500
     5
         Income tax expense                                                                $ 40,430
         – Increase in income taxes payable                                                   2,500
         = Cash payments for income taxes                                                  $ 37,930

2.   ANALYSIS: Your partner is correct in one sense—negative operating cash flow is a bad sign in an
     old, established company. Such companies should be generating enough cash from operations to be
     able to finance investing activities and have extra cash to pay cash dividends, repay loans, and so
     forth. Look again at the cash flow statement—this is exactly the situation that Riker Company is in.
     Your partner has made the mistake of confusing overall change in the cash balance with operating
     cash flow. The change in the cash balance is not a very important number, but the operating cash
     flow is very important.




                                              Chapter 6 – 18
P 6-25 Preparation of an Income Statement Using Balance Sheet and Cash Flow Data
1.
                                            Troi Company
                                          Income Statement
                                For the Year Ended December 31, 2006
     Sales
         $692,3001
     Cost of goods sold
         307,0002
     Gross profit
         $385,300
     Operating expenses:
         General expenses                                           $101,3003
         Wages expense                                               151,7004
         Amortization expense                                          4,0005
         Depreciation expense                                         27,6006       284,600
                                                                                   $100,700
     Other revenue and expenses:
        Interest expense                                        $      (9,800)7
        Loss on retirement of bonds payable                             (3,000)8
        Gain on sale of property, plant, and equipment.                  5,2009    (7,600)
     Income before income taxes                                                          $
         93,100
     Income tax expense                                                               24,30010
     Net income                                                                          $
         68,800
COMPUTATIONS:
     1
         Cash collected from customers                                             $685,300
         + Increase in accounts receivable                                            7,000
         = Sales                                                                   $692,300
     2
         Cash payments for inventory                                               $300,000
         + Increase in accounts payable                                               3,000
         + Decrease in inventory                                                      4,000
         = Cost of goods sold                                                      $307,000
     3
         Cash payments for general expenses                                        $102,000
         – Increase in prepaid general expenses                                         700
         = General expenses                                                        $101,300
     4
         Cash payments for wages                                                   $150,000
         + Increase in wages payable                                                  1,700
         = Wages expense                                                           $151,700
     5
         Beginning goodwill                                                         $40,000
         – Ending goodwill                                                           36,000
         = Amortization expense                                                     $ 4,000



                                             Chapter 6 – 19
6
    Beginning accumulated depreciation                      $ 128,900
    – Accumulated depreciation associated with asset sale      53,000
    = Total                                                   $75,900
    – Ending accumulated depreciation                         103,500
    = Depreciation expense                                    $27,600




                                       Chapter 6 – 20
     7
          Cash payments for interest expense                                                 $11,000
          – Decrease in interest payable                                                       1,200
          = Interest expense                                                                 $ 9,800
     8
          Decrease in bonds payable                                                          $20,000
          – Cash used to retire bonds payable                                                 23,000
          = Loss on retirement                                                               $ (3,000)
     9
          Book value of property, plant, and equipment sold                                  $22,000
          – Sales price                                                                       27,200
          = Gain on sale                                                                     $ 5,200
     10
          Cash payments for income tax expense                                               $23,900
          + Increase in income tax payable                                                       400
          = Income tax expense                                                               $24,300
2.   ANALYSIS: It can be deduced that the $14,000 in dividends payable have already been deducted
     from the retained earnings balance.
        Beginning retained earnings balance                                           $84,000
        Plus: Net income for the year                                                  68,800
        = Ending retained earnings WITHOUT payment of dividends                    $ 152,800
        – Cash dividends during the year (computed)                                    56,000
        = Ending retained earnings balance                                            $96,800
     Total dividends subtracted from retained earnings were $56,000, only $42,000 of which were paid
     in cash (see the cash flow statement). Once a dividend is declared by the board of directors, it is
     considered to be a legal obligation and the amount is subtracted from retained earnings.
P 6-26 Interpretation of Cash Flow Information
1.   The statement of cash flows provides information about Denslowe’s current liquidity, a measure to
     assist Denslowe in setting a dividend payment for the year and in evaluating the effects of the
     company’s investing and financing strategies during the year. It also provides a basis for
     anticipating the company’s future cash flows (especially those from operations) to determine
     whether additional financing (debt, equity, or liquidation of existing assets) will be required to
     continue operations, meet obligations as they come due, and pay dividends.
2.   The principal explanation for why Denslowe earned a profit for the year yet couldn’t pay its current
     debts is revealed in the statement. Most of the net income of $100,000 for the year was attributable
     to the $90,000 gain on sale of the plant. This is deducted from net income because the transaction
     affects net income but does not affect cash flows from operations (the sale of a long-term asset such
     as property, plant, and equipment is an investing activity). A look at the financing section tells us
     that of the $120,000 received from the sale of the plant, $80,000 was spent paying off long-term
     debt (most likely related to the plant), so the net cash generated by the sale is $40,000 ($120,000 –
     $80,000). In addition, the company spent $45,000 on the plant during the year (the plant may have
     required capital improvements before it could be sold to the buyer). Thus, from a cash standpoint,
     the company came out of pocket by $5,000 ($45,000 – $40,000) as a result of the entire “cycle” of
     improving the plant, selling it, and paying off the related debt.
     In addition, the company paid $35,000 in dividends during the year. Receivables and inventories
     increased by $20,000 and $30,000, respectively. Thus, expenditures totaling $85,000 were made
     using cash that potentially could have been available to pay current debts. The company should
     examine and refine its policies for spending cash if it wishes to make cash available to meet current
     debts.


                                                Chapter 6 – 21
3.   ANALYSIS:                          Denslowe Associates
                               FORECASTED Statement of Cash Flows
                                For the Year Ended December 31, 2007

     Cash flows from operating activities
     Net income                                                   $     10,0001

     Adjustments:
         Provision for depreciation and amortization                     40,000
         Changes in assets and liabilities:
         (Increase) in receivables                                      (20,000)2
         (Increase) in inventory                                        (30,000)2
         (Decrease) in payables                                         (20,000)2
     Net cash used by operating activities                                                 $(20,000)

     Cash flows from investing activities
         Addition to plant and equipment                              (45,000)3
     Net cash used by investing activities                                                  (45,000)

     Cash flows from financing activities
         Dividends paid                                                  (35,000)4
         New financing (loans or stock issuance)                         100,0005
     Net cash provided by financing activities                                                 65,000
     Change in cash                                                                   $    0

     Assumptions:
     1. The gain on the sale of the plant was a one-time thing. The best guess of next year’s net income
        is $10,000 which is this year’s net income without the gain ($100,000 this year’s net income –
        $90,000 gain).
     2. Without information to the contrary, it seems reasonable to expect current assets and current
        liabilities to continue to increase or decrease as in the past. Alternatively, it may be assumed
        that, instead of decreasing, accounts payable will be unchanged or even increase.
     3. In order to stay in business, Denslowe will have to continue to update and improve its plant and
        equipment. Accordingly, it is assumed that expenditures for new plant and equipment in 2007
        will be the same as in 2006. It is also assumed that no additional asset disposals will occur.
     4. Companies are very reluctant to reduce the amount of cash dividends. Also, given Denslowe’s
        operating cash flow problems, it seems unlikely that dividends will be increased. Thus, it is
        assumed that dividends in 2007 will be the same as in 2006.
     5. This $100,000 is a plug figure—this is the amount of new financing needed if the total change
        in cash for the year is to be $0.

     This simple exercise illustrates the power of a forecasted statement of cash flows. A few basic
     assumptions lead one to the conclusion that, unless something changes dramatically, Denslowe will
     be forced to obtain a significant amount of external financing in 2007. Armed with this forecasted
     information, the president of Denslowe Associates can now consider what changes to operating
     policy and dividend policy need to be implemented in 2007.




                                             Chapter 6 – 22
P 6-27 Using a Statement of Cash Flows

1.   The balance in the Retained Earnings account as of December 31, 2006 is $30,000, computed as
     follows:
     Beginning retained earnings balance                                               $25,000
     Plus: Net income for the year                                                       6,000
     Less: Cash dividends paid during the year                                          (1,000)
     = Ending retained earnings balance                                                $30,000

2.   The balance in the Equipment (net) account as of December 31, 2006 is $24,000, computed as
     follows:
     Beginning equipment balance                                                     $46,000
     – Depreciation expense for the year                                              –4,000
     – Equipment sold during the year                                                –18,000
     = Ending equipment WITHOUT purchase of new equipment                            $24,000
     + New equipment purchased during the year                                             0
     = Ending equipment balance                                                      $24,000

     The $18,000 net amount of the equipment sold during the year is the book value of the equipment,
     computed as follows:
     Cash proceeds from sale of equipment                                                 $15,000
     Less: Book value (computed)                                                           18,000
     Gain or (loss) on sale                                                               $ (3,000)

3.   Sales for the period were $106,000, computed as follows:
     Beginning accounts receivable balance                                               $18,000
     Plus: Sales for the year (computed)                                                 106,000
     Less: Cash collections during the year                                             (100,000)
     = Ending accounts receivable balance ($18,000 + $6,000)                             $24,000

4.   Cost of goods sold for the period was $62,000, computed as follows:

     Beginning balance in accounts payable                                               $27,000
     + Inventory purchased during the year (computed)                                     60,000
     – Cash paid for inventory purchases                                                 (68,000)
     = Ending balance in accounts payable ($27,000 – $8,000)                             $19,000

     Beginning inventory                                                                 $26,000
     + Inventory purchased during the year (from above)                                   60,000
     – Ending inventory ($26,000 – $2,000)                                               (24,000)
     = Cost of goods sold during the year                                                $62,000

5.   The net increase in TOTAL assets for 2006 was $0, computed as follows:
     Cash                                                                                +$5,000
     Accounts receivable                                                                 + 6,000
     Inventory                                                                           – 2,000
     Equipment (see part [2])                                                            –22,000
     Land                                                                                +13,000
     Total change                                                                        $     0




                                            Chapter 6 – 23
6.   ANALYSIS: This is NOT a point that should be emphasized. In a normal company, cash from
     investing activities is usually negative, reflecting the fact that cash is being used to upgrade,
     replace, or expand property, plant, and equipment. The key number in the cash flow statement is the
     cash from operating activities—the members of the board of directors should spend their time
     figuring out how to explain to the stockholders why this number is so low.
P 6-28 Working Backwards from Cash Flow Data
1.                                       John Company
                                       Income Statement

     Sales                                                        $    105,6001
     Cost of goods sold                                                (67,200)2
     Other expenses                                                    (24,000)
     Depreciation expense                                              (9,600)
     Gain on sale of equipment                                        2,400
     Net income                                                   $   7,200
     1
         Cash collected from customers                                                      $88,800
         + Increase in accounts receivable                                                   16,800
         = Sales                                                                          $ 105,600
     2
         Cash payments for inventory                                                       $48,000
         + Increase in accounts payable                                                     24,000
         – Increase in inventory                                                            –4,800
         = Cost of goods sold                                                              $67,200
2.                                           John Company
                                             Balance Sheet
     Cash                                                                                  $ 7,200
     Accounts receivable
         16,800
     Inventory
         4,800
     Equipment                                                    $   45,6003
     Less: Accumulated depreciation ($9,600 – $2,400)                   (7,200)            38,400
     Total assets                                                                                   $
         67,200

     Accounts payable                                                                               $
         24,000
     Long-term debt
         48,000
     Paid-in capital
         24,000
     Retained earnings ($7,200 – $36,000)
         (28,800)
     Total liabilities and equities                                                        $67,200
     Note: This is John Company’s first year of operations so the beginning balances of all the balance
     sheet accounts were $0.
     3
         Beginning equipment balance                                                       $        0



                                             Chapter 6 – 24
        – Equipment sold during the year                                                   –12,000
        + New equipment purchased during the year                                           57,600
        = Ending equipment balance                                                         $45,600
3.   ANALYSIS: It is somewhat unusual that John is already selling equipment in the first year of
     operations. However, even more unusual is the fact that John paid $36,000 in dividends, five times
     the amount of income for the year. In a real company, it is unlikely that the creditors would allow
     the company to pay out so much cash to stockholders so soon.




                                            Chapter 6 – 25
P 6-29 Forecasted Balance Sheet and Income Statement

1.
                                                             Forecasted
Balance Sheet                                        2006        2007
     Cash                                              40          48   20% natural increase
     Other Current Assets                             350         420   20% natural increase
     Property, Plant, and Equipment, net            1,000         800   $1,000 – $200;
                                                                        no replacements
     Total Assets                                   1,390       1,268

     Accounts Payable                                 100        120        20% natural increase
     Bank Loans Payable                             1,000      1,000        no new loans, item (c)
     Paid-in Capital                                  100       –147        to balance
     Retained Earnings                                190        295        $190 + $120 – $15
     Total Liabilities and Equities                 1,390      1,268


Income Statement
     Sales                                          1,000      1,200        given, item (a)
     Cost of Goods Sold                               350        420        35% of sales,
                                                                            like last year
     Gross Profit                                    650            780
     Depreciation Expense                            200            200     *same as last year;
                                                                            no replacements
     Other Operating Expenses                        250            300     25% of sales,
                                                                            like last year
     Operating Profit                                200            280
     Interest Expense                                120            120     12% of bank loan,
                                                                            like last year
     Income before Taxes                              80            160
     Income Taxes                                     20             40     25% of pre-tax,
                                                                            like last year
     Net Income                                       60            120

     *One could also argue that depreciation expense will be lower in 2007 because the net amount of
     property, plant, and equipment will decline.

     Cash flows from operating activities:
        Net Income                                                                     $120
        Adjustments:
             Depreciation                                                 $200
             Increase in other current assets                             (70)
             Increase in accounts payable                                    20        150
        Net cash provided by operating activities                                  $   270

     Cash flows from investing activities:
        Purchase of property, plant, and equipment              $           (0)1
        Net cash used in investing activities                                          (0)




                                            Chapter 6 – 26
     Cash flows from financing activities:
        New bank loans payable                                    $       0
        Repurchase of common stock                                       (247)2
        Payment of cash dividends                                         (15)
        Net cash provided by financing activities                                      (262)

     Net increase in cash and cash equivalents                                         $       8
     Cash and cash equivalents at beginning of year                                    40
     Cash and cash equivalents at end of year                                          $       48

COMPUTATIONS:
     1
         Beginning property, plant, and equipment                                              $1,000
         Less: Impact of depreciation expense                                                     200
                                                                                                $ 800
         Ending property, plant, and equipment                                                    800
         Difference (assets purchased)                                                          $ 0
     2
         Beginning paid-in capital                                                             $ 100
         Ending paid-in capital                                                                  (147)
         Decrease (common stock repurchased)                                                   $ (247)

2.   ANALYSIS: Payment of cash dividends involves distributing an equal amount of cash for each
     share owned. Repurchase of shares of stock channels the cash to shareholders who are the least
     optimistic about the prospects of the company. Because they are the least optimistic, they are the
     shareholders who offer their shares for sale when the company announces a stock repurchase.


APPLICATIONS AND EXTENSIONS SOLUTIONS
Deciphering Actual Financial Statements
Deciphering 6-1 (McDonald’s)
1.   The single biggest cause of the increase in cash from operating activities in 2003 was the $577.9
     increase in net income—from $893.5 million to $1,471.4 million.
2.   In 2003, the cash generated by McDonald’s operations was $3,268.8 million. This was more than
     sufficient to pay the $1,369.6 million required for McDonald’s investing activities.
3.   In 2003, McDonald’s distributed cash to its stockholders in the following two ways:
     • Cash dividends amounting to $503.5 million.
     • Repurchases of shares of common stock totaling $391.0 million.
4.   If interest paid and income taxes paid were not considered to be part of operating activities,
     McDonald’s would have reported $4,304.2 million in cash from operating activities in 2003,
     computed as follows:
     Reported cash from operating activities                      $3,268.8 million
     Cash paid for interest                                          426.9 million
     Cash paid for income taxes                                      608.5 million
     Total                                                        $4,304.2 million
5.   McDonald’s defines cash equivalents as “short-term, highly liquid investments.”


                                            Chapter 6 – 27
Deciphering 6-2 (Coca-Cola)
1.   The amount represents the operating cash flow generated by Coca-Cola that is in excess of what the
     company needed to pay for new property, plant, and equipment and other investing activities. For
     the years 2001 through 2003, this excess was: $2.922 billion in 2001, $3.677 billion in 2002, and
     $4.520 billion in 2003. In fact, Coca-Cola’s operations generated surplus cash even after paying for
     its financing activities in each of these three years.
2.    Coca-Cola subtracts gains and adds losses on sales of assets in the computation of net cash
      provided by operating activities to avoid double counting these gains and losses. The gains and
      losses are included in the proceeds from the disposal of property, plant, and equipment and other
      investments which are reported in the investing activities section. The gains and losses are also
      included in the computation of net income. If the gains were not subtracted and the losses added in
      computing cash from operating activities, then they would be included in cash from operating
      activities (by being included in net income) and they would also be included in investing activities.
      Subtracting gains and adding losses avoids double counting.
3.
                                                                     2003            2002         2001
      RECEIVED FROM SHAREHOLDERS:
         Issuances of stock                                             98            107           164
      PAID TO SHAREHOLDERS:
         Purchases of stock for treasury                            (1,440)          (691)         (277)
         Dividends                                                  (2,166)        (1,987)       (1,791)
      NET CASH PAID TO SHAREHOLDERS                                 (3,508)        (2,571)       (1,904)

      From 2001 through 2003, the Company paid its shareholders much more than it received from its
      shareholders.

4.    The U.S. dollar got stronger during 2001 and then got weaker during 2002 and 2003. You can tell
      this by looking at the line titled “Effect of exchange rate changes on cash and cash equivalents.”
      This amount represents the change in the U.S. dollar value of the foreign currency cash (yen,
      marks, rupiah, baht, francs, etc.) held by Coca-Cola. Notice that in 2001 this amount results in a
      subtraction from cash. This means that these foreign currencies, as a whole, got weaker (that is, lost
      value) relative to the U.S. dollar in 2001. Another way to say this is that the U.S. dollar got
      stronger. Conversely, notice that in 2002 and 2003 this amount results in an addition to cash, which
      means that these foreign currencies, as a whole, got stronger (that is, gained value) relative to the
      U.S. dollar. Another way to say this is that the U.S. dollar got weaker.

Deciphering 6-3 (Microsoft)
1.   Virtually all companies display the years in their financial statements with the most recent year in
     the far left column. Microsoft does it exactly the opposite. Why? Any answer would be
     speculation. Microsoft just does it different.

2.    Virtually all companies list the activities in the following order – Operating, Investing, Financing.
      Microsoft lists the categories – Operating, Financing, Investing. Why? Again, any answer would
      be speculation. Microsoft just does it different.

3.    a) Microsoft’s primary financing activity is the repurchase of shares of its own stock.
      b) Microsoft’s primary investing activities are the purchase and sale of investments. Microsoft
         uses much of its excess cash to invest in other companies.




                                               Chapter 6 – 28
      c) The addition of ‘unearned revenue’ amounts to the net income figure represents cash that was
         received in the current period but will not be recorded as revenue on the income statement until
         future periods. The subtraction of ‘recognition of unearned revenue’ amounts represents
         revenue that was recognized on the income statement in this period even though the cash was
         received in a prior period.

Deciphering 6-4 (Archer Daniels Midland)
1.   During 2003, ADM increased its long-term borrowing by $517 million and borrowed $282 million
     under lines of credit agreements. These two events account for the majority of the increase in cash
     flow from financing activities from 2002 to 2003.

2.    During 2003, ADM acquired $527 million in assets from various businesses, and it invested $90
      million in affiliates. These two events account for the majority of the increase in cash flow used in
      investing activities from 2002 to 2003.

3.    A dramatic increase in borrowings and no new stock issuance do not necessarily mean there will be
      a correspondingly dramatic increase in the company’s debt ratio. Invested capital can come from
      two sources—from new stock issues and from retained earnings. Comparison of net income to cash
      dividends during the period shows that ADM's retained earnings increased by over $295 million in
      2003. Incidentally, ADM’s debt ratio did increase from 56.1 percent in 2002 to 58.9 percent in
      2003—whether this increase is considered “dramatic” is debatable.

Deciphering 6-5 (Lockheed Martin)
1.
                                         2003        2002        2001
a. Net income plus depreciation         $1,533       $966        $468

b. Cash flow from operating              1,809      2,288        1,825
    activities

c. Cash flow from operating              2,498      2,929        3,369
     activities
   + Cash paid for interest
   + Cash paid for taxes

d. Cash flow from operating               861       1,427        1,014
     activities
   – Capital expenditures
   – Dividends

2.    In order to maintain its long-run potential, a company must consistently replace property, plant, and
      equipment, and must maintain a stable cash dividend level for investors. The cash flow number
      computed in (d) of part (1)-cash flow from operating activities–capital expenditures–dividends—is
      a measure of how much “free cash flow” Lockheed Martin generates after maintaining its long-run
      potential.

3.    Someone considering a leveraged buyout (LBO) is interested in the cash flow from the operations
      of the business before payment of financing costs. This is the cash flow before payments for
      interest and taxes are subtracted. So, someone considering an LBO would be particularly interested
      in the “cash flow” numbers calculated in (c) of part (1)—Cash flow from operating activities +
      Cash paid for interest + Cash paid for taxes.


                                              Chapter 6 – 29
International Financial Statements: GlaxoSmithKline
1.    GlaxoSmithKline uses the following 9 categories in preparing its cash flow statement:
       operating activities
       dividends from joint ventures and associated undertakings
       returns on investment and servicing of finance
       taxation paid
       capital expenditure and financial investment
       acquisitions and disposals
       equity dividends paid
       management of liquid resources
       financing

2.    GlaxoSmithKline has excluded the following items from the computation of cash from operating
      activities. These items would be included in that computation if the cash flow statement were
      prepared according to U.S. standards.
       Dividends from joint ventures and associated undertakings
       interest received
       interest paid
       taxation paid

3.    Looking at the list of items in (2) that GlaxoSmithKline excludes from the computation of cash
      from operating activities but which a U.S. company would include, it appears that the British
      number is a better measure of operating cash flow. The items excluded under the British format are
      not operating items at all, but relate primarily to the payment of interest and taxes. These are
      usually thought of as non-operating items. So, it looks like the British have developed a better
      measure for operating cash flow than that used by the Americans.

4.    The total change in cash is the same no matter how you sort the individual items that caused the
      change. Sort them into three categories as is done in the U.S., into nine categories as done by
      GlaxoSmithKline, or into 114 categories—the net change in cash for GlaxoSmithKline in 2003 will
      still be (27).

Business Memo: Convincing the Old-timers of the Need for Cash Flow Data
                                           MEMO
To:     President, Harry Monst Company
From: Chief Accountant

I can understand your reluctance to sign the statement of cash flows that I presented to you at your office.
In contrast to the long history of the balance sheet and the income statement, the statement of cash flows
has only been a required part of the standard set of financial statements since 1987. It is still a relatively
new statement, and many financial analysts and loan officers are not familiar with how to use it properly.
With that said, let me add that those who have used the statement of cash flows have found it to be a
useful supplement to the income statement. This is the reason that our new loan officer has requested that
we provide the statement. The cash flow data are particularly useful to bankers as they evaluate whether
our operations will generate sufficient cash flow to enable us to make our debt service payments.
I have carefully examined our statement of cash flows and am convinced that it provides accurate and
relevant information about our operations. I have attached a copy of the statement to this memo. Note that



                                                Chapter 6 – 30
the three categories in the statement—operating, investing, and financing—give a nice summary of what
we have done in our business in the past year. I ask that you take another look at the statement.




                                            Chapter 6 – 31
Research: What Is in a REAL Cash Flow Statement?
The February 1, 2004, financial statements for Home Depot will be used to discuss possible findings for
the research project involving five actual cash flow statements.

1.   Home Depot uses the indirect method. Only about one out of 20 large U.S. companies uses the
     direct method.
2.   For the year ended February 1, 2004, Home Depot has the classic pattern: positive cash from
     operations and negative cash from investing activities.
3.   Home Depot’s 2004 cash from operations of $6.545 billion is greater than its net income of $4.304
     billion. For most companies, cash from operations is greater than net income.
4.   The three largest adjustments for Home Depot are:
     Depreciation and amortization                                                $1,076,000,000
     Increase in accounts payable                                                    790,000,000
     Increase in merchandise inventories                                            (693,000,000)
     For many companies, the depreciation and amortization adjustment is the largest. Home Depot is
     growing fast, as is evidenced in its large increases in accounts payable and inventory.
5.   Home Depot’s 2004 “free cash flow” is computed as follows:

     Cash flow from operations                                                   $ 6,545,000,000
     – Capital expenditures                                                       (3,508,000,000)
     – Cash dividends                                                               (595,000,000)
     = Free cash flow                                                             $2,442,000,000

6.   Home Depot’s 2004 “net income plus depreciation” is computed as follows:

     Net income                                                                  $4,304,000,000
     + Depreciation and amortization                                              1,076,000,000
     = Net income plus depreciation                                              $5,380,000,000

     For Home Depot, this is a poor estimate of cash flow from operations. Since Home Depot is
     growing rapidly, changes in the balances of the current operating asset and current operating
     liability accounts are sizable. The “net income plus depreciation” definition of cash flow ignores
     changes in current operating assets and current operating liabilities.

7.   Home Depot’s 2004 “operating cash flow” is computed as follows:

     Cash flow from operations                                                    $ 6,545,000,000
     + Cash paid for interest                                                          70,000,000
     + Cash paid for taxes                                                          2,037,000,000
     = Operating cash flow                                                        $8,652,000,000

     Total assets $34,437,000,000  0.15 = $5,165,550,000

     So, for Home Depot, “operating cash flow” is in excess of 15% of total assets.




                                             Chapter 6 – 32
8.    In its financial summary, Home Depot includes a section called “Statement of Cash Flows Data.”
      However, only three items are listed: depreciation and amortization, capital expenditures, and cash
      dividends per share.

Ethics Dilemma: Is the Price Right?
This is an ethical dilemma without a neat and tidy solution. It seems clear that you cannot give the
presentation to the investment bankers. Your analysis strongly suggests that the earnings numbers have
been manipulated, so you cannot in good conscience present the proposal to the investment bankers
without voicing your concerns. You should notify the board of directors immediately, so that they can
have sufficient time to find someone else to make the presentation. You should offer to brief the new
presenter on the results of your analysis.

Before rendering a harsh judgment against the board for engaging in earnings manipulation, realize that
earnings numbers in an IPO serve much the same purpose as advertising does in the selling of cars.
Everyone knows that the numbers have been puffed up and beautified as much as possible. The
investment bankers, if they are experienced, will look at all of the financial statement numbers with
healthy skepticism.

The Debate: No One Can Understand the Indirect Method!!
Some of the arguments that might be used are listed below.
Direct Method
     Anyone can understand items such as “cash collected from customers” or “cash paid for inventory
      purchases.”
     The direct method gives exactly the type of information that financial statement users expect when
      they view the statement of cash flows—line by line details of how cash was generated and
      consumed.
     The indirect method makes the statement of cash flows seem too complex. In fact, conceptually the
      statement of cash flows is the simplest of the financial statements. The direct method gives simple,
      straightforward information.
Indirect Method
     The indirect method is very important because it highlights the adjustments that are made to
      transform raw cash flow data into net income. These adjustments are the essence of accrual
      accounting.
     Sophisticated financial statement users have long experience with the indirect method. They don’t
      want the direct method.
     The market has spoken; firms have a choice between the two methods and they have
      overwhelmingly chosen the indirect method.
Cumulative Spreadsheet Project
1.  Because of spreadsheet rounding, not all of the displayed totals reconcile exactly.
HANDYMAN                             Sales growth rate              40%
Chapter 6, Part 1                    New PPE                      $ 80
                                     New long-term debt           $ 0
                                     Cash dividends               $ 0
                                     Required current ratio        2.0




                                              Chapter 6 – 33
                                  Year    Forecasted
                                  2006      2007
BALANCE SHEET
Assets
Cash                               10         14       natural 40% increase
Receivables                        27         38       natural 40% increase
Inventory                         153        214       natural 40% increase
Total Current Assets              190        266

Property, Plant, & Equipment      199        279       new PPE of $80
Accumulated Depreciation           9          16       last year plus this year’s depreciation
                                                       expense
Total Assets                      380        529

Liabilities
Accounts Payable                    74       104       natural 40% increase
Short-term Loans Payable            10        29       figure to make current ratio equal to 2.0
Total Current Liabilities           84       133

Long-term Debt                    207        207       no new long-term debt
Total Liabilities                 291        340

Stockholders’ Equity
Paid in Capital                     50       136       balancing figure
Retained Earnings (as of 12/31)     39        53       computed from net income
                                                       and $0 dividends

Total Liab. and Equities          380        529


Retained Earnings (as of 1/1)       31         39
+ Net Income                         8         14
– Dividends                          0          0
Retained Earnings (as of 12/31)     39         53

INCOME STATEMENT

Sales                             700        980       increase of 40%
Cost of Goods Sold                519        727       same percentage of sales as in prior year
Gross Profit                      181        253
Depreciation Expense                5          7       increase in proportion to increase in PPE
Other Operating Expenses          155        217       same percentage of sales as in prior year
Operating Income                   21         29
Interest Expense                    9          9       same as last year; no new long-term debt
Income Before Taxes                12         20
Income Tax Expense                  4          7       same percentage of pre-tax income as last
                                                       year
Net Income                           8         14




                                  Chapter 6 – 34
STATEMENT OF CASH FLOWS
Operating Activities
Net Income                                       14
Depreciation                                      7
Change in A/R                                   –11
Change in Inventory                             –61
Change in A/P                                    30
Cash from operating activities                  –22

Investing Activities
Purchase of new PPE                             –80

Financing Activities
New short-term loans payable                     19
New long-term debt                                0
New paid-in capital                              86
Cash dividends                                    0
Cash from financing activities                  106

Net change in cash                                   4

2. a.
HANDYMAN                                Sales growth rate               25%
Chapter 6, Part 2a                      New PPE                       $80
                                        New long-term debt             $0
                                        Cash dividends                 $0
                                        Required current ratio         2.0

                                 Year                    Forecasted
                                 2006                      2007
BALANCE SHEET
Assets
Cash                              10                        13
Receivables                       27                        34
Inventory                        153                       191
Total Current Assets             190                       238

Property, Plant, & Equipment     199                       279
Accumulated Depreciation           9                        16
Total Assets                     380                       500

Liabilities
Accounts Payable                  74                         93
Short-term Loans Payable          10                         26
Total Current Liabilities         84                        119

Long-term Debt                    207                       207
Total Liabilities                 291                       326




                                    Chapter 6 – 35
Stockholders’ Equity
Paid in Capital                    50                125
Retained Earnings (as of 12/31)    39                 50
Total Liab. and Equities          380                500


Retained Earnings (as of 1/1)     31                  39
+ Net Income                       8                  11
– Dividends                        0                   0
Retained Earnings (as of 12/31)   39                  50


INCOME STATEMENT
Sales                             700                875
Cost of Goods Sold                519                649
Gross Profit                      181                226
Depreciation Expense                5                  7
Other Operating Expenses          155                194
Operating Income                   21                 25
Interest Expense                    9                  9
Income Before Taxes                12                 16
Income Tax Expense                  4                  5
Net Income                          8                 11


STATEMENT OF CASH FLOWS
Operating Activities
Net Income                                            11
Depreciation                                           7
Change in A/R                                         –7
Change in Inventory                                  –38
Change in A/P                                         19
Cash from operating activities                        –8

Investing Activities
Purchase of new PPE                                  –80

Financing Activities
New short-term loans payable                          16
New long-term debt                                     0
New paid-in capital                                   75
Cash dividends                                         0
Cash from financing activities                        91

Net change in cash                                     3




                                    Chapter 6 – 36
b.
HANDYMAN                                   Sales growth rate            50%
Chapter 6, Part 2b                         New PPE                     $80
                                           New long-term debt          $0
                                           Cash dividends              $0
                                           Required current ratio      2.0

                                  Year                    Forecasted
                                  2006                      2007
BALANCE SHEET
Assets
Cash                               10                          15
Receivables                        27                          41
Inventory                         153                         230
Total Current Assets              190                         285

Property, Plant, & Equipment      199                         279
Accumulated Depreciation            9                          16
Total Assets                      380                         548

Liabilities
Accounts Payable                   74                         111
Short-term Loans Payable           10                          32
Total Current Liabilities          84                         143

Long-term Debt                    207                         207
Total Liabilities                 291                         350

Stockholders’ Equity
Paid in Capital                   50                          144
Retained Earnings (as of 12/31)   39                           54
Total Liab. and Equities          380                         548

Retained Earnings (as of 1/1)      31                          39
+ Net Income                        8                          15
– Dividends                         0                           0
Retained Earnings (as of 12/31)    39                          54


INCOME STATEMENT

Sales                             700                       1,050
Cost of Goods Sold                519                         779
Gross Profit                      181                         272
Depreciation Expense                5                           7
Other Operating Expenses          155                         233
Operating Income                   21                          32
Interest Expense                    9                           9
Income Before Taxes                12                          23
Income Tax Expense                  4                           8
Net Income                          8                          15


                                         Chapter 6 – 37
STATEMENT OF CASH FLOWS
Operating Activities
Net Income                                                            15
Depreciation                                                           7
Change in A/R                                                        –14
Change in Inventory                                                  –77
Change in A/P                                                         37
Cash from operating activities                                       –31

Investing Activities
Purchase of new PPE                                                  –80

Financing Activities
New short-term loans payable                                         22
New long-term debt                                                    0
New paid-in capital                                                  94
Cash dividends                                                        0
Cash from financing activities                                      116

Net change in cash                                                     5

3. Growth Rate                                        Forecasted Cash from Operating Activities
     25%                                                                    –$8
     40%                                                                    –22
     50%                                                                    –31

      The faster that Handyman grows, the worse becomes its cash from operating activities. This is
      because the growth requires increases in accounts receivable and inventory and the increases in
      these current assets reduce the amount of cash generated by operating activities.

Internet Search: http://www.coke.com
1.    The name “Coca-Cola” was created by Frank M. Robinson, partner and bookkeeper for Dr. John
      Pemberton, the inventor of the drink itself. Mr. Robinson also penned the words in the unique script
      that is still Coca-Cola’s trademark.
2.    Joseph Whitehead and Benjamin Thomas paid $1 in 1899 for the exclusive rights to bottle Coca-
      Cola.
3.    In addition to Coca-Cola, other Coca-Cola soft drink brand names in South Africa are:
       Bibo—a kids’ drink in such flavors as apple, pineapple, raspberry, lemon, and orange
       Milo—a chocolate malt drink
       Sparletta Kids—flavors include PineNut and Sparberry.
4.    In the press release announcing its quarterly earnings for the first quarter in 2004 (released April 21,
      2004), Coca-Cola said that cash from operations for the quarter nearly doubled to $1.2 billion and
      that it expects strong cash flows to continue in the future.
5.    During the years 2001 through 2003, Coca-Cola spent over $2.4 billion to repurchase shares of its
      own stock—$277 million in 2001, $691 million in 2002, and $1,440 million in 2003.




                                               Chapter 6 – 38
You Be the Analyst!

EBITDA, Operating Cash Flow, and Investing Cash Flow

The data for this solution were gathered on June 4, 2004. Of course, solutions will differ depending on
when this exercise is completed.

1. For the year ended December 31, 2003 (or thereabouts), here are the EBITDA and operating cash
   flow numbers for the six companies. All numbers are in millions.

        Name (ticker symbol)                              EBITDA                Operating Cash Flow
        McDonald’s (MCD)                                   $3,846                            $3,269
        Safeway (SWY)                                       1,444                             1,610
        DuPont (DD)                                         2,064                             2,589
        Sears (S)                                           7,375                             2,524
        General Motors (GM)                                28,025                             7,600
        Home Depot (HD)                                     7,981                             6,545

2. In many cases, EBITDA is a reasonable estimate of operating cash flow. However, there are many
   cases (such as Sears and General Motors in (1) above) where the approximation is very bad indeed.
   The use of EBITDA gained favor before 1988 when the reporting of the statement of cash flows was
   required. Financial statement users still use this traditional estimate of operating cash flow when they
   could instead be using the operating cash flow number from the statement of cash flows itself.

3. For the year ended December 31, 2003 (or thereabouts), here are the operating cash flow and
   investing cash flow numbers for the six companies. All numbers are in millions, and the investing
   cash flow numbers represent cash outflows.

        Name (ticker symbol)                 Operating Cash Flow                Investing Cash Flow
        McDonald’s (MCD)                                  $3,269                             $1,370
        Safeway (SWY)                                      1,610                                795
        DuPont (DD)                                        2,589                              3,375
        Sears (S)                                          2,524                                946
        General Motors (GM)                                7,600                             55,492
        Home Depot (HD)                                    6,545                              3,996

4. For 2003, McDonald’s, Safeway, Sears, and Home Depot were all cash cows with cash flow
   generated by operating activities exceeding the amount of cash flow needed for investing activities.
   The cash flow numbers reflect the fact that 2002 and 2003 were tough years for DuPont because the
   company consistently was a cash cow up until those years. The General Motors cash flow statement is
   substantially complicated by the combination, in one set of financial statements, of the automotive
   manufacturing operations and the financial services of GMAC.


Test Your Intuition
The FASB specifies that a company’s cash flows are to be summarized under three headings: operating
activities, investing activities, and financing activities. Can you think of any alternatives to this three-way
classification scheme?

The international financial statement exercise at the end of this chapter illustrates the format of a cash
flow statement used in the United Kingdom (GlaxoSmithKline plc). That cash flow statement has nine


                                                Chapter 6 – 39
categories—the six extras include one for cash paid for income taxes (domestic and foreign) and one for
interest and dividends received and paid.

With such a large fraction of business being done overseas, another way to categorize cash flow is by the
currency of the cash—cash flows in U.S. dollars, in Japanese yen, and so forth. This type of
categorization would help users evaluate a company’s exposure to foreign currency risk.

In addition, cash flows can also be categorized by line of business. For example, the revenue of PepsiCo
is split between snack foods and soft drinks. It would be useful to see how each of these business
segments generates and uses cash.

Why is depreciation ignored when the direct method is used, but added to cash from operations when the
indirect method is used?

Remember that depreciation is a non-cash item, so the objective is to eliminate it in the computation of
cash from operations. When the direct method is used, the computation starts from zero, with amounts
being added for cash collected and subtracted for cash paid. In this framework, depreciation is ignored,
since it doesn’t involve cash. When the indirect method is used, the computation starts with net income.
Depreciation has already been subtracted in the computation of net income. Therefore, to eliminate the
effect of depreciation, it must be added back to net income in the computation of cash from operations.


Business Context 6.1: Disagreements within the FASB
1.   Arguments in favor of classifying interest paid as cash outflow from operating activities:

      (a) Historically, interest paid has been considered an operating cash flow.
      (b) Interest paid is considered an expense in computing net income; whereas dividends paid are
          not. There is strong support among accountants for maintaining a strong functional relationship
          between net income and cash flow from operating expenses.
      (c) Although both interest and dividends paid can be thought of as costs of obtaining financing,
          they obviously differ in many respects. Interest paid is tax-deductible; dividends paid are not.
          Payment of interest is a contractual obligation; payment of dividends is not.

      In formulating Statement No. 95, the FASB acknowledged the merit of classifying interest paid as a
      cash outflow from financing activities. However, the Board’s conclusion is summarized as follows:

      “The Board therefore was not convinced that changing the prevalent practice in classifying interest
      … paid would not necessarily result in a more meaningful presentation of cash flows. This
      Statement does, however, require that the amount of interest paid during a period … be disclosed,
      which will permit users of financial statements who wish to consider interest paid as a financing
      cash outflow to do so.”

2.    The following items might be useful in deciding whether to require the direct method:

      (a) The degree to which companies use the direct method in their statements of cash flow.
          Evidence thus far indicates that firms overwhelmingly are choosing the indirect method over
          the direct method. If this were to continue, it could be taken as evidence that the demand from
          users for the incremental information provided by the direct method is not sufficient to induce
          firms to provide that information.
      (b) Costs of implementing the direct method. After some years of use, it should be possible to
          better quantify the costs borne by firms in gathering the data necessary to use the direct method.


                                               Chapter 6 – 40
      (c) Use by financial analysts. A study of reports produced by financial analysts can reveal the
          extent to which the community of sophisticated users are interested in the information provided
          by the direct method. If there is no evidence that analysts are doing extra research to
          approximate the direct method cash flow disclosures for firms that do not provide them, this
          again can be taken as an indication that market demand for the direct method may not be great
          enough to justify requiring it.

Data Mining 6.1: Differences between Income and Cash from Operations
1.   For many companies, cash from operations is greater than net income because depreciation expense
     is subtracted in computing net income but is a non-cash expense. Both General Electric and IBM
     report large amounts of depreciation expense, so they both have a large difference between net
     income and cash from operations.

2.    As shown in Exhibit 6-4 in the text, the negative operating cash flow that is typical of a start-up
      company must be made up for through increased cash inflow from financing activities such as
      borrowing or issuance of stock. Amazon.com must have been borrowing money or issuing stock
      during these start-up years.

3.    First of all, financial institutions report very little depreciation expense and, as discussed in (1),
      depreciation is frequently the item that causes the biggest excess of cash flow over net income. In
      addition, the operations of financial institutions include management of large investment portfolios.
      For financial institutions, buying and selling securities is considered an operating activity. Thus, in
      a period when a financial institution spends cash to increase its investment portfolio significantly,
      the financial institution may very well report negative cash from operating activities.
Data Mining 6.2: American and British Operating Cash Flow
1.
                                                                      Exxon

                                                          Altria      Mobil       Diageo     BP Amoco
Cash from operations (U.S. definition)                    10,816      28,498       1,826      16,690
Sales                                                     81,832     237,054      9,440      236,045


Cash from operations / Sales                               13.2%       12.0%        19.3%         7.1%

2.    The British definition of “cash from operations” excludes from the computation of cash from
      operating activities items that are not operating items at all, but relate primarily to the payment of
      interest and taxes. These are usually thought of as non-operating items. So, it looks like the British
      have developed a better measure for operating cash flow than that used by the Americans.

Web Search: http://www.fasb.org
As of July 1, 2003, the seven members of the Financial Accounting Standards Board were:
 Robert Herz, Chairman
 George J. Batavick
 G. Michael Crooch
 Gary S. Schieneman
 Katherine Schipper
 Leslie F. Seidman
 Edward W. Trott



                                               Chapter 6 – 41
Before joining the FASB, Dr. Katherine Schipper was a professor of accounting at Duke University.




                                            Chapter 6 – 42

				
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