CHAPTER 17. The Cash Flow Statement. Brief Questions Exercises 12, 13 3, 4, 5, 11 6, 7, 8, 9, 10, 11

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1 CHAPTER 17 The Cash Flow Statement ASSIGNMENT CLASSIFICATION TABLE Study Objectives Brief Questions Exercises Exercises Problems Set A Problems Set B 1. Describe the purpose and content of the cash flow statement. 1, 2, 3, 4, 5, 6, 7 1, 2 1, 2 1A, 2A 1B, 2B 2. Prepare a cash flow statement using one of two approaches: 8, 9, 18, 19, 20, 21 12, A, 6A 5B, 6B (a) the indirect method or. 10, 11, 12, 16, 17 3, 4, 5, 11 3, 4, 5, 10, 12 3A, 4A, 7A, 8A 3B, 4B, 7B, 8B (b) the direct method. 13, 14, 15, 16, 17 6, 7, 8, 9, 10, 11 6, 7, 8, 11, 12 3A, 4A, 7A, 8A 3B, 4B, 7B, 8B 3. Analyze the cash flow statement. 22, 23, 24, 25 14, 15 13, 14 9A 9B Solutions Manual 17-1 Chapter 17

2 ASSIGNMENT CHARACTERISTICS TABLE Problem Number Description Difficulty Level Time Allotted (min.) 1A 2A 3A 4A 5A Classify transactions by activity. Indicate impact on cash and net income. Indicate impact of transactions on cash, net income, and cash from operating activities. Prepare operating activities section indirect and direct methods. Prepare operating activities section indirect and direct methods. Calculate cash flows for property, plant, and equipment. Simple Simple Moderate Moderate Moderate A Calculate cash flows for shareholders equity. Simple A 8A Prepare cash flow statement indirect and direct methods. Prepare cash flow statement indirect and direct methods. Moderate Moderate A Calculate free cash flow and evaluate cash. Simple B 2B 3B 4B 5B Classify transactions by activity. Indicate impact on cash and net income. Indicate impact of transactions on cash, net income, and cash from operating activities. Prepare operating activities section indirect and direct methods. Prepare operating activities section indirect and direct methods. Calculate cash flows for property, plant, and equipment. Simple Simple Moderate Moderate Moderate B Calculate cash flows for shareholders equity. Simple B 8B Prepare cash flow statement indirect and direct methods. Prepare cash flow statement indirect and direct methods. Moderate Moderate B Calculate free cash flow and evaluate cash. Simple Solutions Manual 17-2 Chapter 17

3 BLOOM S TAXONOMY TABLE Correlation Chart between Bloom s Taxonomy, Study Objectives and End-of- Chapter Material Study Objective Knowledge Comprehension Application Analysis Synthesis Evaluation 1. Describe the purpose and content of the cash flow statement. Q17-2 Q17-6 Q17-1 Q17-3 Q17-4 Q17-5 Q17-7 BE17-2 BE17-1 E17-1 E17-2 P17-1A P17-2A P17-1B 2. Prepare a cash flow statement using one of two approaches: (a) the indirect method. Q17-8 Q17-9 Q17-18 Q17-19 Q17-20 Q17-11 Q17-10 Q17-12 Q17-16 Q17-17 P17-2B Q17-21 BE17-11 BE17-12 BE17-13 E17-9 BE17-3 BE17-4 BE17-5 BE17-11 E17-3 E17-4 E17-5 E17-10 E17-12 P17-5A P17-6A P17-5B P17-6B P17-3A P17-4A P17-7A P17-8A P17-3B P17-4B P17-7B P17-8B (b) the direct method 3. Analyze the cash flow statement. Broadening Your Perspective Q17-17 Q17-13 Q17-14 Q17-15 Q17-16 Q17-22 Q17-23 Q17-24 Q17-25 BE17-6 BE17-7 BE17-8 BE17-9 BE17-10 BE17-11 E17-6 E17-7 E17-8 E17-11 E17-12 BE17-15 P17-3A P17-4A P17-7A P17-8A P17-3B P17-4B P17-7B P17-8B Continuing Cookie Chronicle BE17-14 E17-13 E17-14 P17-9A P17-9B BYP17-1 BYP17-2 BYP17-3 BYP17-4 BYP17-5 Solutions Manual 17-3 Chapter 17

4 0 ANSWERS TO QUESTIONS 1. A balance sheet, income statement, and statement of retained earnings all provide information necessary for preparation of the cash flow statement. A comparative balance sheet indicates how assets, liabilities, and shareholders equity have changed during the period. An income statement provides information about the amount of cash provided from operating activities. A statement of retained earnings provides information about dividends that were declared, which is needed to determine the cash used to pay dividends. The statement of comprehensive income is not needed, because unrealized gains and losses reported in the statement do not affect cash in any way. 2. The cash flow statement is useful because it helps investors, creditors and others assess the following aspects of the firm s financial position: the company s ability to generate future cash flows the ability of the company to pay dividends and meet obligations the reasons for the difference between net income and cash provided (used) by operating activities the cash investing and financing transactions during a period. 3. Disagree. The cash flow statement is not an optional financial statement it is required. It is the fourth basic financial statement and it provides information not readily available elsewhere. 04. Cash equivalents are short-term, highly-liquid investments that are both: (1) readily convertible to known amounts of cash and (2) so near their maturity that their market value is relatively insensitive to changes in interest rates. Generally, only investments with original maturities of three months or less qualify under this definition. Cash equivalents, being equivalent to cash, are treated as cash; i.e., included in the cash account balance and the increase or decrease in the cash balance. Solutions Manual 17-4 Chapter 17

5 QUESTIONS (Continued) The three activities are: Operating activities include the cash effects of transactions that create revenues and expenses, and enter into the determination of net income. Investing activities include: (a) acquiring and disposing of investments and productive long-lived assets and (b) lending money and collecting loans. Financing activities include: (a) obtaining cash from issuing debt and repaying the amounts borrowed and (b) obtaining cash from shareholders and providing them with a return on their investment. 6. Examples of noncash transactions are (1) issue of shares in payment for assets, (2) issue of shares to repay debt, and (3) issue of bonds or notes for assets. If noncash transactions affect financial conditions significantly, GAAP requires that they be disclosed in a separate note to the financial statements. 7. The cash flow statement covers a period of time the same period as the income statement because it reports the operating, investing, and financing activities for the entire period. It ends with the cash balance reported on the balance sheet because it reconciles the changes in cash for the period with the beginning and ending cash balances. In contrast, the balance sheet reports the financial position of the company at the end of a specific period of time. 8. It is necessary to convert accrual-based net income to cash-based income because the accrual-based net income includes items that do not provide or use cash. An example would be amortization, which does not affect cash. Another example is an increase in accounts receivable. If accounts receivable increased during the period, revenues reported on the accrual basis would be higher than the actual cash revenues received. Thus, accrual basis net income must be adjusted to reflect the net cash provided by operating activities. Solutions Manual 17-5 Chapter 17

6 QUESTIONS (Continued) 9. A number of factors could have caused a decrease in cash despite the company earning net income. These include (1) low cash-based revenues relative to high cash-based expenses; (2) purchase of property, plant and equipment; (3) purchase of investments; and (4) repayment of debt or reacquisition of share capital. An increase in cash could have occurred despite the net loss. Factors that could lead to this include (1) high cash-based revenues relative to low cash-based expenses; (2) sales of property, plant and equipment; (3) sales of investments; and (4) issue of debt or share capital. 10. The indirect approach involves converting accrual net income to net cash provided by operating activities. This is done by starting with accrual net income and adding or subtracting noncash items included in net income. Examples of adjustments include amortization expense and other noncash expenses, and changes in the balances of noncash current asset and current liability accounts from one period to the next Amortization expense 2. Gain or loss on sale of property, plant, or equipment 3. Increase (decrease) in accounts receivable 12. Under the indirect method, amortization expense is added back to net income to reconcile net income to net cash provided by operating activities. This is necessary because although amortization is an expense, it does not use cash. Since amortization expense is a deduction in calculating net income, adding it back to net income effectively cancels this expense. 13. Net cash provided by operating activities under the direct method is the difference between cash-based revenues and cash-based expenses. The direct method adjusts the revenues and expenses directly to reflect their cash basis. This results in "net cash provided by operating activities." Items include: cash received from customers, cash received from dividends and interest, cash paid to suppliers, cash paid for operating expenses, cash paid to employees, cash paid for interest, and cash paid for income taxes. 14. No. Sales on the income statement include cash and credit sales made in the current period only. Cash collected from customers on the statement of cash flows can come from sales in the current or previous periods, and not all current period sales are collected in the current period. Solutions Manual 17-6 Chapter 17

7 QUESTIONS (Continued) 15. Amortization expense is not listed in the direct method operating activities section because it is not a cash flow item it does not affect cash. Recall the journal entry to record amortization: debit Amortization Expense and credit Accumulated Amortization. No cash is involved in this entry. 16. (a) The advantage of the direct method is that it presents the major categories of cash receipts and cash payments in a format that is similar to the income statement and familiar to statement users. Its principal disadvantage is that it does not reconcile the cash flows from operating activities with the net income. The advantage of the indirect method is its reconciliation of net income to net cash provided by operating activities. Its primary disadvantage is the difficulty in understanding the adjustments that comprise the reconciliation. (b) Both methods are acceptable. (c) The CICA has expressed a preference for the direct method. (d) Most companies favour the indirect method because: (1) it is easier to prepare, (2) it provides a reconciliation between net income and net cash flow from operating activities and (3) it also discloses less competitive information about the company. 17. Although the approaches are different, both the direct and indirect methods will produce the same net cash provided by operating activities. 18. The cash received from the sale of equipment is reported as an inflow in the investing activities section. Neither the gain nor the loss itself provided or used cash from operating activities. Because a gain does not provide cash from operating activities, it must be deducted from net income in the operating activities section of a cash flow statement prepared using the indirect method. The noncash gain, which was included in net income, must be deducted from income on the cash flow statement to convert net income to net cash provided by operating activities. When the statement is prepared using the direct method, any gain is simply excluded from the operating activities section. Because a loss does not use cash from operating activities, it must be added to net income in the operating activities section of a cash flow statement prepared using the indirect method. The noncash loss, which was included in net income, must be added to income on the cash flow statement to convert net income to net cash provided by operating activities. When the statement is prepared using the direct method, any loss is simply excluded from the operating activities section. Solutions Manual 17-7 Chapter 17

8 QUESTIONS (Continued) 19. The cash paid to redeem the bond is reported as an outflow in the financing activities section. For the indirect method, a loss is added back under the operating activities section; a gain is deducted under the operating activities section. Neither the gain nor the loss itself provided or used cash from operating activities. Rather the cash paid to redeem the bond is the use of cash from financing activities. 20. When short-term notes relate to trade (i.e., purchase and sale) transactions, or have been issued in exchange for an account payable or an account receivable, then they should be reported in the operating activities section of the cash flow statement along with the expense and revenue accounts to which they relate. When short-term notes relate to lending or borrowing, they should be reported in the financing activities section of the cash flow statement. 21. Barbara is correct. The actual cash outflow of $10,000 is reported in the investing activities section of the cash flow statement. The noncash portion of the transaction (the purchase of equipment financed by the issue of a note payable) should be disclosed in the notes. 22. Signs that a company is in trouble are often apparent in the cash flow statement before they appear in other financial statements. For example, if a company never generates a positive inflow from operating activities, it will not survive in the long run. Or if a company is continually borrowing long-term in order to finance operations, it is not healthy. 23. Companies in the early stages of development typically have negative flows from operating activities and investing activities, and positive flows from financing activities. The companies are issuing debt and/or equity and using the funds to acquire property, plant, and equipment. Established companies typically have positive flows from operating activities and lower flows from investing and financing activities. 24. Free cash flow indicates the amount of discretionary cash flow a company has. Free cash flow is calculated as cash provided (used) by operating activities less net capital expenditures. 25. If the net capital expenditures exceed the cash provided by operating activities, the free cash flow will be negative. Solutions Manual 17-8 Chapter 17

9 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 17-1 (a) - (b) + (c) - (d) - (e) NE (f) + (g) NE (h) + (i) NE (j) - BRIEF EXERCISE 17-2 (a) Financing activity (b) Investing activity (c) Financing activity (d) Investing activity (e) Significant noncash activity (f) Financing activity (g) Significant noncash activity (h) Operating activity (i) None of the above. Amortization expense is reported in the operating activities section using the indirect method only to cancel it from net income. It is neither a source nor a use of cash in any way. (j) Financing activity Solutions Manual 17-9 Chapter 17

10 BRIEF EXERCISE 17-3 (a) + (b) (c) + (d) + (e) - (f) - (g) + (h) + BRIEF EXERCISE 17-4 CRYSTAL INC. Cash Flow Statement (Partial) Year Ended November 30, 2008 Operating activities Net income... $775,000 Adjustments to reconcile net income to net cash provided by operating activities: Amortization expense... $260,000 Gain on the sale of equipment... (10,000) Decrease in accounts receivable ,000 Increase in prepaid expenses... (95,000) Decrease in accounts payable... (280,000) 225,000 Net cash provided by operating activities... $1,000,000 Solutions Manual Chapter 17

11 BRIEF EXERCISE 17-5 DUPIGNE CORPORATION Cash Flow Statement (Partial) Indirect Method Year Ended March 31, 2008 Operating activities Net income... $250,000 Adjustments to reconcile net earnings to net cash provided by operating activities Amortization expense... $60,000 Accounts receivable increase... (20,000) Merchandise inventory decrease... 6,000 Prepaid expenses increase... (2,000) Accounts payable decrease... (5,000) Income tax payable increase... 10,000 49,000 Net cash provided by operating activities... $299,000 BRIEF EXERCISE 17-6 Sales $270,000 Less: Increase in accounts receivable (10,000) Cash receipts from customers $260,000 BRIEF EXERCISE 17-7 Cost of goods sold $89,000 Less: Decrease in inventory (3,600) Less: Increase in accounts payable (5,400) Cash payments to suppliers $80,000 Solutions Manual Chapter 17

12 BRIEF EXERCISE 17-8 Operating expenses $100,000 Less: Amortization expense (15,000) Plus: Increase in prepaid expenses 6,600 Decrease in accrued expenses payable 2,600 Cash payments for operating expenses $94,200 BRIEF EXERCISE 17-9 Salaries expense $189,000 Less: Increase in salaries payable (500) Cash payments to employees $188,500 BRIEF EXERCISE Income tax expense $90,000 Less: Increase in income tax payable (1,000) Cash payments for income tax $89,000 BRIEF EXERCISE (a) Cash flow provided by sale of equipment $15,000 Cash 15,000 Loss on Sale of Equipment 1,500 Accumulated Amortization 5,500 Equipment 22,000 (b) The cash flow provided by sale of equipment would appear in the investing activities section. The loss on sale of equipment would appear in the operating activities section only if the indirect method was used. Solutions Manual Chapter 17

13 BRIEF EXERCISE Dividends paid $47.4 million Proof: Retained earnings December 31, 2004 $1,546.9 Add: net income Less: share repurchase ,860.0 Less: dividends declared and paid 47.4 Retained earnings, December 31, 2005 $1,812.6 Solutions Manual Chapter 17

14 BRIEF EXERCISE BAKER CORPORATION Cash Flow Statement Direct Method Year Ended April 30, 2008 Operating activities Net cash provided by operating activities... $ 52,000 Investing activities Proceeds from sale of equipment... $ 6,000 Purchase of land... (25,000) Net cash used by investing activities... (19,000) Financing activities Proceeds from issue of note payable... $20,000 Payment to reacquire common shares.. (19,000) Payment of dividends... (25,000) Net cash used by financing activities... (24,000) Net increase in cash and equivalents... 9,000 Cash and equivalents, May ,000 Cash and equivalents, April $16,000 Note: The land was purchased by paying $25,000 cash and issuing a mortgage note payable for $75,000. BRIEF EXERCISE Company A is more likely to be in the early stages of its development. It has negative cash flow from operating and investing activities and positive cash flow from financing. This indicates the company issued debt and/or equity and used some of the money to buy assets and fund its operations. Solutions Manual Chapter 17

15 BRIEF EXERCISE Free cash flow = Cash provided by operating activities Net capital expenditures = $300,000 - $250,000 = $50,000 Solutions Manual Chapter 17

16 SOLUTIONS TO EXERCISES EXERCISE 17-1 (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) I F I F O NC O O O NC Solutions Manual Chapter 17

17 EXERCISE 17-2 Transaction 1. Sold merchandise inventory for $1, Purchased machine for $30,000. Made a $5,000 down payment and issued long-term note for the remainder. 3. Issued common shares for $50, Collected $16,000 of accounts receivable. 5. Paid a $25,000 cash dividend. 6. Sold an available-for-sale security with a cost of $15,000 for $10,000 cash 7. Redeemed bonds having a carrying value of $200,000 for $175, Paid $18,000 on accounts payable. 9. Purchased merchandise inventory for $28,000 on account. 10. Purchased a held-tomaturity security for $100,000. Cash Inflow Classification or Outflow O +$1,000 I NC -$5,000 NE F +50,000 O +16,000 F -$25,000 I +10,000 F -175,000 O -$18,000 NC NE I -$100,000 Solutions Manual Chapter 17

18 EXERCISE 17-3 Transaction 1. Sold merchandise inventory for cash at a price in excess of cost. 2. Sold merchandise inventory on account at a price in excess of cost. 3. Purchased merchandise inventory on account. 4. Accrued income tax payable. Net Income Net Cash Provided (Used) by Operating Activities NE NE NE - NE 5. Paid income taxes. NE - 6. Purchased supplies for cash. 7. Recorded amortization expense. 8. Paid an amount owing on account. 9. Collected an amount owing from a customer. 10. Paid a one-year insurance policy in advance. NE - - NE NE - NE + NE - Solutions Manual Chapter 17

19 EXERCISE 17-4 PESCI LIMITED Cash Flow Statement (Partial) Year Ended July 31, 2008 Operating activities Net income... $195,000 Adjustments to reconcile net income to net cash provided by operating activities: Amortization expense... $25,000 Loss on sale of equipment... 5,000 Increase in accounts receivable... (15,000) Decrease in prepaid expenses... 4,000 Decrease in accrued liabilities... (3,500) Increase in accounts payable... 10, ,500 Net cash provided by operating activities... $220,500 EXERCISE 17-5 BARTH INC. Cash Flow Statement (Partial) Year Ended December 31, 2008 Operating activities Net income... $135,000 Adjustments to reconcile net income to net cash provided by operating activities: Amortization expense... $19,000 Increase in accounts receivable... (31,000) Decrease in inventory... 25,000 Decrease in prepaid expenses... 5,000 Increase in accrued expenses payable... 10,000 Decrease in accounts payable... (7,000) 0 21,000 Net cash provided by operating activities... $156,000 Solutions Manual Chapter 17

20 EXERCISE 17-6 (b) (a) Add to (+) or (c) Related Deduct from (-) Related Income Income Cash Statement Statement Receipt or Transaction Account(s) Account Payment 1. Increase in accounts Sales - Cash receipts receivable revenue from customers 2. Decrease in accounts Sales + Cash receipts receivable revenue from customers 3. Increase in accounts Cost of - Cash payments payable goods sold to suppliers 4. Decrease in interest Interest + Cash payments payable expense for interest 5. Increase in prepaid Operating + Cash payments expenses expenses for operating expenses 6. Increase in inventory Cost of + Cash payments goods sold to suppliers 7. Decrease in inventory Cost of - Cash payments goods sold to suppliers 8. Increase in income Income tax - Cash payment taxes payable expense for income taxes 9. Increase in salaries Salaries - Cash payments payable expense to employees 10. Decrease in accrued Operating - Cash payments expenses payable expenses for operating expenses Solutions Manual Chapter 17

21 EXERCISE 17-7 MCGILLIS LTD. Cash Flow Statement (Partial) Year Ended December 31, 2008 Operating activities Cash receipts from customers 1 $140,000 Cash payments: for operating expenses 2 $55,000 for income taxes 3 19,500 74,500 Net cash provided by operating activities $ 65,500 Because it was the first year of operations, all account balances were $0 at the beginning of the year. Calculations: 1 Accounts Receivable Balance, Beginning of year 0 Revenues for the year 182,000 Cash receipts for year 140,000 Balance, End of year 42,000 2 Accounts Payable Balance, Beginning of year 0 Operating expenses Payments for the year 55,000 for year 88,000 Balance, End of year 33,000 3 Income Tax Payable Balance, Beginning of year 0 Payments for the year 19,500 Income tax expense 21,000 Balance, End of year 1,500 Solutions Manual Chapter 17

22 EXERCISE 17-8 (a) Sales revenue $190,000 Add: Decrease in accounts receivable 5,000 Cash receipts from customers $195,000 (b) Cost of goods sold $114,000 Add: Increase in inventory 1,400 Less: Increase in accounts payable (1,250) Cash payments to suppliers $114,150 (c) Operating expenses $50,000 Add: Increase in prepaid expenses 500 Less: Amortization expense (11,000) Increase in accrued expenses payable (1,000) Cash payments for operating expenses $38,500 Solutions Manual Chapter 17

23 EXERCISE 17-9 DUPRÉ CORP. Cash Flow Statement (Partial) Year Ended December 31, 2008 Investing activities Sale of equipment*... $ 6,000 Purchase of equipment... (70,000) Purchase of equipment... (10,000) Net cash used by investing activities... $(74,000) Financing activities Payment of cash dividends... (4,000) Note: Equipment costing $53,000 was acquired by paying $10,000 cash and issuing a note payable for $43,000. *Cost of equipment sold... $39,000 Accumulated amortization... 30,000 Net book value... 9,000 Loss on sale of equipment ,000 Cash proceeds... $ 6,000 Cash... 6,000 Accumulated Amortization... 30,000 Loss on Sale of Equipment... 3,000 Equipment... 39,000 Solutions Manual Chapter 17

24 EXERCISE SAVARY LIMITED Cash Flow Statement (Partial) Year Ended December 31, 2008 Operating activities Net income... $200,000 Adjustments to reconcile net income to net cash used by operating activities: Amortization expense... $ 70,000 Increase in accounts receivable... (150,000) Increase in inventory... (170,000) Decrease in prepaid insurance... 7,000 Increase in accounts payable... 26,000 Decrease in salaries payable... (10,000) Increase in interest payable... 6,000 (221,000) Net cash used by operating activities... (21,000) Investing activities Purchase of equipment... $(250,000) Net cash used by investing activities... (250,000) Financing activities Issued note payable... $150,000 Issued preferred shares ,000 Payment of cash dividends*... (50,000) Net cash provided by financing activities ,000 Increase in cash... 79,000 Cash, January ,000 Cash, December $164,000 *Net income was $200,000, and retained earnings only increased by $150,000, so $50,000 in dividends must have been declared and paid. Solutions Manual Chapter 17

25 EXERCISE FLYPAPER AIRLINES INC. Cash Flow Statement (Partial) Year Ended March 31, 2008 Operating activities Cash receipts Cash receipts from customers... $240,000* Dividends on investments... 14, ,000 Cash payments To suppliers... $(110,000) For salaries and wages... (53,000) For interest... (10,000) For income tax... (7,500) For operating expenses... (28,000) (208,500) Net cash provided by operating activities... 45,500 Investing activities Sale of aircraft... $212,000 Purchase of land... (174,000) Purchase of equipment... (22,000) Net cash provided by investing activities... 16,000 Financing activities Payment of cash dividends... $(14,000) Net cash used by financing activities... (14,000) Net increase in cash and equivalents... 47,500 Cash and equivalents, April 1, ,000 Cash and equivalents, March 31, $ 82,500 *$48,000 + $192,000 = $240,000 Solutions Manual Chapter 17

26 EXERCISE (a) PUFFY LTD. Cash Flow Statement Indirect method Year Ended December 31, 2008 Operating activities Net income... $115,000 Adjustments to reconcile net income to net cash provided by operating activities: Amortization expense... $34,000 Gain on sale of land... (5,000) Increase in accounts receivable... (9,000) Decrease in inventory... 9,000 Decrease in accounts payable... (9,000) 0020,000 Net cash provided by operating activities ,000 Investing activities Sale of land ($25,000 + $5,000 gain)... $30,000 Purchase of equipment... (60,000) Net cash used by investing activities... (30,000) Financing activities Payment of cash dividends*... $(19,000) Redemption of bonds... (80,000) Issue of common shares ,000 Net cash used by financing activities... (64,000) Net increase in cash... 41,000 Cash, January ,000 Cash, December $ 63,000 *Net income was $115,000; retained earnings only increased by $96,000, so $19,000 in dividends were declared and paid. Solutions Manual Chapter 17

27 EXERCISE (Continued) (b) PUFFY LTD. Cash Flow Statement Direct Method Year Ended December 31, 2008 Operating activities Cash receipts Cash receipts from customers*.... $969,000 Cash payments To suppliers**... $(751,000) For operating supplies... (43,000) For income taxes... (40,000) (834,000) Net cash provided by operating activities ,000 Investing activities Sale of land ($25,000 + $5,000 gain)... $30,000 Purchase of equipment... (60,000) Net cash used by investing activities... (30,000) Financing activities Payment of cash dividends*... $(19,000) Redemption of bonds... (80,000) Issue of common shares ,000 Net cash used by financing activities... (64,000) Net increase in cash... 41,000 Cash, January ,000 Cash, December $ 63,000 Solutions Manual Chapter 17

28 EXERCISE (Continued) (b) (Continued) *Cash receipts from customers Sales... $978,000 Less: Increase in accounts receivable... (9,000) $969,000 **Cash payments to suppliers Cost of goods sold... $751,000 Less: Decrease in inventory... (9,000) Cost of goods purchased ,000 Add: Decrease in accounts payable... 9,000 $751,000 Solutions Manual Chapter 17

29 EXERCISE Company A is clearly in a better financial position than company B. While both companies experienced similar increases in cash, it should be noted that Company A s cash flow comes mainly from its operations, while company B s cash was acquired through debt/equity, as evidenced by the large amount of cash generated through financing activities. By contrast, Company A appears to be paying down debt/equity, as its cash flow from financing activities is negative. Essentially, Company A appears to be self-sustaining (independent of external sources for its financing) to a greater degree than company B. EXERCISE (a) ($ in millions) Bank of Montreal Scotiabank Cash provided (used) by $ (6,285) $ (3,322) operating activities - Cash used (provided) by (24,053) (31,474) investing activities = Free cash flow $17,768 $28,152 (b) Scotiabank appears to be in better shape. It has a lower amount of cash used by operating activities and a higher amount of cash provided by investing activities. (c) A manufacturing company s free cash flow would come primarily from its operating activities, not its investing activities. In addition, you would expect net uses of cash for investing activities in a manufacturing company as they invest in new and upgraded productive facilities. Finally, manufacturing companies would also borrow to finance their activities so you would expect to see net sources of cash from financing activities. Solutions Manual Chapter 17

30 SOLUTIONS TO PROBLEMS PROBLEM 17-1A Transaction 1. Paid wages to employees. 2. Sold land for cash, at a gain*. 3. Acquired land by issuing common shares. 4. Paid a cash dividend to preferred shareholders. 5. Recorded cash sales. 6. Recorded sales on account. 7. Purchased inventory for cash. 8. Purchased inventory on account. 9. Paid income tax. 10. Made a principal repayment on a trade note payable. (a) Classification (b) Cash (c) Net Income O - - I + + NC NE NE F - NE O + + NC NE + O - NE NC NE NE O - - O - NE * The gain on sale of land would appear in the operating section of the cash flow statement if the indirect method was used. Solutions Manual Chapter 17

31 PROBLEM 17-2A Transaction 1. Paid insurance for the month. 2. Paid semi-annual bond interest. 3. Received rent from a tenant in advance. 4. Recorded amortization expense. 5. Sold equipment for cash, at a loss. 6. Reacquired common shares. Cash Net Income Cash from Operating Activities NE + NE NE direct + indirect* NE direct + indirect* - NE NE 7. Declared and paid a cash dividend to common - NE NE shareholders. 8. Performed services on account. NE + NE 9. Collected cash from a customer on account. + NE Issued a non-trade note payable. + NE NE *Note: These items (amortization expense and loss on sale of equipment) are added to cash from operating activities not because they are sources of cash, but rather to cancel the deduction from net income because there is no use of cash from amortization expense or a loss. Solutions Manual Chapter 17

32 PROBLEM 17-3A (a) GUM SAN LTD. Cash Flow Statement (Partial) Indirect Method Year Ended April 30, 2008 Operating activities Net income... $789,000 Adjustments to reconcile net income to net cash provided by operating activities Amortization expense... $145,000 Gain on sale of equipment... (12,000) Increase in accounts receivable... (510,000) Decrease in inventory ,000 Increase in prepaid expenses... (170,000) Increase in accounts payable... 50,000 Decrease in accrued expenses payable (165,000) Decrease in income taxes payable... (16,000) (458,000) Net cash provided by operating activities $331,000 (b) GUM SAN LTD. Cash Flow Statement (Partial) Direct Method Year Ended April 30, 2008 Operating activities Cash receipts from customers... $4,890,000 (1) Cash payments To suppliers... $(3,020,000) (2) For operating expenses... (1,260,000) (3) For income taxes... (279,000) (4) (4,559,000) Net cash provided by operating activities $ 331,000 Solutions Manual Chapter 17

33 PROBLEM 17-3A (Continued) (b) (Continued) Calculations (1) Cash receipts from customers Sales... $5,400,000 Deduct: increase in accounts receivable. (510,000) Cash receipts from customers... $4,890,000 (2) Cash payments to suppliers Cost of goods sold... $3,290,000 Deduct: Decrease in inventory... (220,000) Cost of purchases... 3,070,000 Deduct: Increase in accounts payable... (50,000) Cash payments to suppliers... $3,020,000 (3) Cash payments for operating expenses Operating expenses... $925,000 Add: Decrease in accrued expenses payable 165,000 Increase in prepaid expenses ,000 Cash payments for operating expenses... $1,260,000 (4) Cash payments for income taxes Income tax expense... $263,000 Add: Decrease in income tax expense... 16,000 Cash payments for income taxes... $279,000 Solutions Manual Chapter 17

34 PROBLEM 17-4A (a) SABLE ISLAND LTD. Cash Flow Statement (Partial) Indirect Method Year Ended December 31, 2008 Operating activities Net income... $138,750 Adjustments to reconcile net income to net cash provided by operating activities Amortization expense... $60,000 Loss on sale of equipment... 26,000 Decrease in accounts receivable... 10,000 Increase in prepaid expenses... (1,500) Increase in accounts payable... 5,000 Decrease in income taxes payable... (5,250) Increase in interest payable Increase in unearned revenue... 3,000 97,700 Net cash provided by operating activities... $236,450 (b) SABLE ISLAND LTD. Cash Flow Statement (Partial) Direct Method Year Ended December 31, 2008 Operating activities Cash receipts from customers... $913,000 (1) Cash payments For operating expenses... $(620,500) (2) For interest... (4,550) (3) For income tax... (51,500) (4) (676,550) Net cash provided by operating activities... $236,450 Solutions Manual Chapter 17

35 PROBLEM 17-4A (Continued) (b) (Continued) Calculations: (1) Cash receipts from customers Revenues from fees... $900,000 Add: Decrease in accounts receivable.. $10,000 Add: Increase in unearned revenue... 3,000 13,000 Cash receipts from customers... $913,000 (2) Cash payments for operating expenses Operating expenses per income statement... $624,000 Add: Increase in prepaid expenses... 1,500 Less: Increase in accounts payable... (5,000) Cash payments for operating expenses... $620,500 (3) Cash payments for interest expense Interest expense per income statement... $5,000 Less: Increase in interest payable (450) Cash payments for income tax... $4,550 (4) Cash payments for income tax Income tax expense per income statement... $46,250 Add: Decrease in income tax payable ,250 Cash payments for income tax... $51,500 Solutions Manual Chapter 17

36 PROBLEM 17-5A (a) Cash inflows (outflows) related to property, plant and equipment 2008: Equipment purchase... ($80,000) Land purchase... (25,000) Proceeds from equipment sale... 23,000* * Cost of equipment sold $480,000 + $80,000 - $500,000 = $60,000 Accumulated amortization removed from accounts $600,000 + $192,000 + $203,000 - $675,000 - $288,000 = $32,000 NBV = $60,000 Cost Accumulated amortization $32,000 = $28,000 Cash proceeds = NBV $28,000 Loss on Sale $5,000 = $23,000 Equipment... 80,000 Cash... 80,000 Land... 50,000 Cash... 25,000 Mortgage Note Payable... 25,000 Cash... 23,000 Accumulated Amortization... 32,000 Loss on Sale of Equipment... 5,000 Equipment... 60,000 Solutions Manual Chapter 17

37 PROBLEM 17-5A (Continued) (b) Equipment purchase Investing activities ($80,000 use) Land purchase Investing activities ($25,000 use) Proceeds from equipment sale Investing activities ($23,000 source) Solutions Manual Chapter 17

38 PROBLEM 17-6A (a) Net income: Retained earnings, beginning of year... $240,000 Add: Net income (calculated)... 80, ,250 Less: Cash dividends... (6,250) Stock dividends... (14,000) Retained earnings, end of year... $300,000 (b) Cash outflow: Payment of cash dividends $ 6,250 Reacquisition of common shares ($32,000 - $1,500) 30,500 (c) Both of the outflows would be classified as financing activities on the cash flow statement. Solutions Manual Chapter 17

39 PROBLEM 17-7A (a) GALENTI, INC. Cash Flow Statement Indirect Method Year Ended December 31, 2008 Operating activities Net income... $90,310 Adjustments to reconcile net income to net cash provided by operating activities Amortization expense... $58,700 Gain on sale of equipment... (8,750) Loss on sale of securities... 7,500 Increase in accounts receivable... (59,800) Increase in inventory... (19,250) Decrease in prepaid expenses... 6,000 Increase in accounts payable... 4,420 Decrease in accrued expenses payable.. (6,730) (17,910) Net cash provided by operating activities... 72,400 Investing activities Sale of investments... $ 15,000 Sale of equipment... 15,550 Purchase of equipment (Note X)... (71,000) Net cash used by investing activities... (40,450) Financing activities Sale of common shares... $50,000 Payment of cash dividends (4)... (36,500) Net cash provided by financing activities... 13,500 Net increase in cash... 45,450 Cash, January ,250 Cash, December $92,700 Note X: During the year, the company acquired equipment with a cost of $141,000 by paying $71,000 cash and incurring a note payable. Solutions Manual Chapter 17

40 PROBLEM 17-7A (Continued) (b) GALENTI, INC. Cash Flow Statement Direct Method Year Ended December 31, 2008 Operating activities Cash receipts from customers... $237,700 (1) Cash payments To suppliers... $(114,290) (2) For operating expenses... (15,400) (3) For income tax... (32,670) For interest... (2,940) (165,300) Net cash provided by operating activities... 72,400 Investing activities Sale of investments... $15,000 Sale of equipment... 15,550 Purchase of equipment (Note X)... (71,000) Net cash used by investing activities... (40,450) Financing activities Sale of common shares... $50,000 Payment of cash dividends... (36,500) (4) Net cash provided by financing activities... 13,500 Net increase in cash... 45,450 Cash, January ,250 Cash, December $ 92,700 Note X: During the year, the company acquired equipment with a cost of $141,000 by paying $71,000 cash and incurring a note payable. Solutions Manual Chapter 17

41 PROBLEM 17-7A (Continued) Calculations: (1) Cash receipts from customers Sales... $297,500 Less: Increase in accounts receivable... (59,800) $237,700 (2) Cash payments to suppliers Cost of goods sold... $ 99,460 Add: Increase in inventory... 19,250 Cost of goods purchased ,710 Less: Increase in accounts payable... (4,420) $114,290 (3) Cash payments for operating expenses Operating expenses... $14,670 Less: Decrease in prepaid expenses... (6,000) Add: Decrease in accrued expenses payable 6,730 $15,400 (4) Cash paid for dividends Retained earnings, beginning... $121,790 Add: Net income... 90, ,100 Less: Cash dividends declared (calculated)... 36,500 Retained earnings, ending... $175,600 Solutions Manual Chapter 17

42 PROBLEM 17-8A (a) (1) Indirect method (b) MILK RIVER LTD. Cash Flow Statement Year Ended December 31, 2008 Operating activities Net income... $27,750 Adjustments to reconcile net income to net cash provided by operating activities: Amortization expense*... $15,500 Gain on sale of equipment... (1,000) Increase in accounts receivable... (28,000) Increase in merchandise inventory... (3,000) Increase in accounts payable... 2,000 Decrease in income taxes payable... (7,000) (21,500) Net cash provided by operating activities... 6,250 Investing activities Sale of equipment... $9,500 Purchase of equipment (Note X)... (6,000) Net cash provided by investing activities 3,500 Financing activities Issue of common shares... $4,000 Payment of dividends **... (4,750) Net cash used by financing activities... (750) Net increase in cash and equivalents... 9,000 Cash and cash equivalents, January ,000 Cash and cash equivalents, December $29,000 Note X: During the year, the company acquired equipment with a cost of $20,000 by paying $6,000 cash and incurring a note payable of $70,000. Solutions Manual Chapter 17

43 PROBLEM 17-8A (Continued) (a) (1) Continued *Amortization expense Cost of equipment... $18,000 Accumulated amortization (calculated)... (9,500) Book value... $ 8,500 Accumulated amortization, beginning... $24,000 Less: amortization for equipment sold... (9,500) Add: amortization expense (calculated)... 15,500 Accumulated amortization, ending... $30,000 **Cash paid for dividends Retained earnings, beginning... $38,000 Add: Net income... 27,750 65,750 Less: Cash dividends declared... (4,750) Retained earnings, ending... $61,000 Solutions Manual Chapter 17

44 PROBLEM 17-8A (Continued) (a) (2) Direct method MILK RIVER LTD. Cash Flow Statement Year Ended December 31, 2008 Cash flows from operating activities Cash receipts from customers (1)... $214,000 Cash payments To suppliers (2)... $(181,000) For operating expenses (3)... (8,500) For interest... (2,000) For income tax (4)... (16,250) (207,750) Net cash provided by operating activities 6,250 Investing activities Sale of equipment... $9,500 Purchase of equipment... (6,000) Net cash provided by investing activities 3,500 Financing activities Issue of common shares... $4,000 Payment of dividends... (4,750) Net cash used by financing activities (750) Net increase in cash and equivalents.. 9,000 Cash and cash equivalents, January 1 020,000 Cash and cash equivalents, December 31 $29,000 Note to the Cash Flow Statement: During the year, the company acquired equipment with a cost of $20,000 by paying $6,000 cash and incurring a note payable. Solutions Manual Chapter 17

45 PROBLEM 17-8A (Continued) (a) (2) (Continued) Calculations: (1) Cash receipts from customers Sales... $242,000 Less: Increase in accounts receivable... ( (28,000) Cash receipts from customers... $214,000 (2) Cash payments to suppliers Cost of goods sold... $180,000 Add: Increase in inventory... (3,000 Cost of goods purchased ,000 Less: Increase in accounts payable... (2,000) Cash payments to suppliers... $181,000 (3) Cash payments for operating expenses Accumulated amortization, beginning... $24,000 Less: amortization for equipment sold... (9,500) Add: amortization expense... 15,500 Accumulated amortization, ending... $30,000 Operating expenses... $24,000 Less: Amortization expense... ((15,500) Cash payments for operating expenses... $ 8,500 (4) Cash payments for income tax Income tax expense... $ 9,250 Add: Decrease in income tax payable... 7,000 Cash payments for income tax... $16,250 Solutions Manual Chapter 17

46 PROBLEM 17-8A (Continued) (b) Money-market instruments are combined with cash because they are readily convertible into cash and have maturities of less than three months. Therefore, they are considered to be cash equivalents. Solutions Manual Chapter 17

47 PROBLEM 17-9A (a) Net cash provided (used) by operating activities net cash (provided) used by investing activities = free cash flow Reitmans: $106,349 $43,509 = $62,840 La Senza: $46,610 $14,895 = $31,715 (b) (c) Reitmans appears to be in the stronger financial position. It generates more cash from operating activities, has a higher net income, more cash and cash equivalents, and a higher free cash flow. Reitmans is likely growing faster than La Senza. Its net income is higher, as is its cash provided by operating activities. It is repaying debt but also investing heavily in property, plant, and equipment as evidenced by its use of investing activities. Reitmans is using a higher proportion of its cash provided by operating activities for investing activities than La Senza. However, it must be noted that the fashion industry is quite volatile, and the differences between the companies may not be representative of growth. In addition, since the amounts given are in absolute dollars, it is difficult to tell how much of the difference is due to the relative size of the two companies. Solutions Manual Chapter 17

48 PROBLEM 17-1B Transaction (a) Classification (b) Cash (c) Net Income 1. Paid telephone bill for the month. O Sold equipment for cash, at a loss.* I Sold an available-for-sale security, I + + at a gain.* 4. Acquired a building by paying 10% in cash, and signing a mortgage payable for the balance. I NC - NE NE NE 5. Made principal repayments on the F - NE mortgage. 6. Paid interest on the mortgage. O Sold inventory on account, at a price greater than cost. NC NE + 8. Paid wages owing (previously O - NE accrued) to employees. 9. Declared and distributed a stock NC NE NE dividend to common shareholders. 10. Paid rent in advance. O - NE * Using the indirect method, the loss/gain would be added/deducted under operating activities. Solutions Manual Chapter 17

49 PROBLEM 17-2B Transaction 1. Recorded cash sales. 2. Received semi-annual bond interest. 3. Wrote down the value of inventory to market, which was lower than cost. 4. Received dividends on an available-for-sale equity investment. 5. Sold equipment for cash, at a gain. 6. Issued common shares. 7. Paid a cash dividend to common shareholders. 8. Sold merchandise on account, at a price greater than cost. 9. Collected cash from customers on account. 10. Collected rent in advance. Cash Net Income Cash from Operating Activities NE - NE NE direct - indirect* + NE NE - NE NE NE + NE + NE + + NE + *Note: The gain on sale of equipment is deducted from cash from operating activities not because it is a use of cash, but rather to cancel the addition in net income because there is no source of cash from a gain on sale. The proceeds from the sale of the equipment are reported in the investing activities section of the cash flow statement. Solutions Manual Chapter 17

50 PROBLEM 17-3B (a) Indirect method BRECKENRIDGE LTD. Cash Flow Statement (Partial) Year Ended November 30, 2008 Operating activities Net income... $850,000 Adjustments to reconcile net income to net cash provided by operating activities Amortization expense... $090,000 Increase in accounts receivable... (200,000) Decrease in inventory ,000 Increase in prepaid expenses... (150,000) Decrease in accounts payable... (300,000) Decrease in accrued expenses payable (100,000) Increase in income tax payable... 20,000 (140,000) Net cash provided by operating activities... $710,000 (b) Direct method BRECKENRIDGE LTD. Cash Flow Statement (Partial) Ended November 30, 2008 Operating activities Cash receipts from customers... $8,000,000 (1) Cash payments To suppliers... $(4,700,000) (2) For operating expenses... (2,310,000) (3) For income taxes... (280,000) (4) (7,290,000) Net cash provided by operating activities... $ 710,000 Solutions Manual Chapter 17

51 PROBLEM 17-3B (Continued) Calculations: (1) Cash receipts from customers Sales... $8,200,000 Less: Increase in accounts receivable ,000 $8,000,000 (2) Cash payments to suppliers Cost of goods sold... $4,900,000 Less: Decrease in inventory... (500,000) Cost of goods purchased... 4,400,000 Add: Decrease in accounts payable ,000 $4,700,000 (3) Cash payments for operating expenses Operating expenses... $2,060,000* Add: Increase in prepaid expenses ,000 Decrease in accrued expenses payable ,000 $2,310,000 *$2,150,000 $90,000 = $2,060,000 (4) Cash payments for income tax expense Income tax expense... $300,000 Less: Increase in income tax payable... ((20,000) $280,000 Solutions Manual Chapter 17

52 PROBLEM 17-4B (a) HANALEI INTERNATIONAL INC. Cash Flow Statement (Partial) Indirect Method Year Ended December 31, 2008 Operating activities Net income... $142,500 Adjustments to reconcile net income to net cash provided by operating activities Amortization expense... $45,000 Gain on sale of equipment... (25,000) Decrease in accounts receivable... 10,000 Increase in prepaid insurance... (3,000) Decrease in accounts payable... (11,000) Increase in interest payable... 1,250 Increase in income taxes payable Decrease in unearned revenue... (4,000) 13,750 Net cash provided by operating activities... $156,250 (b) HANALEI INTERNATIONAL INC. Cash Flow Statement (Partial) Direct Method Year Ended December 31, 2008 Operating activities Cash receipts from customers... $551,000 (1) Cash payments For operating expenses... $(339,000) (2) For interest... (8,750) (3) For income tax... (47,000) (4) (394,750) Net cash provided by operating activities... $156,250 Solutions Manual Chapter 17

53 PROBLEM 17-4B (Continued) (b) (Continued) Calculations: (1) Cash receipts from customers Revenue... $545,000 Add: Decrease in accounts receivable... 10,000 Less: Decrease in unearned revenue... (4,000) Cash receipts from customers... $551,000 (2) Cash payments for operating expenses Operating expenses... $325,000 Add: Increase in prepaid insurance... 3,000 Decrease in accounts payable... 11,000 Cash payments for operating expenses... $339,000 (3) Cash payments for interest Interest expense... $10,000 Less: Increase in interest payable... (1,250) Cash payments for interest... $ 8,750 (4) Cash payments for income tax Income tax expense... $47,500 Less: Increase in income tax payable... (500) Cash payments for income tax... $47,000 Solutions Manual Chapter 17

54 PROBLEM 17-5B (a) Cash inflows (outflows) related to property, plant and equipment 2008: Equipment purchase $(10,000) Land purchase (40,000) Proceeds from equipment sale 7,000* * Cost of equipment sold $240,000 + $75,000 - $293,000 = $22,000 Accumulated amortization removed from accounts $300,000 + $96,000 + $101,500 - $144,000 - $337,500 = $16,000 NBV = $22,000 Cost Accumulated amortization $16,000 = $6,000 Cash proceeds = NBV $6,000 + Gain on sale $1,000 = $7,000 Amortization Expense ,500 Accumulated Amortization Buildings.. 37,500 Accumulated Amortization Equipment (calculated)... 64,000 Equipment... 75,000 Cash... 10,000 Note Payable... 65,000 Land... 40,000 Cash... 40,000 Cash... 7,000 Accumulated Amortization... 16,000 Gain on Sale of Equipment... 1,000 Equipment... 22,000 Solutions Manual Chapter 17