# Chapter 12 The Statement of Cash Flows

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```					                                     CHAPTER 12

The Statement of Cash Flows
OVERVIEW OF EXERCISES, PROBLEMS, AND CASES
Estimated
Time in
Learning Outcomes                                                      Exercises    Minutes    Level
1. Explain the purpose of a statement of cash flows.                       15*         60      Diff

2. Explain what cash equivalents are and how they are treated on            1           5      Easy
the statement of cash flows.                                            12*         10      Easy

3. Describe operating, investing, and financing activities, and give        2          10      Easy
examples of each.                                                        3          10      Mod
12*         10      Easy
13*         10      Easy
14*         25      Diff

4. Describe the difference between the direct and the indirect
methods of computing cash flow from operating activities.

5. Prepare a statement of cash flows, using the                             4           5      Mod
direct method to determine cash flow from operating activities.          5          10      Mod
6          20      Mod
7          20      Mod
8          10      Mod
13*         10      Easy
15*         60      Diff

6. Prepare a statement of cash flows, using                                 9          10      Easy
the indirect method to determine cash flow from operating               10          15      Mod
activities.                                                             14*         25      Diff

7. Use cash flow information to help analyze a company.                    11          15      Mod

8. Use a work sheet to prepare a statement of cash flows, using
the indirect method to determine cash flow from operating
activities (Appendix).

*Exercise, problem, or case covers two or more learning outcomes
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

12-1
12-2    FINANCIAL ACCOUNTING SOLUTIONS MANUAL

Problems     Estimated
and        Time in
Learning Outcomes                                                      Alternates    Minutes    Level
1. Explain the purpose of a statement of cash flows.

2. Explain what cash equivalents are and how they are treated on           13*          30      Diff
the statement of cash flows.

3. Describe operating, investing, and financing activities, and give
examples of each.

4. Describe the difference between the direct and the indirect             11*          30      Mod
methods of computing cash flow from operating activities.               12*          30      Mod

5. Prepare a statement of cash flows, using the                             3           45      Mod
direct method to determine cash flow from operating activities.          6           30      Mod
11*          30      Mod
13*          30      Diff

6. Prepare a statement of cash flows, using                                 1           30      Mod
the indirect method to determine cash flow from operating                4           45      Mod
activities.                                                              7           30      Mod
9           45      Diff
12*          30      Mod

7. Use cash flow information to help analyze a company.

8. Use a work sheet to prepare a statement of cash flows, using             2           60      Mod
the indirect method to determine cash flow from operating                5           60      Mod
activities (Appendix).                                                   8           60      Mod
10           60      Diff

*Exercise, problem, or case covers two or more learning outcomes
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-3

Estimated
Time in
Learning Outcomes                                                          Cases       Minutes     Level
1. Explain the purpose of a statement of cash flows.                          3*          60       Diff
4*          25       Mod
5*          25       Mod

2. Explain what cash equivalents are and how they are treated on              6*          20       Mod
the statement of cash flows.

3. Describe operating, investing, and financing activities, and give          1*          30       Mod
examples of each.                                                          6*          20       Mod

4. Describe the difference between the direct and the indirect                1*          30       Mod
methods of computing cash flow from operating activities.

5. Prepare a statement of cash flows, using the                               3*          60       Diff
direct method to determine cash flow from operating activities.

6. Prepare a statement of cash flows, using                                   4*          25       Mod
the indirect method to determine cash flow from operating                  5*          25       Mod
activities.

7. Use cash flow information to help analyze a company.                       2           20       Mod

8. Use a work sheet to prepare a statement of cash flows, using
the indirect method to determine cash flow from operating
activities (Appendix).

*Exercise, problem, or case covers two or more learning outcomes
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
12-4   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

QUESTIONS

1. The purpose of the statement of cash flows is to summarize an entity’s cash flows
from operating, investing, and financing activities during a period. Because it is con-
cerned with activity for a specific period of time, the statement is similar to the
income statement. However, they differ in two important respects. First, with a few
exceptions, the income statement deals only with operating activities. Second, the
income statement is on an accrual basis, while the statement of cash flows reports
operating activities on a cash basis.
2. A cash equivalent is an item that is readily convertible to a known amount of cash
and has an original maturity of three months or less. These items, such as Treasury
bills and money market funds, present very little risk to the holder, and therefore they
are included with cash for the purpose of preparing the statement of cash flows. That
is, purchases and sales of cash equivalents are not considered significant activities
to be separately reported on the statement.
3. The down payment of \$20,000 is a cash outflow that would be reported in the invest-
ing activities section of the statement of cash flows. The issuance of the promissory
note for \$60,000 would appear in a supplemental schedule of noncash investing and
financing activities.
4. A 60-day Treasury bill would be classified as a cash equivalent and combined with
cash on the balance sheet. Therefore, the purchase of the treasury bill would not be
reported as an investing activity. However, the purchase of Motorola stock would
appear as a cash outflow in the investing activities section of the statement of cash
flows.
5. Companies cannot continue in business if they do not generate positive cash flows
from operating activities. Also, over a period of years, a company cannot continue to
borrow more than it repays, nor can it issue capital stock indefinitely. Thus, you
would not expect a net cash outflow from financing activities over a sustained period
of time. However, many companies regularly experience a net cash outflow from in-
vesting activities. A company must at a minimum replace existing assets and in
many cases acquire additional plant and equipment to remain competitive. At the
same time, disposals of long-term assets may be fairly common, but usually they will
not generate significant amounts of cash inflow.
6. The student is correct in that it is simple enough to find the net inflow or outflow of
cash during the period. But this is only the starting point in preparing the statement
of cash flows. First, all of the balance sheet accounts must be analyzed to find the
explanations for the increases and decreases in cash during the period. Second,
each of these inflows and outflows must be classified as either operating, investing,
or financing activities.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-5

7. The only accurate part of this statement is that depreciation is often one of the larg-
est items in the Operating Activities section of the statement. However, this is merely
a result of using the indirect method to prepare this section. In computing net in-
come, depreciation is deducted. Therefore, under the indirect method it must be
added back to net income because it is a noncash expense. Depreciation does not
in any way generate cash.
8. There is considerable debate over which method is most useful. Many accountants,
as well as users of the statements, believe that the direct method, with its emphasis
on cash receipts and cash payments, provides the most information. Others believe
that the indirect method is better because it focuses attention on the differences be-
tween net income and net cash provided by operations. Accounting standards allow
the use of either method, but companies are strongly encouraged to use the direct
method.
9. Under the indirect method, net income is reported at the top of the Operating Activi-
ties section, and adjustments are made to convert income to a cash basis. Sales
revenue is included in net income. However, on a cash basis we are interested in
cash collections from sales, not the sales on an accrual basis. A decrease in ac-
counts receivable indicates that cash collections exceeded sales revenue. There-
fore, the excess is added back to the net income of the period.
10. Inventory is analyzed to determine the purchases of the period. Cost of goods sold
decreases the Inventory account, and purchases increase it. After the purchases of
the period are found, they are added to the beginning balance in the Accounts Pay-
able account. The difference between the addition of these amounts and the ending
balance in Accounts Payable is the amount of cash payments.
11. A profitable year does not guarantee a large cash balance at the end of the year. A
large share of the profits may be returned to the stockholders in the form of cash div-
idends. Investments in new plant and equipment require significant amounts of cash,
as does the repayment of various forms of borrowing.
12. Yes, it is possible to report a net loss and still experience a net increase in cash.
First, a company could report large noncash charges against net income, such as
depreciation and various types of losses. Thus, it is possible that net cash provided
by operating activities is positive even though a net loss is reported. Second, the net
loss deals only with operating activities. It is possible that a net cash inflow was pro-
vided by either investing or financing activities, or both.
13. Regardless of which method is used, a decrease in income taxes payable means
that cash paid to the government during the period exceeded income tax expense
on the income statement. Under the direct method, the amount of cash paid is re-
ported as a cash outflow in the Operating Activities section of the statement. If the
indirect method is used, the decrease in taxes payable is deducted from net income
to arrive at net cash flow from operations.
12-6    FINANCIAL ACCOUNTING SOLUTIONS MANUAL

14. The requirement to separately disclose income taxes paid and interest paid when
the indirect method is used is a compromise. Accounting standards strongly encour-
age companies to use the direct method because each major operating cash receipt
and payment is reported in the Operating Activities section of the statement. Howev-
er, if a company chooses to use the indirect approach, they are still required to re-
port separately how much cash was actually paid to the government in taxes and to
creditors in interest.
15. An argument can be made that it is inconsistent to report interest paid in the operat-
ing section and dividends paid in the financing section. Both represent returns to
providers of capital: interest to creditors and dividends to stockholders. Furthermore,
the cash raised from each of these sources—the amounts borrowed from creditors
and the amounts contributed by stockholders—is classified as an inflow in the fi-
nancing section of the statement. The rationale normally given for this treatment is
that interest enters into the determination of net income, and thus the cash ex-
pended in interest should appear in the operating section. Many believe that this is il-
logical and that both interest paid and dividends paid belong in the financing section.
16. An analysis of the Prepaid Rent account can be used to find the amount of cash paid
for rent:
Beginning Prepaid Rent                                                                   \$ 9,600
+ Cash payments                                                                              X
– Rent Expense                                                                          45,900
= Ending Prepaid Rent                                                                  \$ 7,300
\$9,600 + X – \$45,900 = \$7,300
X = \$43,600
17. The purchase of 2,000 shares of treasury stock at \$20 per share would be reflected
on the statement of cash flows as a cash outflow of \$40,000 in the financing activi-
ties section of the statement.
18. The effect on the accounting equation of the sale of the truck is as follows:

BALANCE SHEET                                    INCOME STATEMENT
Assets            =     Liabilities     +   Stockholders’ Equity + Revenues – Expenses

Cash              9,000
Loss on Sale
of Asset       (2,000)*
Accumulated
Depreciation 14,000**
Delivery Truck (25,000)

*\$11,000 – \$9,000 = \$2,000
**\$25,000 – \$11,000 = \$14,000
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-7

Two items would be reported on a statement of cash flows using the indirect me-
thod. First, the loss of \$2,000 would be added back to net income in the operating
activities section. Second, the cash received of \$9,000 would be reported as a cash
inflow in the investing activities section.
19. Since the company neither bought nor sold any patents during the year, the de-
crease in the balance in the account of \$4,000 represents the amortization of the pa-
tent for the year. Amortization is a noncash expense, as is depreciation, and is add-
ed back to net income under the indirect method.
20. A stock dividend does not involve the inflow or outflow of cash and therefore is not
reported on a statement of cash flows. It is questionable whether it is even a signifi-
cant noncash activity that should be reported in the supplemental schedule. It could
be argued that the issuance of stock in connection with a stock dividend is a financ-
ing activity and that it should be included on the schedule. If a 10% stock dividend is
included on the schedule, it would be reported at the market value of the shares is-
sued.
21. The information needed to determine a company’s cash flow adequacy comes from
two sources. The numbers in the numerator of the ratio, net cash provided by oper-
ating activities and capital expenditures, appear on the statement of cash flows. The
amount of average annual debt maturing over the next five years in the denominator
can be found in a note to the financial statements.

EXERCISES

LO 2      EXERCISE 12-1 CASH EQUIVALENTS

Investments made during December 2007 that qualify as cash equivalents at December
31, 2007:
Certificate of deposit, due January 31, 2008                                        \$ 35,000
Money Market fund                                                                    105,000
90-day Treasury bills                                                                 75,000
Cash equivalents at December 31, 2007                                                 \$215,000
12-8      FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 3          EXERCISE 12-2 CLASSIFICATION OF ACTIVITIES

1. F                                                       8. F
2. S                                                       9. S
3. F                                                      10. I
4. F                                                      11. I or O*
5. O                                                      12. O
6. O                                                      13. O
7. O

*Investing activity if stock is classified as an available-for-sale security; operating ac-
tivity if it is classified as a trading security.

LO 3          EXERCISE 12-3 RETIREMENT OF BONDS PAYABLE ON THE STATEMENT OF
CASH FLOWS—INDIRECT METHOD

1. The effect on the accounting equation of the December 31, 2007, bond retirement is
as follows:

BALANCE SHEET                                           INCOME STATEMENT
Assets           =        Liabilities   +      Stockholders’ Equity + Revenues – Expenses

Cash           (510,000)       Bonds Payable (500,000)                         Loss on Retire-
Discount on                                       ment of Bonds   (50,000)*
Bonds Payable 40,000

*\$510,000 – \$460,000 = \$50,000

2. The \$510,000 in cash paid to retire the bonds would be reported as a cash outflow in
the financing activities section. Assuming the company uses the indirect method, the
loss of \$50,000 would be added back in the operating activities section.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-9

LO 5      EXERCISE 12-4 CASH COLLECTIONS—DIRECT METHOD

Cash collections to be reported in the operating activities section of Stanley’s 2007
statement of cash flows (direct method):
Accounts receivable, December 31, 2006                                   \$ 80,800
Plus sales during 2007                                                    1,450,000
Less cash collections during 2007                                                (X)
Accounts receivable, December 31, 2007                                   \$ 101,100
\$80,800 + \$1,450,000 – X = \$101,100
X = \$1,429,700

LO 5      EXERCISE 12-5 CASH PAYMENTS—DIRECT METHOD

Cash payments for inventory to be reported in the operating activities section of Lester
Enterprise’s 2007 statement of cash flows (direct method):
Inventory, December 31, 2006                                               \$ 90,200
Plus purchases during 2007                                                         X
Less cost of goods sold during 2007                                         (770,900)
Inventory, December 31, 2007                                               \$ 70,600
\$90,200 + X – \$770,900 = \$70,600
X = \$751,300

Accounts payable, December 31, 2006                                        \$ 57,700
Plus purchases during 2007                                                  751,300
Less cash payments during 2007                                                   (X)
Accounts payable, December 31, 2007                                        \$ 39,200
\$57,700 + \$751,300 – X = \$39,200
X = \$769,800
12-10   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 5        EXERCISE 12-6 OPERATING ACTIVITIES SECTION—DIRECT METHOD

1. Operating activities section of the statement of cash flows:

PARTIAL STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
Cash Flows from Operating Activities
Cash collected from customers                                       \$ 102,0001
Cash payments for:
Inventory                                                        \$ (79,000)2
Interest                                                            (3,500)4
Taxes                                                               (3,500)5
Total cash payments                                                 \$ (92,000)
Net cash provided by operating activities                           \$ 10,000
Footnotes:
1
Cash collections from customers:
Sales revenue                                                    \$ 100,000
Add: Decrease in accounts receivable                                 2,000
Cash collections                                                 \$ 102,000
2
Payments for inventory:
Cost of goods sold                                               \$ 75,000
Less: Increase in accounts payable                                 (3,000)
Cash payments                                                    \$ 79,000
3
General and administrative expense                               \$    8,000
Less: Decrease in office supplies                                    (3,000)
Add: Decrease in salaries and wages payable                           1,000
Cash payments                                                    \$    6,000
4
For interest:
Interest expense                                                 \$   3,000
Add: Decrease in interest payable                                      500
Cash payments                                                    \$   3,500
5
For taxes:
Income tax expense                                               \$    5,000
Less: Increase in income taxes payable                               (1,500)
Cash payments                                                    \$    3,500
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-11

EXERCISE 12–6 (Concluded)

2. The use of the direct method reveals the amounts collected from customers and the
amounts paid for inventory, interest, taxes, and other operating purposes. The indi-
rect method simply reconciles the net income of the period to the net cash flow from
operations. The direct method shows the reader of the statement the specific
amounts collected and paid for operating purposes.

LO 5      EXERCISE 12-7 DETERMINATION OF MISSING AMOUNTS—CASH FLOW FROM
OPERATING ACTIVITIES

Case 1:
Beginning accounts receivable                                            \$ 150,000
+ Credit sales revenue                                                     175,000
– Write-offs                                                               (35,000)
– Cash collections                                                              (X)
= Ending accounts receivable                                             \$ 100,000

\$150,000 + \$175,000 – \$35,000 – X = \$100,000
X = \$190,000 credit sales
\$190,000 + \$60,000 (cash sales) = \$250,000

Case 2:
Beginning inventory                                                      \$ 80,000
+ Purchases                                                                      X
– Cost of goods sold                                                      (175,000)
= Ending inventory                                                       \$ 55,000

\$80,000 + X – \$175,000 = \$55,000
X = \$150,000

Beginning accounts payable                                               \$ 25,000
+ Purchases                                                               150,000
– Cash payments                                                                (X)
= Ending accounts payable                                                \$ 15,000

\$25,000 + \$150,000 – X = \$15,000
X = \$160,000

Case 3:
Beginning prepaid insurance                                              \$ 17,000
+ Cash payments                                                                  X
– Insurance expense                                                        (15,000)
= Ending prepaid insurance                                               \$ 20,000

\$17,000 + X – \$15,000 = \$20,000
X = \$18,000
12-12   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

EXERCISE 12-7 (Concluded)

Case 4:
Beginning income taxes payable                                        \$ 95,000
+ Income tax expense                                                    300,000
– Cash payments                                                              (X)
= Ending income taxes payable                                         \$ 115,000

\$95,000 + \$300,000 – X = \$115,000
X = \$280,000

LO 5        EXERCISE 12-8 DIVIDENDS ON THE STATEMENT OF CASH FLOWS

1. First, determine the amount of dividends declared:
Beginning retained earnings                                       \$ 250,000
+ Net income                                                        285,000
– Stock dividends                                                   (50,000)
– Dividends declared                                                     (X)
= Ending retained earnings                                        \$ 375,000

\$250,000 + \$285,000 – \$50,000 – X = \$375,000
X = \$110,000

Then, solve for the amount of dividends paid:
Beginning dividends payable                                       \$ 20,000
+ Dividends declared                                               110,000
– Cash dividends paid                                                   (X)
= Ending dividends payable                                        \$ 30,000

\$20,000 + \$110,000 – X = \$30,000
X = \$100,000

2. Because a stock dividend does not involve cash, it is not reported on the statement
of cash flows. It is questionable whether or not a stock dividend is a significant non-
cash activity that should be reported on a supplemental schedule.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-13

LO 6      EXERCISE 12-9 ADJUSTMENTS TO NET INCOME WITH THE INDIRECT METHOD

1. A                                        6. A
2. D                                        7. D
3. A                                        8. A
4. A                                        9. NR
5. NR                                      10. A

LO 6      EXERCISE 12-10 OPERATING ACTIVITIES SECTION—INDIRECT METHOD

1. Operating activities section of the statement of cash flows:

SUFFOLK COMPANY
PARTIAL STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
Cash Provided by Operating Activities
Net income                                                                            \$40,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense                                                            20,000
Increase in accounts receivable                                                 (8,000)
Decrease in inventory                                                           10,000
Increase in prepaid rent                                                        (2,000)
Increase in accounts payable                                                     7,000
Decrease in income taxes payable                                                (4,000)
Increase in interest payable                                                     3,000
Net cash inflow from operating activities                                             \$66,000

2. The primary reason that net cash inflow from operating activities of \$66,000 is more
than net income of \$40,000 is depreciation of \$20,000. It is deducted on the income
statement but it does not require the use of cash. Other reasons for the higher
amount of net cash inflow from operating activities are the decrease in inventory (the
company is not buying as much inventory) and the increase in accounts payable (the
company is slowing down payments to its creditors).
12-14   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 7        EXERCISE 12-11 CASH FLOW ADEQUACY

(Net cash provided by operations – Capital expenditures)/Average annual debt
maturing over next five years
= (\$12,000,000 – \$2,000,000)/(\$20,000,000/5)
= \$10,000,000/\$4,000,000
= 2.5

2. The cash flow adequacy ratio gives the user an indication of whether or not the
company is generating sufficient cash from its operations to repay its debts, after
taking into consideration the need to make necessary expenditures on new plant
and equipment. It would appear that a ratio of 2.5 is reasonable; however, other fac-
tors should be considered, including how the ratio compares with prior years as well
as with competitors.

MULTI-CONCEPT EXERCISES

LO 2,3          EXERCISE 12-12 CLASSIFICATION OF ACTIVITIES

1. OI                                            6. CE
2. CE                                            7. II
3. IF                                            8. OI
4. OI                                            9. IF
5. OF                                           10. OF

LO 3,5          EXERCISE 12-13 CLASSIFICATION OF ACTIVITIES

1. IO                                            7. OO
2. OO                                            8. OI
3. NR                                            9. OF
4. IF                                           10. NR
5. IO                                           11. OF
6. NR                                           12. II
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-15

LO 3,6            EXERCISE 12-14 LONG-TERM ASSETS ON THE STATEMENT OF CASH
FLOWS—INDIRECT METHOD

First, determine the accumulated depreciation on the assets sold so that the book value
of those sold can be found:

Beginning accumulated depreciation                                              \$ 200,000
+ Depreciation expense                                                             50,000
– Accumulated depreciation on assets sold                                              (X)
= Ending accumulated depreciation                                               \$ 160,000

\$200,000 + \$50,000 – X = \$160,000
X = \$90,000

Thus, the effect on the accounting equation of the sale would be as follows:

BALANCE SHEET                                   INCOME STATEMENT
Assets          =    Liabilities   +   Stockholders' Equity + Revenues – Expenses

Cash             64,000                                              Gain on Sale        4,000
Accumulated
Depreciation    90,000
Plant and
Equipment      (150,000)

Beginning plant and equipment                                                   \$ 500,000
+ Acquisitions                                                                          X
– Sales of plant and equipment                                                   (150,000)
= Ending plant and equipment                                                    \$ 750,000

\$500,000 + X – \$150,000 = \$750,000
X = \$400,000

Similarly, acquisitions of new patents can be determined:

Beginning patents                                                                \$ 80,000
+ Acquisitions                                                                          X
– Amortization expense                                                             (8,000)
= Ending patents                                                                 \$ 92,000

\$80,000 + X – \$8,000 = \$92,000
X = \$20,000
12-16   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

EXERCISE 12-14 (Concluded)

These items would appear on the statement of cash flows as follows:
Cash Flows from Operating Activities
Net income                                                              \$ 200,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense                                               50,000
Amortization expense                                                8,000
Gain on sale of plant and equipment                                (4,000)
Cash Flows from Investing Activities
Sale of plant and equipment                                                64,000
Acquisition of plant and equipment                                       (400,000)
Acquisition of patents                                                    (20,000)

LO 1,5          EXERCISE 12-15 INCOME STATEMENT, STATEMENT OF CASH FLOWS
(DIRECT METHOD), AND BALANCE SHEET

1. Income statement:

HANDSOME HOUNDS GROOMING COMPANY
INCOME STATEMENT
FOR THE YEAR ENDED XX/XX/XX
Grooming service revenue                                           \$150,000
Expenses:
Rent expense                                        \$12,000
Amortization of patent                               10,0001
Other operating expenses                             58,0002      80,000
Net income                                                         \$ 70,000
1
\$100,000/10 years
2
\$80,000 – \$10,000 – \$12,000
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-17

EXERCISE 12-15 (Continued)

2. Statement of cash flows:

HANDSOME HOUNDS GROOMING COMPANY
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED XX/XX/XX
Cash Flows from Operating Activities
Cash receipts from:
Cash sales                                                                  \$ 110,0001
Collections on account                                                         30,0002
Total cash receipts                                                         \$ 140,000
Cash payments for:
Rent                                                                        \$ (12,000)
Security deposit                                                               (2,000)
Other operating expenses                                                      (58,000)3
Total cash payments                                                         \$ (72,000)
Net cash provided by operating activities                                      \$ 68,000
Cash Flows from Investing Activities
Down payment on patent                                                       \$ (20,000)4
Cash Flows from Financing Activities
Issuance of common stock                                                    \$ 50,000
Cash dividends paid                                                           (20,000)
Net cash provided by financing activities                                      \$ 30,000
Net increase in cash                                                           \$ 78,000
Cash balance, beginning of year                                                        0
Cash balance, end of year                                                      \$ 78,000
Supplemental Schedule of Noncash Activities
Acquisition of patent in exchange for four-year note                           \$ 80,000
1                                           3
\$150,000 – \$40,000                         \$80,000 – \$12,000 – \$10,000
2                                           4
\$40,000 – \$10,000                          \$100,000 × 20%
12-18   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

EXERCISE 12-15 (Concluded)

3. The company generated slightly less cash flow from operations, \$68,000, than it
earned in net income, \$70,000. The differences between the two can be reconciled
as follows:
Net income                                                          \$ 70,000
Amortization of patent                                             10,000
Deduct:
Security deposit (not yet an expense)                              (2,000)
Uncollected accounts receivable                                   (10,000)
Net cash flow from operating activities                          \$ 68,000

4. Balance sheet:

HANDSOME HOUNDS GROOMING COMPANY
BALANCE SHEET
AS OF XX/XX/XX
Assets
Current assets:
Cash (from Part 2.)                                  \$78,000
Accounts receivable                                   10,000
Security deposit                                       2,000
Total current assets                                         \$ 90,000
Long-term assets:
Patent                                                            90,0001
Total assets                                                       \$180,000
Liabilities and Stockholders’ Equity
Long-term liabilities:
Notes payable                                                    \$ 80,000
Stockholders’ equity:
Common stock                                         \$50,000
Retained earnings                                     50,0002
Total stockholders’ equity                                  100,000
Total liabilities and stockholders’ equity                         \$180,000
1
\$100,000 – \$10,000
2
Net income of \$70,000 less cash dividends of \$20,000
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-19

PROBLEMS

LO 6      PROBLEM 12-1 STATEMENT OF CASH FLOWS—INDIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)        Explanation
Cash                                 (2)
Accounts receivable                   5
Inventory                           (10)
Prepaid rent                          3
Land                                  0
Plant and equipment                 100           Purchase
Accumulated depreciation            (35)          Depreciation expense
Accounts payable                     (2)
Income taxes payable                  2
Short-term notes payable            (10)          Issuance
Bonds payable                        25           Retirement
Common stock                        (50)          Issuance
Retained earnings                   (26)          Net income
Total                                 0
12-20   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-1 (Concluded)

Statement of cash flows:

CHRISMAN COMPANY
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net income                                                                    \$ 26
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation expense                                                         35
Increase in accounts receivable                                              (5)
Decrease in inventory                                                        10
Increase in prepaid rent                                                     (3)
Increase in accounts payable                                                  2
Decrease in income taxes payable                                             (2)
Net cash provided by operating activities                                     \$ 63
Cash Flows from Investing Activities
Acquisition of plant and equipment                                          \$(100)
Cash Flows from Financing Activities
Retirement of bonds payable                                                \$ (25)
Issuance of short-term notes payable                                          10
Issuance of common stock                                                      50
Net cash provided by financing activities                                     \$ 35
Net increase (decrease) in cash                                               \$ (2)
Cash balance, December 31, 2006                                                  10
Cash balance, December 31, 2007                                               \$ 8

2. No, Chrisman did not generate enough cash from its operations to pay for its invest-
ing activities. Cash flow from operating activities amounted to only \$63,000, while
the company spent \$100,000 to acquire plant and equipment. The additional cash
needed to finance the acquisition was raised by issuing a note for \$10,000 and is-
suing common stock for \$50,000.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-21

LO 8       PROBLEM 12-2 STATEMENT OF CASH FLOWS USING A WORK SHEET—
INDIRECT METHOD (Appendix)

1. Statement of cash flows work sheet (all amounts are in thousands of dollars):

Balances                          Cash Inflows (Outflows)
Accounts            12/31/07  12/31/06      Changes     Operating Investing Financing
Cash                        8        10           (2)
Accounts receivable        20        15            5           (5)
Inventory                  15        25          (10)          10
Prepaid rent                9         6            3           (3)
Land                       75        75            –
Plant and equipment       400       300          1001                      (100)
Accumulated
depreciation           (65)      (30)          (35)2        35
Accounts payable          (12)      (10)           (2)          2
Income tax payable         (3)       (5)            2          (2)
Short-term notes
payable               (35)        (25)         (10)3                                       10
Bonds payable            (75)      (100)           254                                       (25)
Common stock            (200)      (150)          (50)5                                       50
Retained earnings       (137)       (111)         (26)6        26
Totals                  0           0            0          63          (100)              35
Net increase
(decrease) in cash                                          (2)
1                                           4
Purchase of equipment.                      Retirement of bonds.
2                                           5
Depreciation expense.                       Issuance of common stock.
3                                           6
Proceeds from note.                         Net income.
12-22   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-2 (Concluded)

2. Statement of cash flows:

CHRISMAN COMPANY
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net income                                                                    \$ 26
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation expense                                                         35
Increase in accounts receivable                                              (5)
Decrease in inventory                                                        10
Increase in prepaid rent                                                     (3)
Increase in accounts payable                                                  2
Decrease in income taxes payable                                             (2)
Net cash provided by operating activities                                     \$ 63
Cash Flows from Investing Activities
Acquisition of plant and equipment                                          \$(100)
Cash Flows from Financing Activities
Retirement of bonds payable                                                \$ (25)
Issuance of short-term notes payable                                          10
Issuance of common stock                                                      50
Net cash provided by financing activities                                     \$ 35
Net increase (decrease) in cash                                               \$ (2)
Cash balance, December 31, 2006                                                  10
Cash balance, December 31, 2007                                               \$   8

3. No, Chrisman did not generate enough cash from its operations to pay for its invest-
ing activities. Cash flow from operating activities amounted to only \$63,000, while
the company spent \$100,000 to acquire plant and equipment. The additional cash
needed to finance the acquisition was raised by issuing a note for \$10,000 and is-
suing common stock for \$50,000.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-23

LO 5       PROBLEM 12-3 STATEMENT OF CASH FLOWS—DIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)        Explanation
Cash                                 (38)
Accounts receivable                   50
Inventory                             30
Prepayments                          (10)
Land                                 150            Purchase (c)
Plant and equipment                  200            Purchase (c)
Accumulated depreciation             (50)           Depreciation expense (b)
Accounts payable                      18
Other accrued liabilities             (5)
Income tax payable                    20
Long-term bank loan
payable                           (50)           Proceeds from bank loan (c)
Common stock                        (150)           Issuance of common stock (c)
Retained earnings                   (165)           60 Dividends (a)
(225) Net income
Total                                  0

Conversion of income statement items to a cash basis (in thousands of dollars):
Income Statement     Amount          Adjustment                        Cash Flows
Sales revenue         \$1,250                                               \$1,250
– Increase in accounts receivable         (50)
Cash collected                        \$1,200
Cost of goods sold          700                                            \$ 700
+ Increase in inventory                    30
+ Decrease in accounts payable             18
Cash payments                         \$ 748
Operating expenses          150                                            \$ 150
– Decrease in prepayments                 (10)
– Depreciation expense                    (50)
– Increase in accrued liabilities          (5)
Cash payments                         \$ 85
Interest expense             25                                            \$ 25
No interest payable                         0
Cash payments                         \$ 25
Income tax expense          150                                            \$ 150
+ Decrease in income tax payable           20
Cash paid for taxes                   \$ 170
Net income             \$ 225         Net cash flow from operations         \$ 172
12-24   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-3 (Continued)

Statement of cash flows:

PEORIA CORP.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Cash collections from customers                                             \$ 1,200
Cash payments for:
Inventory                                                                \$ (748)
Operating expenses                                                           (85)
Interest                                                                     (25)
Income taxes                                                                (170)
Total cash payments                                                  \$(1,028)
Net cash provided by operating activities                                   \$ 172
Cash Flows from Investing Activities
Acquisition of land                                                      \$ (150)
Acquisition of plant and equipment                                         (200)
Net cash used by investing activities                                       \$ (350)
Cash Flows from Financing Activities
Issuance of common stock                                                     150
Cash dividends paid                                                          (60)
Net cash provided by financing activities                                   \$   140
Net decrease in cash                                                        \$   (38)
Cash balance, December 31, 2006                                                  90
Cash balance, December 31, 2007                                             \$    52

2. Memorandum to the president:
TO:            President of Peoria Corp.
FROM:          Student’s name
DATE:          January 20, 2008
SUBJECT: Cash flows
You recently expressed concern that in spite of the profitable year according to the
income statement, cash decreased during 2007. Furthermore, there was a concern
about the decrease in the company’s cash balance during 2007 to \$52,000 at year-
end, given that existing loan covenants require a \$50,000 minimum balance at all
times. My thoughts and a copy of the 2007 statement of cash flows follow.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-25

PROBLEM 12-3 (Concluded)

Although net income on an accrual basis was \$225,000, net cash flow from op-
erating activities was only \$172,000. One of the reasons is that cash collections
were only \$1,200,000 even though sales were \$1,250,000. Also, inventory was in-
creased by \$30,000 during the period, and accounts payable was reduced by
\$18,000. Similarly, taxes payable was reduced by \$20,000, resulting in a further
drain on cash. Finally, two major acquisitions were made during the year: \$200,000
was spent on new plant and equipment and another \$150,000 to acquire new land.
These were only partially offset by the sale of additional stock for \$150,000 and the
issuance of additional notes in the amount of \$50,000. Finally, cash dividends
amounted to \$60,000, a further drain on cash.
Our cash flow should improve in future years without the need to invest so heavi-
ly in new property, plant, and equipment. We can also improve our operating cash
flow by accelerating the collection of receivables as much as possible. Similarly, we
should be able to reduce the amount of inventory on hand at any one time and over
the long run reduce the cash paid for inventory purchases.

LO 6       PROBLEM 12-4 STATEMENT OF CASH FLOWS—INDIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)         Explanation
Cash                                 (38)
Accounts receivable                   50
Inventory                             30
Prepayments                          (10)
Land                                 150           Purchase (c)
Plant and equipment                  200           Purchase (c)
Accumulated depreciation             (50)          Depreciation expense (b)
Accounts payable                      18
Other accrued liabilities             (5)
Income tax payable                    20
Long-term bank loan payable          (50)          Proceeds from bank loan (c)
Common stock                        (150)          Issuance of common stock (c)
Retained earnings                   (165)          60 Dividends (a)
(225) Net income
Total                                  0
12-26   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-4 (Continued)

Statement of cash flows:

PEORIA CORP.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net income                                                                  \$ 225
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense                                                        50
Increase in accounts receivable                                            (50)
Increase in inventories                                                    (30)
Decrease in prepayments                                                     10
Decrease in accounts payable                                               (18)
Increase in other accrued liabilities                                        5
Decrease in income taxes payable                                           (20)
Net cash provided by operating activities                                   \$ 172
Cash Flows from Investing Activities
Acquisition of land                                                      \$(150)
Acquisition of plant and equipment                                        (200)
Net cash used by investing activities                                       \$(350)
Cash Flows from Financing Activities
Issuance of common stock                                                   150
Cash dividends paid                                                        (60)
Net cash provided by financing activities                                   \$ 140
Net decrease in cash                                                        \$ (38)
Cash balance, December 31, 2006                                                90
Cash balance, December 31, 2007                                             \$ 52

2. Memorandum to the president:
TO:            President of Peoria Corp.
FROM:          Student’s name
DATE:          January 20, 2008
SUBJECT: Cash flows
You recently expressed concern regarding the decrease in cash during 2007 in spite
of the profitable year shown on the income statement. Furthermore, there was a
concern about the decrease in the company’s cash balance during 2007 to \$52,000
at year-end, given that existing loan covenants require a \$50,000 minimum balance
at all times. My thoughts and a copy of the 2007 statement of cash flows follow.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-27

PROBLEM 12-4 (Concluded)

Although net income on an accrual basis was \$225,000, changes in various non-
cash working capital accounts resulted in net cash flow from operating activities of
only \$172,000. For example, \$50,000 less was collected in cash than the sales of
the period. Accounts payable was reduced by \$18,000 and taxes payable by
\$20,000, both resulting in a drain on cash. Finally, two major acquisitions were made
during the year: \$200,000 was spent on new plant and equipment and another
\$150,000 to acquire new land. These were only partially offset by the sale of addi-
tional stock for \$150,000 and the issuance of additional notes in the amount of
\$50,000. Finally, cash dividends amounted to \$60,000, a further drain on cash.
Our cash flow should improve in future years without the need to invest so heavi-
ly in new property, plant, and equipment. We can also improve our operating cash
flow by accelerating the collection of receivables as much as possible. Similarly, we
should be able to reduce the amount of inventory on hand at any one time and over
the long run reduce the cash paid for inventory purchases.

LO 8       PROBLEM 12-5 STATEMENT OF CASH FLOWS USING A WORK SHEET—
INDIRECT METHOD (Appendix)

1. Statement of cash flows work sheet (all amounts are in thousands of dollars):
Balances                         Cash Inflows (Outflows)
Accounts            12/31/07  12/31/06     Changes     Operating Investing Financing
Cash                      52         90         (38)
Accounts receivable      180        130          50          (50)
Inventory                230        200          30          (30)
Prepayments               15         25         (10)          10
Land                     750        600         1501                      (150)
Plant and equipment      700        500         2002                      (200)
Accumulated
depreciation         (250)      (200)         (50)3        50
Accounts payable        (130)      (148)          18         (18)
Accrued liabilities      (68)       (63)          (5)          5
Income tax payable       (90)      (110)          20         (20)
Long-term loan
payable              (350)      (300)         (50)4                                       50
Common stock            (550)      (400)        (150)5                                      150
Retained earnings       (489)      (324)          606                                       (60)
(225)7      225
Totals                   0         0            0        172           (350)             140
Net increase
(decrease) in cash                                        (38)
1                                          5
Purchase of land.                          Issuance of common stock.
2                                          6
Purchase of plant and equipment.           Dividends.
3                                          7
Depreciation expense.                      Net income.
4
Proceeds from bank loan.
12-28   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-5 (Continued)

2. Statement of cash flows:

PEORIA CORP.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net income                                                  \$ 225
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense                                        50
Increase in accounts receivable                            (50)
Increase in inventories                                    (30)
Decrease in prepayments                                     10
Decrease in accounts payable                               (18)
Increase in other accrued liabilities                        5
Decrease in income taxes payable                           (20)
Net cash provided by operating activities                   \$ 172
Cash Flows from Investing Activities
Acquisition of land                                      \$(150)
Acquisition of plant and equipment                        (200)
Net cash used by investing activities                       \$(350)
Cash Flows from Financing Activities
Issuance of common stock                                   150
Cash dividends paid                                        (60)
Net cash provided by financing activities                   \$ 140
Net decrease in cash                                        \$ (38)
Cash balance, December 31, 2006                                90
Cash balance, December 31, 2007                             \$ 52
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-29

PROBLEM 12-5 (Concluded)

3. Memorandum to the president:
TO:        President of Peoria Corp.
FROM:      Student’s name
DATE:      January 20, 2008
SUBJECT: Cash flows
You recently expressed concern to me regarding the decrease in cash during 2007
in spite of the profitable year shown on the income statement. Furthermore, there
was a concern about the decrease in the company’s cash balance during 2007 to
\$52,000 at year-end, given that existing loan covenants require a \$50,000 minimum
balance at all times. My thoughts and a copy of the 2007 statement of cash flows fol-
low.
Although net income on an accrual basis was \$225,000, changes in various non-
cash working capital accounts resulted in net cash flow from operating activities of
only \$172,000. For example, \$50,000 less was collected in cash than the sales of
the period. Accounts payable was reduced by \$18,000 and taxes payable by
\$20,000, both resulting in a drain on cash. Finally, two major acquisitions were made
during the year: \$200,000 was spent on new plant and equipment and another
\$150,000 to acquire new land. These were only partially offset by the sale of addi-
tional stock for \$150,000 and the issuance of additional notes in the amount of
\$50,000. Finally, cash dividends amounted to \$60,000, a further drain on cash.
Our cash flow should improve in future years without the need to invest so heavi-
ly in new property, plant, and equipment. We can also improve our operating cash
flow by accelerating the collection of receivables as much as possible. Similarly, we
should be able to reduce the amount of inventory on hand at any one time and over
the long run reduce the cash paid for inventory purchases.
12-30   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 5        PROBLEM 12-6 STATEMENT OF CASH FLOWS—DIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)       Explanation
Cash                                          15
Accounts receivable                          (25)
Inventory                                    (50)
Prepayments                                   10
Land                                          75          Purchase (c)
Plant and equipment                           70          Purchase (c)
Accumulated depreciation                     (70)         Depreciation expense (b)
Accounts payable                             (25)
Other accrued liabilities                     10
Interest payable                              (5)
Long-term bank loan payable                  (90)         Proceeds from bank loan (c)
Common stock                                 (50)         Issuance of common stock (c)
Retained earnings                            135          35 Dividends (a)
100 Net loss
Total                                     0

Conversion of income statement items to a cash basis (in thousands of dollars):
Income Statement           Amount            Adjustment                        Cash Flows
Sales revenue               \$ 500                                                    \$500
+ Decrease in accounts receivable          25
Cash collected                          \$525
Cost of goods sold               400                                                 \$400
– Decrease in inventory                   (50)
– Increase in accounts payable            (25)
Cash payments                           \$325
Operating expenses               180                                                 \$180
+ Increase in prepayments                  10
– Depreciation expense                    (70)
+ Decrease in accrued liabilities          10
Cash payments                           \$130
Interest expense                   20                                                \$ 20
– Increase in interest payable             (5)
Cash payments                           \$ 15
Net income (loss)              \$(100)        Net cash flow from operations           \$ 55
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-31

PROBLEM 12-6 (Continued)

Statement of cash flows:

ASTRO INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Cash collections on account                                                            \$ 525
Cash payments for:
Inventory                                                                           \$(325)
Operating expenses                                                                   (130)
Interest                                                                              (15)
Total cash payments                                                                    \$(470)
Net cash provided by operating activities                                              \$ 55
Cash Flows from Investing Activities
Acquisition of land                                                                 \$ (75)
Acquisition of plant and equipment                                                    (70)
Net cash used by investing activities                                                  \$(145)
Cash Flows from Financing Activities
Issuance of common stock                                                               50
Cash dividends paid                                                                   (35)
Net cash provided by financing activities                                              \$ 105
Net increase in cash                                                                   \$ 15
Cash balance, December 31, 2006                                                           80
Cash balance, December 31, 2007                                                        \$ 95
12-32   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-6 (Concluded)

2. Memorandum to the president:
TO:            President of Astro Inc.
FROM:          Student’s name
DATE:          January 20, 2008
SUBJECT: Cash flows
You recently expressed concern to me regarding the large loss we sustained during
2007 in view of the net increase in cash during the year. Following are my thoughts,
along with a copy of the 2007 statement of cash flows for your reference.
Astro was able to generate a significant amount of cash from operations even
though we incurred the large net loss of \$100,000. One reason for the difference be-
tween cash generated from operations and the net loss was the large amount of de-
preciation expense on the income statement. This noncash expense reduced net
income, but without a corresponding effect on cash flow. Further, the decrease in
accounts receivable indicates that we collected more cash from our customers dur-
ing the year than the amount of sales to them. Finally, the combined effect of a
reduction in inventory and an increase in the amounts owed suppliers (accounts
payable) added to the cash generated.
Operating expenses need to be decreased relative to gross profit if we are to im-
prove our bottom line in the future. The gross profit percentage of 20% appears rea-
sonable, although this depends on many factors, including how our competitors are
doing in this area. A significant portion of the operating expenses is the depreciation
of \$70,000. Because this represents the write-off of a sunk cost (the cost of plant
and equipment acquired already), we cannot reduce the amount of this expense un-
less we decide to sell fixed assets. In fact, during 2007 we actually added to our
base of long-term assets. I would recommend that we explore ways to reduce our
other operating expenses. I look forward to hearing from you before moving forward
with any actions.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-33

LO 6      PROBLEM 12-7 STATEMENT OF CASH FLOWS—INDIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)        Explanation
Cash                                 15
Accounts receivable                 (25)
Inventory                           (50)
Prepayments                          10
Land                                 75           Purchase (c)
Plant and equipment                  70           Purchase (c)
Accumulated depreciation            (70)          Depreciation expense (b)
Accounts payable                    (25)
Other accrued liabilities            10
Interest payable                     (5)
Long-term bank loan payable         (90)          Proceeds from bank loan (c)
Common stock                        (50)          Issuance of common stock (c)
Retained earnings                   135           35 Dividends (a)
100 Net loss
Total                             0
12-34   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-7 (Continued)

Statement of cash flows:

ASTRO INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(AMOUNTS IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net loss                                                    \$(100)
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation expense                                        70
Decrease in accounts receivable                             25
Decrease in inventories                                     50
Increase in prepayments                                    (10)
Increase in accounts payable                                25
Decrease in other accrued liabilities                      (10)
Increase in interest payable                                 5
Net cash provided by operating activities                   \$ 55
Cash Flows from Investing Activities
Acquisition of land                                      \$ (75)
Acquisition of plant and equipment                         (70)
Net cash used by investing activities                       \$(145)
Cash Flows from Financing Activities
Issuance of common stock                                    50
Cash dividends paid                                        (35)
Net cash provided by financing activities                   \$ 105
Net increase in cash                                        \$ 15
Cash balance, December 31, 2006                                80
Cash balance, December 31, 2007                             \$ 95
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-35

PROBLEM 12-7 (Concluded)

2. Memorandum to the president:
TO:         President of Astro Inc.
FROM:       Student’s name
DATE:       January 20, 2008
SUBJECT: Cash flows
You recently expressed concern to me regarding the large loss we sustained during
2007 in spite of the net increase in cash during the year. Following are my thoughts,
along with a copy of the 2007 statement of cash flows for your reference.
Astro was able to generate a significant amount of cash from operations even
though we incurred the large net loss of \$100,000. One reason for the difference be-
tween cash generated from operations and the net loss was the large amount of de-
preciation expense on the income statement. This noncash expense reduced
reported net income without a corresponding effect on cash flow. Further, the de-
crease in accounts receivable indicates that we collected more cash from our cus-
tomers during the year than the amount of sales to them. Finally, the combined
effect of a reduction in inventory and an increase in the amounts owed suppliers
(accounts payable) added to the cash generated.
Operating expenses need to be decreased relative to gross profit if we are to im-
prove our bottom line in the future. The gross profit percentage of 20% appears rea-
sonable, although this depends on many factors, including how our competitors are
doing in this area. A significant portion of the operating expenses is the depreciation
of \$70,000. Because this represents the write-off of a sunk cost (the cost of plant
and equipment acquired already), we cannot reduce the amount of this expense un-
less we decide to sell fixed assets. In fact, during 2007 we actually added to our
base of long-term assets. I would recommend that we explore ways to reduce our
other operating expenses. I look forward to hearing from you before moving forward
with any actions.
12-36   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 8        PROBLEM 12-8 STATEMENT OF CASH FLOWS USING A WORK SHEET—
INDIRECT METHOD (APPENDIX)

1. Statement of cash flows work sheet (all amounts are in thousands of dollars):

Balances                        Cash Inflows (Outflows)
Accounts                12/31/07  12/31/06      Changes   Operating Investing Financing
Cash                            95            80        15
Accounts receivable             50            75       (25)      25
Inventory                      100           150       (50)      50
Prepayments                     55            45        10      (10)
Land                           475           400        751                (75)
Plant and equipment            870           800        702                (70)
Accumulated
depreciation              (370)          (300)     (70)3    70
Accounts payable              (125)          (100)     (25)     25
Other accrued
liabilities                 (35)          (45)     10       (10)
Interest payable                (15)          (10)     (5)        5
Long-term loan
payable                   (340)          (250)    (90)4                            90
Common stock                  (450)          (400)    (50)5                            50
Retained earnings             (310)          (445)    1006     (100)
357                            (35)
Totals                         0             0       0       55         (145)      105
Net increase
(decrease) in cash                                           15
1
Purchase of land.
2
Purchase of plant and equipment.
3
Depreciation expense.
4
Proceeds from borrowings.
5
Issuance of common stock.
6
Net loss.
7
Cash dividends paid.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-37

PROBLEM 12-8 (Continued)

2. Statement of cash flows:

ASTRO INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(AMOUNTS IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net loss                                                                                 \$(100)
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation expense                                                                     70
Decrease in accounts receivable                                                          25
Decrease in inventories                                                                  50
Increase in prepayments                                                                 (10)
Increase in accounts payable                                                             25
Decrease in other accrued liabilities                                                   (10)
Increase in interest payable                                                              5
Net cash provided by operating activities                                                \$ 55
Cash Flows from Investing Activities
Acquisition of land                                                                   \$ (75)
Acquisition of plant and equipment                                                      (70)
Net cash used by investing activities                                                    \$(145)
Cash Flows from Financing Activities
Issuance of common stock                                                                 50
Cash dividends paid                                                                     (35)
Net cash provided by financing activities                                                \$ 105
Net increase in cash                                                                     \$ 15
Cash balance, December 31, 2006                                                             80
Cash balance, December 31, 2007                                                          \$ 95

3. Memorandum to the president:
TO:         President of Astro Inc.
FROM:       Student’s name
DATE:       January 20, 2008
SUBJECT: Cash flows
You recently expressed concern to me regarding the large loss we sustained during
2007 in spite of the net increase in cash during the year. Following are my thoughts,
along with a copy of the 2007 statement of cash flows for your reference.
12-38   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-8 (Concluded)

Astro was able to generate a significant amount of cash from operations even
though we incurred the large net loss of \$100,000. One reason for the difference be-
tween cash generated from operations and the net loss was the large amount of de-
preciation expense on the income statement. This noncash expense reduced
reported net income without a corresponding effect on cash flow. Furthermore, the
decrease in accounts receivable indicates that we collected more cash from our cus-
tomers during the year than the amount of sales to them. Finally, the combined
effect of a reduction in inventory and an increase in the amounts owed suppliers
(accounts payable) added to the cash generated.
Operating expenses need to be decreased relative to gross profit if we are to im-
prove our bottom line in the future. The gross profit percentage of 20% appears rea-
sonable, although this depends on many factors, including how our competitors are
doing in this area. A significant portion of the operating expenses is the depreciation
of \$70,000. Because this represents the write-off of a sunk cost (the cost of plant
and equipment acquired already), we cannot reduce the amount of this expense un-
less we decide to sell fixed assets. In fact, during 2007 we actually added to our
base of long-term assets. I recommend that we explore ways to reduce our other
operating expenses. I look forward to hearing from you before moving forward with
any actions.

LO 6        PROBLEM 12-9 YEAR-END BALANCE SHEET AND STATEMENT OF CASH
FLOWS—INDIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):
Net Change
Dr. (Cr.)    Explanation
Cash                                           ?
Accounts receivable                           10       h. sales exceeded cash
collections
Land                                         100       g. bonds were exchanged
for land—a noncash
activity
Plant and equipment                           200      f. purchase
Accumulated depreciation                      (20)     b. depreciation expense
Investments                                     0         no change given
Current liabilities                             0      i. no change
Bonds payable                                (250)     d. 150 issued for cash and
g. 100 issued for land
Common stock                                   50      e. common stock retired
Retained earnings                             (45)     c. dividends of 25
a. net income of (70)
Total without cash                            45 dr.
Thus, the change in cash must be 45 cr. (decrease) to balance the total changes in
the accounts.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-39

PROBLEM 12-9 (Continued)

Statement of Cash Flows:

TERRIER COMPANY
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net income                                                                              \$ 70
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense                                                                    20
Increase in accounts receivable                                                        (10)
Net cash provided by operating activities                                               \$ 80
Cash Flows from Investing Activities
Acquisitions of plant and equipment                                                   \$(200)
Cash Flows from Financing Activities
Payment of cash dividends                                                            \$ (25)
Acquisition and retirement of stock                                                    (50)
Net cash provided by financing activities                                               \$ 75
Net increase (decrease) in cash                                                         \$ (45)
Cash balance, December 31, 2006                                                           140
Cash balance, December 31, 2007                                                         \$ 95
Schedule of Noncash Investing and Financing Activities
Acquisition of land in exchange for bonds                                             \$ 100
12-40   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-9 (Concluded)

2. Balance sheet:

TERRIER COMPANY
BALANCE SHEET
DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash                                                                  \$   951
Accounts receivable                                                      1652
Total current assets                                               \$ 260
Land                                                                  \$ 4003
Plant and equipment                                                      7004
Accumulated depreciation                                                (170)5
Investments                                                              100
Total long-term assets                                             \$1,030
Total assets                                                   \$1,290
Current liabilities                                                   \$ 205
Bonds payable                                                         \$ 5506
Common stock                                                          \$ 3507
Retained earnings                                                        1858
Total stockholders’ equity                                         \$ 535
Total liabilities and stockholders’ equity                     \$1,290
1                                            5
\$140 – \$45                                   \$150 + \$20
2                                            6
\$155 + \$10                                   \$300 + \$250
3                                            7
\$300 + \$100                                  \$400 – \$50
4                                            8
\$500 + \$200                                  \$140 + \$45

3. In addition to the bonds issued in exchange for land, Terrier issued \$150,000 of
bonds for cash. The money raised from this issuance was needed to help finance
the addition of \$200,000 in plant and equipment.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-41

LO 8      PROBLEM 12-10 STATEMENT OF CASH FLOWS USING A WORK SHEET—
INDIRECT METHOD (Appendix)

1. Balance sheet:

TERRIER COMPANY
BALANCE SHEET
DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash                                                                                   \$   951
Accounts receivable                                                                       1652
Total current assets                                                                \$ 260
Land                                                                                   \$ 4003
Plant and equipment                                                                       7004
Accumulated depreciation                                                                 (170)5
Investments                                                                               100
Total long-term assets                                                              \$1,030
Total assets                                                                    \$1,290
Current liabilities                                                                    \$ 205
Bonds payable                                                                          \$ 5506
Common stock                                                                           \$ 3507
Retained earnings                                                                         1858
Total stockholders’ equity                                                          \$ 535
Total liabilities and stockholders’ equity                                      \$1,290
1                                          5
\$140 – \$45                                 \$150 + \$20
2                                          6
\$155 + \$10                                 \$300 + \$250
3                                          7
\$300 + \$100                                \$400 – \$50
4                                          8
\$500 + \$200                                \$140 + \$45
12-42   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-10 (Continued)

2. Statement of cash flows work sheet (all amounts are in thousands of dollars):

Balances                        Cash Inflows (Outflows)
Accounts                12/31/07  12/31/06      Changes   Operating Investing Financing
Cash                            95           140      (45)
Accounts receivable            165           155       10       (10)
Land                           400           300      1001
Plant and equipment            700           500      2002                (200)
Accumulated
depreciation               (170)          (150)     (20)3    20
Investments                    100            100        0
Current liabilities           (205)          (205)       0
Bonds payable                 (550)          (300)    (100)1
(150)4                          150
Common stock                  (350)          (400)      505                           (50)
Retained earnings             (185)          (140)     (70)6    70
257                            (25)
Totals                         0             0        0      80        (200)         75
Net increase
(decrease) in cash                                           (45)
1
Acquisition of land in exchange for bonds (noncash transaction).
2
Purchase of plant and equipment.
3
Depreciation expense.
4
Proceeds from issuance of additional bonds.
5
Acquisition and retirement of common stock.
6
Net income.
7
Cash dividends paid.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-43

PROBLEM 12-10 (Concluded)

3. Statement of cash flows:

TERRIER COMPANY
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net income                                                                              \$ 70
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense                                                                    20
Increase in accounts receivable                                                        (10)
Net cash provided by operating activities                                               \$ 80
Cash Flows from Investing Activities
Acquisitions of plant and equipment                                                   \$(200)
Cash Flows from Financing Activities
Payment of cash dividends                                                            \$ (25)
Acquisition and retirement of stock                                                    (50)
Net cash provided by financing activities                                               \$ 75
Net increase (decrease) in cash                                                         \$ (45)
Cash balance, December 31, 2006                                                           140
Cash balance, December 31, 2007                                                         \$ 95
Schedule of Noncash Investing and Financing Activities
Acquisition of land in exchange for bonds                                             \$ 100

4. In addition to the bonds issued in exchange for land, Terrier issued \$150,000 of
bonds for cash. The money raised from this issuance was needed to help finance
the addition of \$200,000 in plant and equipment.
12-44   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

MULTI-CONCEPT PROBLEMS

LO 4,5        PROBLEM 12-11 STATEMENT OF CASH FLOWS—DIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)   Explanation
Cash                                          (9)
Accounts receivable                           15
Inventory                                    (15)
Prepaid rent                                  (4)
Land                                          80      Purchase
Plant and equipment                          150      Purchase of 195 and sale of (45)
Accumulated depreciation                     (60)     15 Sale of asset (cost of 45 less
book value of 30) and (75)
depreciation
Accounts payable                               (7)
Other accrued liabilities                      (6)
Income tax payable                              2
Long-term bank loan payable                    30     Repayment
Common stock                                 (150)    Issuance of common stock
Retained earnings                             (26)    7 Dividends
(33) Net income
Total                                           0
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-45

PROBLEM 12-11 (Continued)

Conversion of income statement items to a cash basis (in thousands of dollars):
Income Statement       Amount        Adjustment                        Cash Flows
Sales revenue            \$550                                                \$550
– Increase in accounts receivable         (15)
Cash collected                          \$535
Cost of goods sold        350                                                \$350
– Decrease in inventory                   (15)
– Increase in accounts payable             (7)
Cash payments                           \$328
General and
– Decrease in prepaid rent                            (4)
– Increase in accrued liabilities                     (6)
Cash payments                                       \$ 45
Depreciation expense       75        No cash flow effect                                 \$ 0
Loss on sale of                      Not an operating activity                           \$ 0
plant assets            5
Interest expense           15        No interest payable
Cash payments                                       \$ 15
Income tax expense         17                                                            \$ 17
+ Decrease in income
taxes payable                                       2
Cash payments                                       \$ 19
Net income               \$ 33        Net cash flow from operations                       \$128
12-46   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-11 (Concluded)

Statement of cash flows:

GLENDIVE CORP.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED JUNE 30, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flow from Operating Activities
Cash collections from customers                                                \$ 535
Cash payments for:
Inventory                                                                   \$ (328)
Interest                                                                       (15)
Income taxes                                                                   (19)
Total cash payments                                                         \$ (407)
Net cash provided by operating activities                                      \$ 128
Cash Flow from Investing Activities
Sale of plant assets                                                        \$ 25
Acquisition of land                                                           (80)
Acquisition of new plant assets                                              (195)
Net cash used by investing activities                                          \$(250)
Cash Flow from Financing Activities
Repayment of long-term loan                                                 \$ (30)
Payment of cash dividends                                                      (7)
Net cash provided by financing activities                                      \$ 113
Net decrease in cash                                                           \$ (9)
Cash balance, June 30, 2006                                                       40
Cash balance, June 30, 2007                                                    \$ 31

2. It is true that the amount of cash flow from operating activities is the same regard-
less of which method (direct or indirect) is used. The two methods, however, differ in
the information reported to the reader of the statement of cash flows. The direct me-
thod shows the actual inflows and outflows of cash, while the indirect method arrives
at the same amount by reconciling net income to cash flow from operating activities.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-47

LO 4,6     PROBLEM 12-12 STATEMENT OF CASH FLOWS—INDIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)        Explanation
Cash                                 (9)
Accounts receivable                  15
Inventory                           (15)
Prepaid rent                         (4)
Land                                 80           Purchase
Plant and equipment                 150           Purchase of 195 and sale of (45)
Accumulated depreciation            (60)          15 Sale of asset (cost of 45 less
book value of 30) and (75)
depreciation
Accounts payable                     (7)
Other accrued liabilities            (6)
Income tax payable                    2
Long-term bank loan payable          30           Repayment
Common stock                       (150)          Issuance of common stock
Retained earnings                   (26)          7 Dividends
(33) Net income
Total                                 0
12-48   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-12 (Concluded)

Statement of cash flows:

GLENDIVE CORP.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED JUNE 30, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flow from Operating Activities
Net income                                                                      \$ 33
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense                                                            75
Loss on sale of plant assets                                                     5*
Increase in accounts receivable                                                (15)
Decrease in inventory                                                           15
Decrease in prepaid rent                                                         4
Increase in accounts payable                                                     7
Increase in other accrued liabilities                                            6
Decrease in income taxes payable                                                (2)
Net cash provided by operating activities                                       \$ 128
*Book value \$30 – proceeds \$25
Cash Flow from Investing Activities
Sale of plant assets                                                         \$ 25
Acquisition of land                                                            (80)
Acquisition of new plant assets                                               (195)
Net cash used by investing activities                                           \$(250)
Cash Flow from Financing Activities
Repayment of long-term loan                                                  \$ (30)
Payment of cash dividends                                                       (7)
Net cash provided by financing activities                                       \$ 113
Net decrease in cash                                                            \$ (9)
Cash balance, June 30, 2006                                                        40
Cash balance, June 30, 2007                                                     \$ 31

2. It is true that the amount of cash flow from operating activities is the same regard-
less of which method (direct or indirect) is used. The two methods, however, differ in
the information reported to the reader of the statement of cash flows. The direct me-
thod shows the actual inflows and outflows of cash, while the indirect method arrives
at the same amount by reconciling net income to cash flow from operating activities.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-49

LO 2,5     PROBLEM 12-13 STATEMENT OF CASH FLOWS—DIRECT METHOD

1. No, the U.S. Treasury bills are not cash equivalents, because they have a maturity in
excess of three months. Instead, the six-month Treasury bills are properly classified
as current assets.

2. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)         Explanation
Cash                                 (40)
U.S. Treasury bills                  (50)          Sale
Accounts receivable                  110
Inventory                            120
Land                                  10           Purchase
Buildings and equipment              110           Purchase
Accumulated depreciation             (60)          Depreciation expense
Patents                              (25)          Amortization
Accounts payable                     (60)
Taxes payable                         (5)
Notes payable                          0
Term notes payable                     0
Common stock                        (130)          (130) Stock dividend
Retained earnings                     20           (110) Net income
130 Stock dividend
Total                               0
12-50   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-13 (Continued)

Conversion of income statement items to a cash basis (in thousands of dollars):
Income Statement           Amount            Adjustment                        Cash Flows
Sales revenue               \$2,408                                                 \$2,408
– Increase in accounts receivable        (110)
Cash collected                        \$2,298
Cost of goods sold             1,100                                               \$1,100
+ Increase in inventory                   120
– Increase in accounts payable            (60)
Cash payments                         \$1,160
Salaries & benefits    850                   No payable                            \$ 850
Heat, light, and power  75                   No payable                            \$ 75
Depreciation            60                   No cash flow effect
Property taxes          18                   No payable*                           \$ 18
Patent amortization     25                   No cash flow effect
Miscellaneous expenses 10                    No payable                            \$ 10
Interest expense        55                   No payable                            \$ 55
Income tax expense     105                                                         \$ 105
– Increase in income tax payable*          (5)
Cash payments                         \$ 100
Net income                    \$ 110          Net cash flow from operations         \$ 30

*The current liability Taxes Payable is assumed to relate entirely to income taxes ra-
ther than property taxes.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-51

PROBLEM 12-13 (Concluded)

Statement of cash flows:

LANG COMPANY
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Cash collections from customers                                                     \$ 2,298
Cash payments for:
Inventory                                                                        \$(1,160)
Salaries and benefits                                                               (850)
Heat, light, and power                                                               (75)
Property taxes                                                                       (18)
Miscellaneous activities                                                             (10)
Interest                                                                             (55)
Income taxes                                                                        (100)
Total cash payments                                                                 \$(2,268)
Net cash provided by operating activities                                           \$    30
Cash Flows from Investing Activities
Sale of U.S. Treasury bills                                                      \$   50
Acquisition of land                                                                 (10)
Acquisition of buildings and equipment                                             (110)
Net cash used by investing activities                                               \$ (70)
Net decrease in cash                                                                \$ (40)
Cash balance, December 31, 2006                                                        100
Cash balance, December 31, 2007                                                     \$   60

Note: It is questionable whether or not the stock dividend is a significant noncash
activity. If it is determined to be significant, it should be shown on a supplemental
schedule of noncash activities.
12-52   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

ALTERNATE PROBLEMS

LO 6        PROBLEM 12-1A STATEMENT OF CASH FLOWS—INDIRECT METHOD

1. Account changes Dr (Cr) and Explanations:
Cash                                            2,000
Accounts receivable                            (2,000)
Inventory                                       1,000
Prepaid rent                                      200
Land                                                0
Plant and equipment                            50,000    Purchase
Accumulated depreciation                      (50,000)   Depreciation expense
Accounts payable                                    0
Income taxes payable                             (500)
Short-term notes payable                        2,500    Repayment
Bonds payable                                 (25,000)   Issuance
Common stock                                        0
Retained earnings                              21,800    Net loss
Total                                               0
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-53

PROBLEM 12-1A (Concluded)

Statement of cash flows:

STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
Cash Flows from Operating Activities
Net loss                                                                          \$(21,800)
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense                                                             50,000
Decrease in accounts receivable                                                   2,000
Increase in inventory                                                            (1,000)
Increase in prepaid rent                                                           (200)
Increase in income taxes payable                                                    500
Net cash provided by operating activities                                         \$ 29,500
Cash Flows from Investing Activities
Acquisition of plant and equipment                                              \$(50,000)
Cash Flows from Financing Activities
Issuance of bonds payable                                                      \$ 25,000
Repayment of short-term notes payable                                            (2,500)
Net cash provided by financing activities                                         \$ 22,500
Net increase in cash                                                              \$ 2,000
Cash balance, December 31, 2006                                                     10,000
Cash balance, December 31, 2007                                                   \$ 12,000

2. Madison was able to increase its cash balance even though it incurred a net loss
primarily because it had one very large expense that did not require the use of any
cash: depreciation of \$50,000. This one adjustment is the major difference between
the net loss of \$21,800 and the net cash flow from operating activities of \$29,500.
12-54   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 8        PROBLEM 12-2A STATEMENT OF CASH FLOWS USING A WORK SHEET—
INDIRECT METHOD (Appendix)

1. Statement of cash flows work sheet (all amounts are in thousands of dollars)

Balances                            Cash Inflows (Outflows)
Accounts                12/31/07  12/31/06        Changes     Operating Investing Financing
Cash                           12.0          10.0        2.0
Accounts receivable            10.0          12.0       (2.0)        2.0
Inventory                       8.0           7.0        1.0        (1.0)
Prepaid rent                    1.2           1.0        0.2        (0.2)
Land                           75.0          75.0        0.0
Plant and equipment           200.0         150.0       50.01                 (50)
Accumulated
depreciation                (75.0)        (25.0)     (50.0)2    50.0
Accounts payable               (15.0)        (15.0)       0.0
Income tax payable              (2.5)         (2.0)      (0.5)       0.5
Short-term notes
payable                    (20.0)         (22.5)       2.53                            (2.5)
Bonds payable                 (75.0)         (50.0)     (25.0)4                           25.0
Common stock                 (100.0)        (100.0)       0.0
Retained earnings             (18.7)         (40.5)      21.85     (21.8)
Totals                       0.0            0.0        0.0       29.5      (50)        22.5
Net increase
(decrease) in cash                                                2.0
1
Purchase of equipment.
2
Depreciation expense.
3
Retirement of note.
4
Issuance of bonds.
5
Net loss.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-55

PROBLEM 12-2A (Concluded)

2. Statement of cash flows:

STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
Cash Flows from Operating Activities
Net loss                                                                          \$(21,800)
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense                                                             50,000
Decrease in accounts receivable                                                   2,000
Increase in inventory                                                            (1,000)
Increase in prepaid rent                                                           (200)
Increase in income taxes payable                                                    500
Net cash provided by operating activities                                         \$ 29,500
Cash Flows from Investing Activities
Acquisition of plant and equipment                                              \$(50,000)
Cash Flows from Financing Activities
Issuance of bonds payable                                                      \$ 25,000
Repayment of short-term notes payable                                            (2,500)
Net cash provided by financing activities                                         \$ 22,500
Net increase (decrease) in cash                                                   \$ 2,000
Cash balance, December 31, 2006                                                     10,000
Cash balance, December 31, 2007                                                   \$ 12,000

3. Madison was able to increase its cash balance even though it incurred a net loss
primarily because it had one very large expense that did not require the use of any
cash: depreciation of \$50,000. This one adjustment is the major difference between
the net loss of \$21,800 and the net cash flow from operating activities of \$29,500.
12-56   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 5        PROBLEM 12-3A STATEMENT OF CASH FLOWS—DIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)        Explanation
Cash                                          (70)
Accounts receivable                           (85)
Inventory                                      20
Prepayments                                   (10)
Land                                         (100)         Sale (c)
Plant and equipment                           250          Purchase (c)
Accumulated depreciation                      (25)         Depreciation expense (b)
Accounts payable                              (20)
Other accrued liabilities                       5
Income tax payable                             35
Long-term bank loan payable                    50          Retirement of bank loan (d)
Common stock                                  (50)         Issuance of common stock (d)
Retained earnings                              (0)         350 Dividends (a)
(350) Net income
Total                                      0

Conversion of income statement items to a cash basis (in thousands of dollars):
Income Statement           Amount             Adjustment                        Cash Flows
Sales revenue               \$2,460                                                  \$2,460
+ Decrease in accounts receivable          85
Cash collected                        \$2,545
Cost of goods sold             1,400                                                \$1,400
+ Increase in inventory                    20
– Increase in accounts payable            (20)
Cash payments                         \$1,400
Operating expenses               460                                                \$ 460
– Decrease in prepayments                 (10)
– Depreciation expense                    (25)
+ Decrease in accrued liabilities           5
Cash payments                         \$ 430
Interest expense                 100                                                \$ 100
No interest payable                         0
Cash payments                         \$ 100
Income tax expense               150                                                \$ 150
+ Decrease in income tax payable           35
Cash paid for taxes                   \$ 185
Net income                    \$ 350           Net cash flow from operations         \$ 430
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-57

PROBLEM 12-3A (Continued)

Statement of cash flows:

WABASH CORP.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Cash collections from customers                                                    \$ 2,545
Cash payments for:
Inventory                                                                       \$(1,400)
Operating expenses                                                                 (430)
Interest                                                                           (100)
Income taxes                                                                       (185)
Total cash payments                                                                \$(2,115)
Net cash provided by operating activities                                          \$ 430
Cash Flows from Investing Activities
Sale of land                                                                    \$  100
Acquisition of plant and equipment                                                (250)
Net cash used by investing activities                                              \$ (150)
Cash Flows from Financing Activities
Repayment of long-term borrowings                                               \$  (50)
Issuance of common stock                                                            50
Cash dividends paid                                                               (350)
Net cash used by financing activities                                              \$ (350)
Net decrease in cash                                                               \$ (70)
Cash balance, December 31, 2006                                                       210
Cash balance, December 31, 2007                                                    \$ 140

2. Memorandum to the president:
TO:        President of Wabash Corp.
FROM:      Student’s name
DATE:      January 20, 2008
SUBJECT: Cash flows
You recently expressed concern to me regarding the decrease in cash during 2007
in spite of the profitable year shown on the income statement. Furthermore, there
was a concern regarding the decline in our cash balance during the year, given that
existing loan covenants require a \$100,000 minimum balance at all times. My
thoughts and a copy of the 2007 statement of cash flows follow.
12-58   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-3A (Concluded)

Although net income on an accrual basis was \$350,000, net cash flow from op-
erating activities was even higher, \$430,000. However, the favorable cash flow dur-
ing the year was used for various purposes. First, significant additions were made to
plant and equipment, \$250,000, and this drain on cash was only partially offset by
the sale of land for \$100,000. Additional stock was sold for \$50,000, which was the
amount needed to repay an existing bank loan. The major reason, however, for the
drain on cash is the size of our dividend payments. Dividends of \$350,000 were paid
during the year, which is equal to the income of the period.
Our cash flow should improve in future years without the need to invest so heavi-
ly in new property, plant, and equipment. At the same time, I recommend that we
limit the amount paid in any one year for dividends as a way to keep our cash bal-
ance at a sufficient level to satisfy the bank.

LO 6        PROBLEM 12-4A STATEMENT OF CASH FLOWS—INDIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)   Explanation
Cash                                          (70)
Accounts receivable                           (85)
Inventory                                      20
Prepayments                                   (10)
Land                                         (100)    Sale (c)
Plant and equipment                           250     Purchase (c)
Accumulated depreciation                      (25)    Depreciation expense (b)
Accounts payable                              (20)
Other accrued liabilities                       5
Income tax payable                             35
Long-term bank loan payable                    50     Retirement of bank loan (d)
Common stock                                  (50)    Issuance of common stock (d)
Retained earnings                              (0)    350 Dividends (a)
(350) Net income
Total                                      0
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-59

PROBLEM 12-4A (Continued)

Statement of cash flows:

WABASH CORP.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net income                                                                              \$ 350
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense                                                                    25
Decrease in accounts receivable                                                         85
Increase in inventories                                                                (20)
Decrease in prepayments                                                                 10
Increase in accounts payable                                                            20
Decrease in other accrued liabilities                                                   (5)
Decrease in income taxes payable                                                       (35)
Net cash provided by operating activities                                               \$ 430
Cash Flows from Investing Activities
Sale of land                                                                         \$ 100
Acquisition of plant and equipment                                                    (250)
Net cash used by investing activities                                                   \$(150)
Cash Flows from Financing Activities
Repayment of long-term borrowings                                                    \$ (50)
Issuance of common stock                                                                50
Cash dividends paid                                                                   (350)
Net cash used by financing activities                                                   \$(350)
Net decrease in cash                                                                    \$ (70)
Cash balance, December 31, 2006                                                           210
Cash balance, December 31, 2007                                                         \$ 140

2. Memorandum to the president:
TO:        President of Wabash Corp.
FROM:      Student’s name
DATE:      January 20, 2008
SUBJECT: Cash flows
You recently expressed concern to me regarding the decrease in cash during 2007
in spite of the profitable year shown on the income statement. Furthermore, there
was a concern regarding the decline in our cash balance during the year, given that
existing loan covenants require a \$100,000 minimum balance at all times. My
thoughts and a copy of the 2007 statement of cash flows follow.
12-60   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-4A (Concluded)

Although net income on an accrual basis was \$350,000, net cash flow from
operating activities was even higher, \$430,000. However, the favorable cash flow
during the year was used for various purposes. First, significant additions were
made to plant and equipment, \$250,000, and this drain on cash was only partially
offset by the sale of land for \$100,000. Additional stock was sold for \$50,000, which
was the amount needed to repay an existing bank loan. The major reason, however,
for the drain on cash is the size of our dividend payments. Dividends of \$350,000
were paid during the year, which is equal to the income of the period.
Our cash flow should improve in future years without the need to invest so heavi-
ly in new property, plant, and equipment. At the same time, I recommend that we
limit the amount paid in any one year for dividends as a way to keep our cash bal-
ance at a sufficient level to satisfy the bank.

LO 8        PROBLEM 12-5A STATEMENT OF CASH FLOWS USING A WORK SHEET—
INDIRECT METHOD (Appendix)

1. Statement of cash flows work sheet (all amounts are in thousands of dollars):

Balances                          Cash Inflows (Outflows)
Accounts                12/31/07  12/31/06      Changes     Operating Investing Financing
Cash                          140           210       (70)
Accounts receivable            60           145       (85)        85
Inventory                     200           180        20        (20)
Prepayments                    15            25       (10)        10
Land                          600           700      (100)1                 100
Plant and equipment           850           600       2502                 (250)
Accumulated
depreciation              (225)          (200)       (25)3     25
Accounts payable             (140)          (120)       (20)      20
Accrued liabilities           (50)           (55)         5       (5)
Income tax payable            (80)          (115)        35      (35)
Long-term loan
payable                   (200)          (250)      504                             (50)
Common stock                 (450)          (400)     (50)5                             50
Retained earnings            (720)          (720)     3506                            (350)
(350)7     350
Totals                        0             0        0       430        (150)      (350)
Net increase
(decrease) in cash                                            (70)
1                                                       5
Sale of land.                                           Issuance of common stock.
2                                                       6
Purchase of plant and equipment.                        Dividends.
3                                                       7
Depreciation expense.                                   Net income.
4
Retirement of bank loan.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-61

PROBLEM 12-5A (Continued)

2. Statement of cash flows:

WABASH CORP.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net income                                                                              \$ 350
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation expense                                                                    25
Decrease in accounts receivable                                                         85
Increase in inventories                                                                (20)
Decrease in prepayments                                                                 10
Increase in accounts payable                                                            20
Decrease in other accrued liabilities                                                   (5)
Decrease in income taxes payable                                                       (35)
Net cash provided by operating activities                                               \$ 430
Cash Flows from Investing Activities
Sale of land                                                                         \$ 100
Acquisition of plant and equipment                                                    (250)
Net cash used by investing activities                                                   \$(150)
Cash Flows from Financing Activities
Repayment of long-term borrowings                                                    \$ (50)
Issuance of common stock                                                                50
Cash dividends paid                                                                   (350)
Net cash used by financing activities                                                   \$(350)
Net decrease in cash                                                                    \$ (70)
Cash balance, December 31, 2006                                                           210
Cash balance, December 31, 2007                                                         \$ 140

3. Memorandum to the president:
TO:        President of Wabash Corp.
FROM:      Student’s name
DATE:      January 20, 2008
SUBJECT: Cash flows
You recently expressed concern to me regarding the decrease in cash during 2007
in spite of the profitable year shown on the income statement. Furthermore, there
was a concern regarding the decline in our cash balance during the year, given that
existing loan covenants require a \$100,000 minimum balance at all times. My
thoughts and a copy of the 2007 statement of cash flows follow.
12-62   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-5A (Concluded)

Although net income on an accrual basis was \$350,000, net cash flow from
operating activities was even higher, \$430,000. However, the favorable cash flow
during the year was used for various purposes. First, significant additions were
made to plant and equipment, \$250,000, and this drain on cash was only partially
offset by the sale of land for \$100,000. Additional stock was sold for \$50,000, which
was the amount needed to repay an existing bank loan. The major reason, however,
for the drain on cash is the size of our dividend payments. Dividends of \$350,000
were paid during the year, which is equal to the income of the period.
Our cash flow should improve in future years without the need to invest so heavi-
ly in new property, plant, and equipment. At the same time, I recommend that we
limit the amount paid in any one year for dividends as a way to keep our cash bal-
ance at a sufficient level to satisfy the bank.

LO 5        PROBLEM 12-6A STATEMENT OF CASH FLOWS—DIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)   Explanation
Cash                                           15
Accounts receivable                           (50)
Inventory                                       0
Prepayments                                     1
Land                                          100     Purchase (c)
Plant and equipment                           250     Purchase (c)
Accumulated depreciation                      (40)    Depreciation expense (b)
Accounts payable                              (40)
Other accrued liabilities                     (20)
Interest payable                              (10)
Long-term bank loan payable                  (350)    Proceeds from bank loan (c)
Common stock                                    0
Retained earnings                             144     84 Dividends (a)
60 Net loss
Total                                      0
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-63

PROBLEM 12-6A (Continued)

Conversion of income statement items to a cash basis (in thousands of dollars):
Income Statement      Amount          Adjustment                        Cash Flows
Sales revenue           \$350                                                  \$350
+ Decrease in accounts receivable          50
Cash collected                          \$400
Cost of goods sold          150                                               \$150
No change in inventory
– Increase in accounts payable            (40)
Cash payments                           \$110
Operating expenses          250                                               \$250
+ Increase in prepayments                   1
– Depreciation expense                    (40)
– Increase in accrued liabilities         (20)
Cash payments                           \$191
Interest expense             10                                               \$ 10
– Increase in interest payable            (10)
Cash payments                           \$ 0
Net income (loss)          \$(60)      Net cash flow from operations           \$ 99

Statement of cash flows:

PLUTO INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Cash collections on account                                                              \$ 400
Cash payments for:
Inventory                                                                             \$(110)
Operating expenses                                                                     (191)
Total cash payments                                                                   \$(301)
Net cash provided by operating activities                                                \$ 99
Cash Flows from Investing Activities
Acquisition of land                                                                   \$(100)
Acquisition of plant and equipment                                                     (250)
Net cash used by investing activities                                                    \$(350)
Cash Flows from Financing Activities
Cash dividends paid                                                                     (84)
Net cash provided by financing activities                                                \$ 266
Net increase in cash                                                                     \$ 15
Cash balance, December 31, 2006                                                             10
Cash balance, December 31, 2007                                                          \$ 25
12-64   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-6A (Concluded)
2. Memorandum to the president:
TO:            President of Pluto Inc.
FROM:          Student’s name
DATE:          January 20, 2008
SUBJECT: Cash flows
You recently expressed concern to me regarding the large loss we sustained during
2007 in spite of the net increase in cash during the year. Following are my thoughts,
along with a copy of the 2007 statement of cash flows for your reference.
Pluto was able to generate a significant amount of cash from operations even
though we incurred a net loss of \$60,000. One reason for the difference between
cash generated from operations and the net loss was the \$40,000 of depreciation
expense on the income statement. This noncash expense reduced reported net in-
come without a corresponding effect on cash flow. Furthermore, the large decrease
in accounts receivable of \$50,000 indicates that we collected more cash from our
customers during the year than the amount of sales to them. Finally, the large buil-
dup of our accounts payable by \$40,000 had the effect of improving our cash flow for
the year.
The gross profit percentage of 57% is very strong. However, operating expenses
need to be decreased relative to gross profit if we are to improve our bottom line in
the future. A portion of the operating expenses is the depreciation of \$40,000. Be-
cause this represents the write-off of a sunk cost (the cost of plant and equipment
acquired already), we cannot reduce the amount of this expense unless we decide
to sell fixed assets. In fact, during 2007 we actually added \$350,000 to our base of
long-term assets, in the form of land and plant and equipment acquisitions. You will
note on the statement of cash flows that these acquisitions were entirely financed
with the issuance of a long-term bank loan.
I recommend two immediate courses of action. First, we must find ways to re-
duce our operating expenses. Second, until we see an improvement in the bottom
line, it is imperative that we cut back, if not eliminate entirely, our dividends. A divi-
dend payment of \$84,000 in a year in which we sustained a net loss of \$60,000 is
not prudent. I look forward to hearing from you before moving forward with any ac-
tions.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-65

LO 6      PROBLEM 12-7A STATEMENT OF CASH FLOWS—INDIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)        Explanation
Cash                                 15
Accounts receivable                 (50)
Inventory                             0
Prepayments                           1
Land                                100           Purchase (c)
Plant and equipment                 250           Purchase (c)
Accumulated depreciation            (40)          Depreciation expense (b)
Accounts payable                    (40)
Other accrued liabilities           (20)
Interest payable                    (10)
Long-term bank loan payable        (350)          Proceeds from bank loan (c)
Common stock                          0
Retained earnings                   144           84 Dividends (a)
60 Net loss
Total                             0
12-66   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-7A (Continued)

Statement of cash flows:

PLUTO INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net loss                                                    \$ (60)
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation expense                                       40
Decrease in accounts receivable                            50
Increase in prepayments                                    (1)
Increase in accounts payable                               40
Increase in other accrued liabilities                      20
Increase in interest payable                               10
Net cash provided by operating activities                   \$ 99
Cash Flows from Investing Activities
Acquisition of land                                      \$(100)
Acquisition of plant and equipment                        (250)
Net cash used by investing activities                       \$(350)
Cash Flows from Financing Activities
Cash dividends paid                                        (84)
Net cash provided by financing activities                   \$ 266
Net increase in cash                                        \$ 15
Cash balance, December 31, 2006                                10
Cash balance, December 31, 2007                             \$ 25
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-67

PROBLEM 12-7A (Concluded)

2. Memorandum to the president:
TO:         President of Pluto, Inc.
FROM:       Student’s name
DATE:       January 20, 2008
SUBJECT: Cash flows
You recently expressed concern to me regarding the large loss we sustained during
2007 in spite of the net increase in cash during the year. Following are my thoughts,
along with a copy of the 2007 statement of cash flows for your reference.
Pluto was able to generate a significant amount of cash from operations even
though we incurred a net loss of \$60,000. One reason for the difference between
cash generated from operations and the net loss was the \$40,000 of depreciation
expense on the income statement. This noncash expense reduced reported net in-
come without a corresponding effect on cash flow. Furthermore, the large decrease
in accounts receivable of \$50,000 indicates that we collected more cash from our
customers during the year than the amount of sales to them. Finally, the large buil-
dup of our accounts payable by \$40,000 had the effect of improving our cash flow for
the year.
The gross profit percentage of 57% is very strong. However, operating expenses
need to be decreased relative to gross profit if we are to improve our bottom line in
the future. A portion of the operating expenses is the depreciation of \$40,000. Be-
cause this represents the write-off of a sunk cost (the cost of plant and equipment
acquired already), we cannot reduce the amount of this expense unless we decide
to sell fixed assets. In fact, during 2007 we actually added \$350,000 to our base of
long-term assets, in the form of land and plant and equipment acquisitions. You will
note on the statement of cash flows that these acquisitions were entirely financed
with the issuance of a long-term bank loan.
I recommend two immediate courses of action. First, we must find ways to re-
duce our operating expenses. Second, until we see an improvement in the bottom
line, it is imperative that we cut back, if not eliminate entirely, our dividends. A divi-
dend payment of \$84,000 in a year in which we sustained a net loss of \$60,000 is
not prudent. I look forward to hearing from you before moving forward with any ac-
tions.
12-68   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 8        PROBLEM 12-8A STATEMENT OF CASH FLOWS USING A WORK SHEET—
INDIRECT METHOD (Appendix)

1. Statement of cash flows work sheet (all amounts are in thousands of dollars):
Balances                          Cash Inflows (Outflows)
Accounts                12/31/07  12/31/06      Changes     Operating Investing Financing
Cash                            25            10          15
Accounts receivable             30            80         (50)     50
Inventory                      100           100           0
Prepayments                     36            35           1       (1)
Land                           300           200         1001               (100)
Plant and equipment            500           250         2502               (250)
Accumulated
depreciation                (90)          (50)       (40)3    40
Accounts payable                (50)          (10)       (40)     40
Other accrued
liabilities                 (40)          (20)       (20)     20
Interest payable                (22)          (12)       (10)     10
Long-term loan
payable                   (450)          (100)    (350)4                            350
Common stock                  (300)          (300)       0
Retained earnings              (39)          (183)      605       (60)
846                             (84)
Totals                         0             0        0        99        (350)       266
Net increase
(decrease) in cash                                             15
1                                                    4
Purchase of land.                                    Proceeds from borrowings.
2                                                    5
Purchase of plant and equipment.                     Net loss.
3                                                    6
Depreciation expense.                                Cash dividends paid.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-69

PROBLEM 12-8A (Continued)

2. Statement of cash flows:

PLUTO INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net loss                                                                                 \$ (60)
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation expense                                                                    40
Decrease in accounts receivable                                                         50
Increase in prepayments                                                                 (1)
Increase in accounts payable                                                            40
Increase in other accrued liabilities                                                   20
Increase in interest payable                                                            10
Net cash provided by operating activities                                                \$ 99
Cash Flows from Investing Activities
Acquisition of land                                                                   \$(100)
Acquisition of plant and equipment                                                     (250)
Net cash used by investing activities                                                    \$(350)
Cash Flows from Financing Activities
Cash dividends paid                                                                     (84)
Net cash provided by financing activities                                                \$ 266
Net increase in cash                                                                     \$ 15
Cash balance, December 31, 2006                                                             10
Cash balance, December 31, 2007                                                          \$ 25

3. Memorandum to the president:
TO:         President of Pluto, Inc.
FROM:       Student’s name
DATE:       January 20, 2008
SUBJECT: Cash flows
You recently expressed concern to me regarding the large loss we sustained during
2007 in spite of the net increase in cash during the year. Following are my thoughts,
along with a copy of the 2007 statement of cash flows for your reference.
12-70   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-8A (Concluded)

Pluto was able to generate a significant amount of cash from operations even
though we incurred a net loss of \$60,000. One reason for the difference between
cash generated from operations and the net loss was the \$40,000 of depreciation
expense on the income statement. This noncash expense reduced reported net in-
come without a corresponding effect on cash flow. Furthermore, the large decrease
in accounts receivable of \$50,000 indicates that we collected more cash from our
customers during the year than the amount of sales to them. Finally, the large buil-
dup of our accounts payable by \$40,000 had the effect of improving our cash flow for
the year.
The gross profit percentage of 57% is very strong. However, operating expenses
need to be decreased relative to gross profit if we are to improve our bottom line in
the future. A portion of the operating expenses is the depreciation of \$40,000. Be-
cause this represents the write-off of a sunk cost (the cost of plant and equipment
acquired already), we cannot reduce the amount of this expense unless we decide
to sell fixed assets. In fact, during 2007 we actually added \$350,000 to our base of
long-term assets, in the form of land and plant and equipment acquisitions. You will
note on the statement of cash flows that these acquisitions were entirely financed
with the issuance of a long-term bank loan.
I recommend two immediate courses of action. First, we must find ways to re-
duce our operating expenses. Second, until we see an improvement in the bottom
line, it is imperative that we cut back, if not eliminate entirely, our dividends. A divi-
dend payment of \$84,000 in a year in which we sustained a net loss of \$60,000 is
not prudent. I look forward to hearing from you before moving forward with any ac-
tions.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-71

LO 6      PROBLEM 12-9A YEAR-END BALANCE SHEET AND STATEMENT OF CASH
FLOWS—INDIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):
Net Change
Dr. (Cr.)         Explanation
Cash                                  ?
Accounts receivable                  15            h. sales exceeded cash
collections
Land                                200            g. note was exchanged for land,
a noncash activity
Plant and equipment                  60            f. purchase
Accumulated depreciation            (25)           b. depreciation expense
Investments                           0            no change given
Current liabilities                  20            i. decrease
Long-term note payable             (200)           g. note was exchanged for land,
a noncash activity
Bonds payable                       100            e. bonds retired
Common stock                        (50)           d. common stock issued
Retained earnings                   (10)           c. dividends of 40
a. income of (50)
Total without cash                  110 dr.

Thus, the change in cash must be 110 cr. (decrease) to balance the total changes in
the accounts.
12-72   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-9A (Continued)

Statement of cash flows:

POODLE COMPANY
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net income                                                  \$ 50
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense                                        25
Increase in accounts receivable                            (15)
Decrease in current liabilities                            (20)
Net cash provided by operating activities                   \$ 40
Cash Flows from Investing Activities
Acquisitions of plant and equipment                       \$ (60)
Cash Flows from Financing Activities
Payment of cash dividends                                \$ (40)
Retirement of bonds                                       (100)
Issuance of common stock                                    50
Net cash used by financing activities                       \$ (90)
Net increase (decrease) in cash                             \$(110)
Cash balance, December 31, 2006                               155
Cash balance, December 31, 2007                             \$ 45
Schedule of Noncash Investing and Financing Activities
Acquisition of land in exchange for note                  \$ 200
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-73

PROBLEM 12-9A (Concluded)

2. Balance sheet:

POODLE COMPANY
BALANCE SHEET
DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash                                                                                   \$   451
Accounts receivable                                                                       1552
Total current assets                                                                \$ 200
Land                                                                                   \$ 3003
Plant and equipment                                                                       7604
Accumulated depreciation                                                                 (200)5
Investments                                                                               125
Total long-term assets                                                              \$ 985
Total assets                                                                    \$1,185
Current liabilities                                                                    \$ 3056
Long-term note payable                                                                 \$ 200
Common stock                                                                           \$ 5507
Retained earnings                                                                         1308
Total stockholders’ equity                                                          \$ 680
Total liabilities and stockholders’ equity                                      \$1,185
1                                          5
\$155 – \$110                                \$175 + \$25
2                                          6
\$140 + \$15                                 \$325 – \$20
3                                          7
\$100 + \$200                                \$500 + \$50
4                                          8
\$700 + \$60                                 \$120 + \$10

3. Poodle’s cash from operations of \$40,000 was insufficient to cover its acquisitions of
new plant and equipment of \$60,000 and the payment of cash dividends of \$40,000.
Common stock of \$50,000 was issued, but this was more than offset by the
\$100,000 needed to retire the bonds. The lack of cash from operations to cover ac-
quisitions, pay dividends, and retire the bonds are all responsible for the large de-
crease in the company’s cash balance at the end of the year.
12-74   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 8        PROBLEM 12-10A STATEMENT OF CASH FLOWS USING A WORK SHEET—
INDIRECT METHOD (Appendix)

1. Balance sheet:

POODLE COMPANY
BALANCE SHEET
DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash                                                              \$    451
Accounts receivable                                                   1552
Total current assets                                           \$ 200
Land                                                              \$ 3003
Plant and equipment                                                   7604
Accumulated depreciation                                             (200)5
Investments                                                           125
Total long-term assets                                         \$ 985
Total assets                                               \$ 1,185
Current liabilities                                               \$ 3056
Long-term note payable                                            \$ 200
Common stock                                                      \$ 5507
Retained earnings                                                     1308
Total stockholders’ equity                                     \$ 680
Total liabilities and stockholders’ equity                 \$ 1,185
1                                            5
\$155 – \$110                                  \$175 + \$25
2                                            6
\$140 + \$15                                   \$325 – \$20
3                                            7
\$100 + \$200                                  \$500 + \$50
4                                            8
\$700 + \$60                                   \$120 + \$10
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-75

PROBLEM 12-10A (Continued)

2. Statement of cash flows work sheet (all amounts are in thousands of dollars):

Balances                       Cash Inflows (Outflows)
Accounts            12/31/07  12/31/06   Changes     Operating Investing Financing
Cash                       45       155       (110)
Accounts receivable       155       140         15         (15)
Land                      300       100        2001
Plant and equipment       760       700         602                       (60)
Accumulated
depreciation           (200)    (175)       (25)3        25
Investments                125      125          0
Current liabilities       (305)    (325)        20         (20)
Long-term note
payable                (200)       0       (200)1
Bonds payable                0     (100)       1004                                       (100)
Common stock              (550)    (500)       (50)5                                        50
Retained earnings         (130)    (120)       (50)6        50
407                                        (40)
Totals                    0        0          0          40            (60)             (90)
Net increase
(decrease) in cash                                    (110)
1
Acquisition of land in exchange for note (noncash transaction).
2
Purchase of plant and equipment.
3
Depreciation expense.
4
Retirement of bonds payable.
5
Issuance of common stock.
6
Net income.
7
Cash dividends paid.
12-76   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-10A (Concluded)

3. Statement of cash flows:

POODLE COMPANY
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Net income                                                                      \$ 50
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation expense                                                            25
Increase in accounts receivable                                                (15)
Decrease in current liabilities                                                (20)
Net cash provided by operating activities                                       \$ 40
Cash Flows from Investing Activities
Acquisitions of plant and equipment                                           \$ (60)
Cash Flows from Financing Activities
Payment of cash dividends                                                    \$ (40)
Retirement of bonds                                                           (100)
Issuance of common stock                                                        50
Net cash used by financing activities                                           \$ (90)
Net increase (decrease) in cash                                                 \$(110)
Cash balance, December 31, 2006                                                   155
Cash balance, December 31, 2007                                                 \$ 45
Schedule of Noncash Investing and Financing Activities
Acquisition of land in exchange for note                                      \$ 200

4. Poodle’s cash from operations of \$40,000 was insufficient to cover its acquisitions of
new plant and equipment of \$60,000 and the payment of cash dividends of \$40,000.
Common stock of \$50,000 was issued, but this was more than offset by the
\$100,000 needed to retire the bonds. The lack of cash from operations to cover ac-
quisitions, pay dividends, and retire the bonds are all responsible for the large de-
crease in the company’s cash balance at the end of the year.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-77

ALTERNATE MULTI-CONCEPT PROBLEMS

LO 4,5        PROBLEM 12-11A STATEMENT OF CASH FLOWS—DIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)        Explanation
Cash                                (15)
Accounts receivable                  11
Inventory                            25
Prepaid rent                        (16)
Land                                (90)          Sale
Plant and equipment                  75           Purchase of 125 and sale of (50)
Accumulated depreciation            (60)          20 Sale of asset (cost of 50 less
book value of 30) and
(80) depreciation
Accounts payable                     (5)
Other accrued liabilities            (5)
Income tax payable                   10
Long-term bank loan payable          75           Repayment
Common stock                          0
Retained earnings                    (5)          5 Dividends
(10) Net income
Total                              0
12-78   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-11A (Continued)

Conversion of income statement items to a cash basis (in thousands of dollars):
Income Statement           Amount            Adjustment                        Cash Flows
Sales revenue                \$400                                                    \$400
– Increase in accounts receivable         (11)
Cash collected                          \$389
Cost of goods sold               240                                                 \$240
+ Increase in inventory                    25
– Increase in accounts payable             (5)
Cash payments                           \$260
General and
– Decrease in prepaid rent               (16)
– Increase in accrued liabilities         (5)
Cash payments                           \$ 19
Depreciation expense               80        (No cash flow effect)                   \$ 0
Loss on sale of
plant assets                   10        Not an operating activity               \$   0
Interest expense                   15        No interest payable
Cash payments                           \$ 15
Income tax expense                  5                                                \$ 5
+ Decrease in income taxes payable        10
Cash payments                           \$ 15
Net income                      \$ 10         Net cash flow from operations           \$ 80
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-79

PROBLEM 12-11A (Concluded)

Statement of cash flows:

BANNACK CORP.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED JUNE 30, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Cash collections from customers                                                           \$ 389
Cash payments for:
Inventory                                                                              \$(260)
Interest                                                                                 (15)
Income taxes                                                                             (15)
Total cash payments                                                                       \$(309)
Net cash provided by operating activities                                                 \$ 80
Cash Flows from Investing Activities
Sale of land                                                                           \$ 90
Purchase of plant and equipment                                                         (125)
Sale of plant and equipment                                                               20
Net cash used by investing activities                                                     \$ (15)
Cash Flows from Financing Activities
Repayment of long-term loan                                                            \$ (75)
Payment of cash dividends                                                                 (5)
Net cash used by financing activities                                                     \$ (80)
Net decrease in cash                                                                      \$ (15)
Cash balance, June 30, 2006                                                                  40
Cash balance, June 30, 2007                                                               \$ 25

2. It is true that the amount of cash flow from operating activities is the same regard-
less of which method (direct or indirect) is used. The two methods, however, differ in
the information reported to the reader of the statement of cash flows. The direct me-
thod shows the actual inflows and outflows of cash, while the indirect method arrives
at the same amount by reconciling net income to cash flow from operating activities.
12-80   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 4,6          PROBLEM 12-12A STATEMENT OF CASH FLOWS—INDIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)         Explanation
Cash                                         (15)
Accounts receivable                           11
Inventory                                     25
Prepaid rent                                 (16)
Land                                         (90)     Sale
Plant and equipment                           75      Purchase of 125 and sale of (50)
Accumulated depreciation                     (60)     20 Sale of asset (cost of 50 less
book value of 30) and (80)
depreciation
Accounts payable                             (5)
Other accrued liabilities                    (5)
Income tax payable                           10
Long-term bank loan payable                  75       Repayment
Common stock                                  0
Retained earnings                            (5)      5 Dividends
(10) Net income
Total                                    0
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-81

PROBLEM 12-12A (Concluded)

Statement of cash flows:

BANNACK CORP.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED JUNE 30, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flow from Operating Activities
Net income                                                                                 \$ 10
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation expense                                                                      80
Loss on sale of plant assets                                                              10
Increase in accounts receivable                                                          (11)
Increase in inventory                                                                    (25)
Decrease in prepaid rent                                                                  16
Increase in accounts payable                                                               5
Increase in other accrued liabilities                                                      5
Decrease in income taxes payable                                                         (10)
Net cash provided by operating activities                                                  \$ 80
Cash Flow from Investing Activities
Sale of land                                                                            \$ 90
Purchase of plant and equipment                                                         (125)
Sale of plant and equipment                                                               20
Net cash used by investing activities                                                      \$(15)
Cash Flow from Financing Activities
Repayment of long-term loan                                                             \$(75)
Payment of cash dividends                                                                 (5)
Net cash used by financing activities                                                      \$(80)
Net decrease in cash                                                                       \$(15)
Cash balance, June 30, 2006                                                                  40
Cash balance, June 30, 2007                                                                \$ 25

2. It is true that the amount of cash flow from operating activities is the same regard-
less of which method (direct or indirect) is used. The two methods, however, differ in
the information reported to the reader of the statement of cash flows. The direct me-
thod shows the actual inflows and outflows of cash, while the indirect method arrives
at the same amount by reconciling net income to cash flow from operating activities.
12-82   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 2,5          PROBLEM 12-13A STATEMENT OF CASH FLOWS—DIRECT METHOD

1. No, the U.S. Treasury bills are not cash equivalents, because they have a maturity in
excess of three months. Instead, the six-month Treasury bills are properly classified
as current assets.

2. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)   Explanation
Cash                                         (25)
U.S. Treasury bills                           25
Accounts receivable                          (75)
Inventory                                     25
Land                                          20      Purchase
Buildings and equipment                       60      Purchase
Accumulated depreciation                     (40)     Depreciation expense
Patents                                      (20)     Amortization
Accounts payable                             (40)
Taxes payable                                 10
Notes payable                                100      Retirement of note
Term notes payable                             0
Common stock                                 (20)     (20) Stock dividend
Retained earnings                            (20)     (40) Net income
20 Stock dividend
Total                                     0
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-83

PROBLEM 12-13A (Continued)

Conversion of income statement items to a cash basis (in thousands of dollars):

Income Statement      Amount         Adjustment                        Cash Flows
Sales revenue          \$1,416                                              \$1,416
+ Decrease in accounts receivable          75
Cash collected                        \$1,491
Cost of goods sold           990                                           \$ 990
+ Increase in inventory                    25
– Increase in accounts payable            (40)
Cash payments                         \$ 975
Salaries and benefits        195     No payable                            \$ 195
Heat, light, and power        70     No payable                            \$ 70
Depreciation                  40     No cash flow effect
Property taxes                 2     No payable*                           \$     2
Patent amortization           20     No cash flow effect
Miscellaneous expense          2     No payable                            \$     2
Interest expense              45     No payable                            \$ 45
Income tax expense            12                                           \$ 12
+ Decrease in income tax payable*          10
Cash payments                         \$ 22
Net income               \$    40     Net cash flow from operations         \$ 180

*The current liability Taxes Payable is assumed to relate entirely to income taxes ra-
ther than property taxes.
12-84   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

PROBLEM 12-13A (Concluded)

Statement of cash flows:

SHEPARD COMPANY
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Cash collections from customers                                              \$ 1,491
Cash payments for:
Inventory                                                                 \$ (975)
Salaries and benefits                                                        (195)
Heat, light, and power                                                        (70)
Property taxes                                                                 (2)
Miscellaneous activities                                                       (2)
Interest                                                                      (45)
Income taxes                                                                  (22)
Total cash payments                                                          \$(1,311)
Net cash provided by operating activities                                    \$ 180
Cash Flows from Investing Activities
Purchase of U.S. Treasury bills                                           \$  (25)
Acquisition of land                                                          (20)
Acquisition of buildings and equipment                                       (60)
Net cash used by investing activities                                        \$ (105)
Cash Flows from Financing Activities
Retirement of notes payable                                                \$ (100)
Net decrease in cash                                                       \$ (25)
Cash balance, December 31, 2006                                                  75
Cash balance, December 31, 2007                                              \$   50

Note: It is questionable whether or not the stock dividend is a significant noncash
activity. If it is determined to be significant, it should be shown on a supplemental
schedule of noncash activities.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-85

DECISION CASES

LO 3,4     DECISION CASE 12-1 COMPARING TWO COMPANIES IN THE SAME INDUSTRY:
FINISH LINE AND FOOT LOCKER

1. Both companies use the indirect method in preparing the Operating Activities section
of their statement of cash flows. Both begin the statement with net income and then
make the adjustments to reconcile this number to cash provided by operating activi-
ties.

2. Finish Line’s net cash provided by operating activities decreased during the year by
\$87,147,000 – \$74,027,000 or \$13,120,000. The largest adjustment to reconcile net
income to net cash provided by operating activities was the add back of depreciation
and amortization of \$34,633,000. Foot Locker’s net cash provided by operating ac-
tivities of continuing operations increased during the year by \$354,000,000 -–
\$289,000,000 or \$65,000,000. The largest adjustment to reconcile net income to net
cash provided by operating activities was the add back of depreciation and amortiza-
tion of \$171,000,000.

3. Finish Line’s merchandise inventories increased during the year, net of the effects of
acquisitions, by \$27,348,000. Foot Locker’s merchandise inventories increased dur-
ing the year by \$111,000,000. An increase in inventory during the year indicates that
the company purchased more than it sold. An increase in inventory would be normal
for companies such as Finish Line and Foot Locker that are growing and adding
more stores each year.

4. Finish Line spent \$70,126,000 and \$58,172,000 to purchase property and equip-
ment in the years ended February 25, 2006 and February 26, 2005, respectively.
Foot Locker spent \$155,000,000 and \$156,000,000 on property and equipment
(capital expenditures) in the years ended January 28, 2006 and January 29, 2005,
respectively.

5. The primary source of financing for Finish Line during the most recent year was from
the issuance of common stock for \$4,105,000. Foot Locker’s largest source of fi-
nancing was also from the issuance of common stock in the amount of \$12,000,000.
Both companies bought back some of their own shares during the year in the form of
treasury stock. Finish Line spent \$19,865,000 and Foot Locker spent \$35,000,000
for this purpose. Companies buy back their own stock for a variety of reasons includ-
ing the need to have stock available to distribute to employees as part of bonus and
other benefit plans.
12-86   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 7        DECISION CASE 12-2 COMPUTING AND INTERPRETING FOOT LOCKER’S CASH

1. Cash flow adequacy ratio for the year ended January 28, 2006: (Net cash provided
by operating activities of continuing operations – Capital expenditures)/Average an-
nual debt maturing over next five years (amounts in millions of dollars):

(\$354 – \$155)/[(\$50 + \$0 + \$2 + \$88 + \$0)/5] = \$199/28 = 7.1

2. The cash flow adequacy ratio gives the user an indication of whether or not the
company is generating sufficient cash from its operations to repay its debts after
taking into consideration the need to make necessary expenditures on new property
and equipment. This ratio indicates that Foot Locker’s cash flow was more than suf-
ficient to repay its average debt after allowing for capital expenditures.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-87

MAKING FINANCIAL DECISIONS

LO 1,5     DECISION CASE 12-3 DIVIDEND DECISION AND THE STATEMENT OF CASH
FLOWS—DIRECT METHOD

1. Changes in account balances and explanations (in thousands of dollars):

Net Change
Dr. (Cr.)        Explanation
Cash                                 30
Accounts receivable                  50
Inventory                           150
Prepayments                         (15)
Land                              1,055           Issued bonds to acquire 700 and
cash for 355
Plant and equipment               1,700           Purchase
Accumulated depreciation           (250)          Depreciation expense
Long-term investments              (400)          Sale
Patents                            (100)          Amortization
Accounts payable                    (70)
Other accrued liabilities           (60)
Taxes payable                       (70)
Dividends payable                   200           Paid dividends
Short-term notes payable           (200)          Reclassification of note
Long-term notes payable             200           Reclassification of note
Bonds payable                      (700)          Issued for land
Common stock                       (500)          Issued stock
Retained earnings                (1,020)          1,020 Net income
Total                              0
12-88   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

DECISION CASE 12-3 (Continued)

Conversion of income statement items to a cash basis (in thousands of dollars):
Income Statement           Amount            Adjustment                        Cash Flows
Sales revenue               \$8,000                                                 \$8,000
– Increase in accounts receivable         (50)
Cash collected from customers         \$7,950
Cost of goods sold             4,500                                               \$4,500
+ Increase in inventory                   150
– Increase in accounts payable            (70)
Cash paid to suppliers                \$4,580
Operating expenses             1,450                                               \$1,450
– Decrease in prepayments                 (15)
– Increase in accrued liabilities         (60)
– Depreciation included on
income statement                     (250)
– Amortization included on
income statement                     (100)
Cash paid for operating expenses      \$1,025
Interest expense                 350         No interest payable                   \$ 350
Income tax expense               680                                               \$ 680
– Increase in taxes payable               (70)
Cash paid for taxes                   \$ 610
Net income                    \$1,020         Net cash flow from operations         \$1,385
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-89

DECISION CASE 12-3 (Concluded)

2. Statement of cash flows:
BAILEY CORP.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN THOUSANDS OF DOLLARS)
Cash Flows from Operating Activities
Cash collected from customers                                                        \$ 7,950
Cash payments:
For inventory                                                                     \$(4,580)
For operating expenses                                                             (1,025)
For interest                                                                         (350)
For income taxes                                                                     (610)
Total cash payments                                                                  \$ 6,565
Net cash provided by operating activities                                            \$ 1,385
Cash Flows from Investing Activities
Sale of long-term investments                                                     \$   400
Acquisition of land                                                                  (355)
Acquisition of plant and equipment                                                 (1,700)
Net cash used by investing activities                                                \$(1,655)
Cash Flows from Financing Activities
Issuance of additional common stock                                               \$  500
Payment of 2006 cash dividend                                                       (200)
Net cash provided by financing activities                                            \$ 300
Net increase in cash                                                                 \$   30
Cash balance, December 31, 2006                                                         450
Cash balance, December 31, 2007                                                      \$ 480
Supplemental Schedule of Noncash Investing and
Financing Activities
Acquisition of land by issuance of bonds                                           \$     700
Reclassification of long-term notes due within next year                                 200

3. Bailey Corp. should be able to safely pay a cash dividend in 2008 of \$250,000 (note
that there are now 250,000 shares of stock outstanding). The cash provided by op-
erating activities of \$1,385,000 indicates that the company is generating a very sig-
nificant amount of cash from the business. Because the company invested heavily in
new plant and equipment during 2007, it should not need to reserve large amounts
of cash for capital expenditures in the near future. The profit margin of 12.75% indi-
cates that management is doing a good job of controlling costs.
Bailey will need to pay \$200,000 in 2008 to retire the short-term notes payable. In
assessing the company’s cash needs in future years, it would be important to know
how soon any of the bonds payable will be due for retirement. Assuming that a large
portion of the bonds is not due to be retired in 2008, Bailey should have no problem
in paying its tenth annual dividend of \$1 per share.
12-90   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

LO 1,6        DECISION CASE 12-4 EQUIPMENT REPLACEMENT DECISION AND CASH FLOWS
FROM OPERATIONS

1. Cash flow from operations                    Year 1   Year 2    Year 3      Year 4
Net income (loss)                            \$(10)     \$ (2)     \$ 15        \$20
Depreciation expense                        30       25         15          14
Increase in accounts receivable            (32)      (5)       (12)        (20)
Increase in inventories                    (26)      (8)        (5)         (9)
Increase in prepayments                      0        0        (10)         (5)
Increase in accounts payable                15        3
Decrease in accounts payable                                    (5)         (4)
Net cash flow from operations                \$(23)     \$13       \$ (2)       \$ (4)

2. Memo to the president:
TO:            President
FROM:          Student’s name
DATE:          XX/XX/XX
SUBJECT: Cash flow
As you are aware, our company has made significant strides in improving our profit-
ability. Our net losses in the first two years have been replaced with profits of \$15
million and \$20 million, respectively, for the last two years. We are all also aware,
however, of the need to generate sufficient cash flow operations to make the neces-
sary capital expenditures to replace existing equipment.
I have enclosed for your review a four-year summary of cash flow from opera-
tions. The summary shows that in our second year we did a good job of generating
cash from operations but that the results have not been as good in the last two
years. Specifically, our operations have drained \$2 million and \$4 million of cash
from the treasury in these years rather than the desired result of generating cash to
help pay for capital expenditures.
The buildup of various current assets, such as accounts receivable, inventories,
and prepayments, is the main reason for our problems. First, we need to do a better
job of collecting our receivables in a timely fashion. Second, we must find ways to
limit our purchases of inventory and maintain products on hand at a minimum. Third,
whenever possible, we should limit the amount of items we prepay, such as office
supplies and rent. Finally, the company needs to take full advantage of the credit
terms offered by our suppliers and not pay open accounts any sooner than is neces-
sary.
Please call me at your earliest convenience to discuss how we can improve our
efforts in this critical area.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-91

ETHICAL DECISION MAKING

LO 1,6     DECISION CASE 12-5 LOAN DECISION AND THE STATEMENT OF CASH FLOWS—
INDIRECT METHOD

1. Mega reported the sale of the business by netting the gain against the cash
proceeds and thus reporting the book value of \$300 million as an investing activity
inflow. This is not in accordance with generally accepted accounting principles,
which require that the actual amount of cash received from the sale of \$450 million
be shown as an investing activity inflow. The gain of \$150 million should have been
deducted from net income to arrive at cash flow from operations.
The use of the net approach to reporting the transaction, rather than the correct
approach under GAAP, does not have an effect on the increase or decrease in cash
for the period. The issue involves the appropriate reporting and disclosure of the
transaction rather than the net change in cash for the period.

2. Revised statement:
MEGA ENTERPRISES
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
(IN MILLIONS OF DOLLARS)
Cash Flows from Operating Activities
Net income                                                                               \$ 65
Adjustments to reconcile net income to net cash provided
by operating activities:
Gain on sale of California business                                                    (150)
Depreciation and amortization                                                            56
Increase in accounts receivable                                                         (19)
Decrease in inventory                                                                    27
Decrease in accounts payable                                                            (42)
Increase in other accrued liabilities                                                    18
Net cash used by operating activities                                                    \$ (45)
Cash Flows from Investing Activities
Acquisitions of plant and equipment                                                    (125)
Net cash provided by investing activities                                                \$ 91
Cash Flows from Financing Activities
Repayments of borrowings                                                               (180)
Cash dividends paid                                                                     (50)
Net cash used by financing activities                                                    \$ (80)
Net decrease in cash                                                                     \$ (34)
Cash balance, December 31, 2006                                                             42
Cash balance, December 31, 2007                                                          \$ 8
12-92   FINANCIAL ACCOUNTING SOLUTIONS MANUAL

DECISION CASE 12-5 (Concluded)

3. The controller has not acted ethically in this situation. The officer is aware that the
bank intends to rely on cash generated from operations for repayment of the loans.
As shown in 2. on the previous page, the netting of the sale transaction grossly
overstates the cash flow from operating activities and understates the cash flow from
investing activities. It appears that the controller intentionally misreported the trans-
action on the statement of cash flows to influence the bank’s appraisal of the ability
of Mega to generate cash from its ongoing operations.

LO 2,3        DECISION CASE 12-6 CASH EQUIVALENTS AND THE STATEMENT OF CASH
FLOWS

1. According to current accounting standards, only those investments in highly liquid
securities with an original maturity to the investor of three months or less should be
classified as cash equivalents. Because the Treasury notes do not mature until ten
months after they are purchased, their purchase should be classified as an invest-
ing activity for purposes of preparing a statement of cash flows. (Note: The notes
would be classified as held to maturity securities because Rangers expects to hold
them until maturity.)
2.   If the purchase of the notes is classified as an operating activity rather than an in-
vesting activity, the information provided to readers is not free from bias. The com-
pany would be attempting to disguise the fact that the purchase of the notes was a
significant investing activity that used cash. The decision to classify the notes as
cash equivalents would be made to present the company’s cash outflows in the
most favorable manner, regardless of the substance of the transaction to acquire
the notes.
3. As controller, you need to explain to the treasurer that accounting standards do not
allow the company to classify the treasury notes as cash equivalents. You are sym-
pathetic to his desire to minimize the net cash outflow for investing activities, but the
company does not have a choice in its presentation of the notes, nor does the deci-
sion on classification rest with you as controller. Rangers must report the purchase
on the statement of cash flows as a cash outflow from investing activities.

REAL WORLD PRACTICE 12.1

Best Buy uses the indirect method in the Operating Activities section of the statement of
cash flows. The first line on the statement is net earnings and the necessary adjust-
ments are made to reconcile net income to total cash provided by operating activities
from continuing operations.
CHAPTER 12 • THE STATEMENT OF CASH FLOWS   12-93

REAL WORLD PRACTICE 12.2

Best Buy’s Receivables increased during the year that ended February 26, 2005. An
increase in Receivables means that the company sold more than it collected in cash
during the year, and therefore the difference must be deducted from net income in the
Operating Activities section of the statement.

REAL WORLD PRACTICE 12.3

Best Buy paid \$241,000,000 in income taxes during the year that ended February 26,
2005. This is not necessarily the amount that appears as expense on the income state-
ment for the year. The amount of income tax expense on the income statement is based
on accrual accounting concepts. For example, any taxes owed at the end of the year
would be included in the tax expense but would not be considered a cash outflow.

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