LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Feature Story
Companies must be ready to respond to changes quickly in order to survive and thrive. This requires careful management of cash. One company that managed cash successfully in its early years was Microsoft. During those years, the company paid much of its payroll with stock options (rights to purchase company stock in the future at a given price) instead of cash. This conserved cash and turned more than a thousand of its employees into millionaires.
In recent years, Microsoft has had a different kind of cash problem. Now that it has reached a more “mature” stage in life, it generates so much cash—roughly $1 billion per month—that it cannot always figure out what to do with it. At one time, Microsoft had accumulated $60 billion.
The company said it was accumulating cash to invest in new opportunities, buy other companies, and pay off pending lawsuits. Microsoft's stockholders complained that holding all this cash was putting a drag on the company's profitability. Why? Because Microsoft had the cash invested in very low-yielding government securities. Stockholders felt that the company either should find new investment projects that would bring higher returns, or return some of the cash to stockholders.
Finally, Microsoft announced a plan to return cash to stockholders by paying a special one-time $32 billion dividend. This special dividend was so large that, according to the U.S. Commerce Department, it caused total personal income in the United States to rise by 3.7% in one month—the largest increase ever recorded by the agency. (It also made the holiday season brighter, especially for retailers in the Seattle area.) Microsoft also doubled its regular annual dividend to $3.50 per share. Further, it announced that it would spend another $30 billion buying treasury stock.
In recent years, Apple also encountered this cash “problem.” At the end of 2011, Apple had nearly $100 billion in liquid assets (cash, cash equivalents, and investment securities). At that time, it was generating $37 billion of cash per year from its operating activities but spending only about $7 billion on plant assets and purchases of patents. Shareholders pressured Apple to unload some of this cash. In response, Apple announced that it would begin to pay a quarterly dividend of $2.65 per share and it would buy back up to $10 billion of its stock. Analysts noted that the dividend consumes only $10 billion of cash per year. This leaves Apple wallowing in cash. The rest of us should have such problems.
Source: “Business: An End to Growth? Microsoft's Cash Bonanza,” The Economist (July 23, 2005), p. 61.
INSIDE CHAPTER 12…
PREVIEW OF CHAPTER 12
The balance sheet, income statement, and retained earnings statement do not always show the whole picture of the financial condition of a company or institution. In fact, looking at the financial statements of some well-known companies, a thoughtful investor might ask questions like these: How did Eastman Kodak finance cash dividends of $649 million in a year in which it earned only $17 million? How could United Air Lines purchase new planes that cost $1.9 billion in a year in which it reported a net loss of over $2 billion? How did the companies that spent a combined fantastic $3.4 trillion on mergers and acquisitions in a recent year finance those deals? Answers to these and similar questions can be found in this chapter, which presents the statement of cash flows.
The content and organization of this chapter are as follows.
LEARNING OBJECTIVE 1
Indicate the usefulness of the statement of cash flows.
The balance sheet, income statement, and retained earnings statement provide only limited information about a company's cash flows (cash receipts and cash payments). For example, comparative balance sheets show the increase in property, plant, and equipment during the year. But, they do not show how the additions were financed or paid for. The income statement shows net income. But, it does not indicate the amount of cash generated by operating activities. The retained earnings statement shows cash dividends declared but not the cash dividends paid during the year. None of these statements presents a detailed summary of where cash came from and how it was used.
The statement of cash flows reports the cash receipts and cash payments from operating, investing, and financing activities during a period, in a format that reconciles the beginning and ending cash balances. The information in a statement of cash flows helps investors, creditors, and others assess:
Ethics Note Though we would discourage reliance on cash flows to the exclusion of accrual accounting, comparing net cash provided by operating activities to net income can reveal important information about the “quality” of reported net income. Such a comparison can reveal the extent to which net income provides a good measure of actual performance.
LEARNING OBJECTIVE 2
Distinguish among operating, investing, and financing activities.
The statement of cash flows classifies cash receipts and cash payments as operating, investing, and financing activities. Transactions and other events characteristic of each kind of activity are as follows.
The operating activities category is the most important. It shows the cash provided by company operations. This source of cash is generally considered to be the best measure of a company's ability to generate sufficient cash to continue as a going concern.
Illustration 12-1 (page 628) lists typical cash receipts and cash payments within each of the three classifications. Study the list carefully. It will be very useful in solving homework exercises and problems.
Note the following general guidelines:
Companies classify as operating activities some cash flows related to investing or financing activities. For example, receipts of investment revenue (interest and dividends) are classified as operating activities. So are payments of interest to lenders. Why are these considered operating activities? Because companies report these items in the income statement, where results of operations are shown.
International Note The statement of cash flows is very similar under GAAP and IFRS. One difference is that, under IFRS, noncash investing and financing activities are not reported in the statement of cash flows but instead are reported in the notes to the financial statements.
Not all of a company's significant activities involve cash. Examples of significant noncash activities are:
Helpful Hint Do not include noncash investing and financing activities in the body of the statement of cash flows. Report this information in a separate schedule below the statement of cash flows.
Companies do not report in the body of the statement of cash flows significant financing and investing activities that do not affect cash. Instead, they report these activities in either a separate schedule at the bottom of the statement of cash flows or in a separate note or supplementary schedule to the financial statements. The reporting of these noncash activities in a separate schedule satisfies the full disclosure principle.
In solving homework assignments, you should present significant noncash investing and financing activities in a separate schedule at the bottom of the statement of cash flows. (See the last entry in Illustration 12-2 for an example.)
Accounting Across the Organization
Net What?
Net income is not the same as net cash provided by operating activities. The differences are illustrated by the following results from recent annual reports ($ in millions). Note the wide disparity among these companies that all engaged in retail merchandising.
In general, why do differences exist between net income and net cash provided by operating activities? (See page 684.)
The general format of the statement of cash flows presents the results of the three activities discussed previously—operating, investing, and financing—plus the significant noncash investing and financing activities. Illustration 12-2 shows a widely used form of the statement of cash flows.
The cash flows from operating activities section always appears first, followed by the investing activities section and then the financing activities section. The sum of the operating, investing, and financing activities sections equals the net increase or decrease in cash for the period. This amount is added to the beginning cash balance to arrive at the ending cash balance—the same amount reported on the balance sheet.
Do it!
CASH FLOW ACTIVITIES
During its first week, Duffy & Stevenson Company had these transactions.
Classify each of these transactions by type of cash flow activity.
Action Plan
Solution
Related exercise material: BE12-1, BE12-2, BE12-3, 12-1, E12-1, and E12-2.
LEARNING OBJECTIVE 3
Explain the impact of the product life cycle on a company's cash flows.
All products go through a series of phases called the product life cycle. The phases (in order of their occurrence) are introductory phase, growth phase, maturity phase, and decline phase. The introductory phase occurs at the beginning of a company's life, when it purchases fixed assets and begins to produce and sell products. During the growth phase, the company strives to expand its production and sales. In the maturity phase, sales and production level off. During the decline phase, sales of the product decline due to a weakening in consumer demand.
In the same way that products have life cycles, companies have life cycles as well. Companies generally have more than one product, and not all of a company's products are in the same phase of the product life cycle at the same time. This sometimes makes it difficult to classify a company's phase. Still, we can characterize a company as being in one of the four phases because the majority of its products are in a particular phase.
Illustration 12-3 shows that the phase a company is in affects its cash flows. In the introductory phase, we expect that the company will not generate positive cash from operations. That is, cash used in operations will exceed cash generated by operations in the introductory phase. Also, the company spends considerable amounts to purchase productive assets such as buildings and equipment. To support its asset purchases, the company issues stock or debt. Thus, during the introductory phase, we expect negative cash from operations, negative cash from investing, and positive cash from financing.
During the growth phase, we expect to see the company start to generate small amounts of cash from operations. During this phase, net cash provided by operating activities on the statement of cash flows is less than net income. One reason net income exceeds cash flow from operations during this period is explained by the difference between the cash paid for inventory and the amount expensed as cost of goods sold. Since the company projects increasing sales, the size of inventory purchases increases. Thus, in the growth phase, the company expenses less inventory on an accrual basis than it purchases on a cash basis. Also, collections on accounts receivable lag behind sales, and accrual sales during a period exceed cash collections during that period. Cash needed for asset acquisitions will continue to exceed net cash provided by operating activities. The company makes up the deficiency by issuing new stock or debt. Thus, in the growth phase, the company continues to show negative cash from investing and positive cash from financing activities.
During the maturity phase, net cash provided by operating activities and net income are approximately the same. Cash generated from operations exceeds investing needs. Thus, in the maturity phase, the company starts to pay dividends, retire debt, or buy back stock.
Investor Insight
Operating with Negative Cash
Listed here are recent amounts of net income and net cash provided (used) by operating, investing, and financing activities for a variety of companies. The final column suggests the companies' likely phase in the life cycle based on these figures.
Why do companies have negative net cash provided by operating activities during the introductory phase? (See page 684.)
Finally, during the decline phase, net cash provided by operating activities decreases. Cash from investing activities might actually become positive as the company sells off excess assets. Cash from financing activities may be negative as the company buys back stock and redeems debt.
Consider Microsoft. During its early years, it had significant product development costs and little revenue. Microsoft was lucky in that its agreement with IBM to provide the operating system for IBM PCs gave it an early steady source of cash to support growth. As noted in the Feature Story, Microsoft conserved cash by paying employees with stock options rather than cash. Today, Microsoft could be characterized as being in the maturity phase. It continues to spend considerable amounts on research and development and investment in new assets. In recent years, though, its net cash provided by operating activities has exceeded its net income. Also, cash from operations over this period exceeded cash used for investing, and common stock repurchased exceeded common stock issued. For Microsoft, as for any large company, the challenge is to maintain its growth. In the software industry, where products become obsolete very quickly, the challenge is particularly great.
Companies prepare the statement of cash flows differently from the three other basic financial statements. First, it is not prepared from an adjusted trial balance. It requires detailed information concerning the changes in account balances that occurred between two points in time. An adjusted trial balance will not provide the necessary data. Second, the statement of cash flows deals with cash receipts and payments. As a result, the company adjusts the effects of the use of accrual accounting to determine cash flows.
The information to prepare this statement usually comes from three sources:
Preparing the statement of cash flows from these data sources involves three major steps, explained in Illustration 12-4 on the next page.
In order to perform Step 1, a company must convert net income from an accrual basis to a cash basis. This conversion may be done by either of two methods: (1) the indirect method or (2) the direct method. Both methods arrive at the same total amount for “Net cash provided by operating activities.” They differ in how they arrive at the amount.
The indirect method adjusts net income for items that do not affect cash to determine net cash provided by operating activities. A great majority of companies (98%) use this method, as shown in the chart on the left.1 Companies favor the indirect method for two reasons. (1) It is easier and less costly to prepare, and (2) it focuses on the differences between net income and net cash flow from operating activities.
The direct method shows operating cash receipts and payments. It is prepared by adjusting each item in the income statement from the accrual basis to the cash basis. The FASB has expressed a preference for the direct method but allows the use of either method.
The next section illustrates the more popular indirect method. Appendix 12A illustrates the direct method. Appendix 12B demonstrates an approach that employs T-accounts to prepare the statement of cash flows. Many students find the T-account approach provides a useful structure. We encourage you to give it a try as you walk through the Computer Services example.
LEARNING OBJECTIVE 4
Prepare a statement of cash flows using the indirect method.
To explain how to prepare a statement of cash flows using the indirect method, we use financial information from Computer Services Company. Illustration 12-5 (page 634) presents Computer Services' current and previous-year balance sheets, its current-year income statement, and related financial information.
Illustration 12-5 Comparative balance sheets, income statement, and additional information for Computer Services Company
We now apply the three steps to the information provided for Computer Services Company.
DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS
To determine net cash provided by operating activities under the indirect method, companies adjust net income in numerous ways. A useful starting point is to understand why net income must be converted to net cash provided by operating activities.
Under generally accepted accounting principles, most companies use the accrual basis of accounting. As you have learned, this basis requires that companies record revenue when the performance obligation is satisfied and record expenses when incurred. Revenues include credit sales for which the company has not yet collected cash. Expenses incurred include some items that it has not yet paid in cash. Thus, under the accrual basis of accounting, net income is not the same as net cash provided by operating activities.
Therefore, under the indirect method, companies must adjust net income to convert certain items to the cash basis. The indirect method (or reconciliation method) starts with net income and converts it to net cash provided by operating activities. Illustration 12-6 lists the three types of adjustments.
Illustration 12-6 Three types of adjustments to convert net income to net cash provided by operating activities
We explain the three types of adjustments in the next three sections.
Helpful Hint Depreciation is similar to any other expense in that it reduces net income. It differs in that it does not involve a current cash outflow. That is why it must be added back to net income to arrive at net cash provided by operating activities.
Computer Services' income statement reports depreciation expense of $9,000. Although depreciation expense reduces net income, it does not reduce cash. In other words, depreciation expense is a noncash charge. The company must add it back to net income to arrive at net cash provided by operating activities. Computer Services reports depreciation expense as follows in the statement of cash flows.
As the first adjustment to net income in the statement of cash flows, companies frequently list depreciation and similar noncash charges such as amortization of intangible assets, depletion expense, and bad debt expense.
Illustration 12-1 states that cash received from the sale of plant assets is reported in the investing activities section. Because of this, companies eliminate from net income all gains and losses resulting from investing activities, to arrive at cash provided by operating activities.
In our example, Computer Services' income statement reports a $3,000 loss on the disposal of plant assets (book value $7,000, less cash received from sale of equipment $4,000). The company's loss of $3,000 is eliminated in the operating activities section of the statement of cash flows. Illustration 12-8 shows that the $3,000 loss is eliminated by adding $3,000 back to net income to arrive at net cash provided by operating activities.
If a gain on sale occurs, the company deducts the gain from net income in order to determine net cash provided by operating activities. In the case of either a gain or a loss, companies report the actual amount of cash received from the sale as a source of cash in the investing activities section of the statement of cash flows.
A final adjustment in reconciling net income to net cash provided by operating activities involves examining all changes in current asset and current liability accounts. The accrual-accounting process records revenues in the period in which the performance obligation is satisfied and expenses in the period incurred. For example, Accounts Receivable reflects amounts owed to the company for sales that have been made but for which cash collections have not yet been received. Prepaid Insurance reflects insurance that has been paid for but which has not yet expired and therefore has not been expensed. Similarly, Salaries and Wages Payable reflects salaries expense that has been incurred but has not been paid.
As a result, we need to adjust net income for these accruals and prepayments to determine net cash provided by operating activities. Thus, we must analyze the change in each current asset and current liability account to determine its impact on net income and cash.
CHANGES IN NONCASH CURRENT ASSETS. The adjustments required for changes in noncash current asset accounts are as follows. Deduct from net income increases in current asset accounts, and add to net income decreases in current asset accounts, to arrive at net cash provided by operating activities. We observe these relationships by analyzing the accounts of Computer Services Company.
DECREASE IN ACCOUNTS RECEIVABLE. Computer Services Company's accounts receivable decreased by $10,000 (from $30,000 to $20,000) during the period. For Computer Services, this means that cash receipts were $10,000 higher than sales revenue. The Accounts Receivable account in Illustration 12-9 shows that Computer Services Company had $507,000 in sales revenue (as reported on the income statement), but it collected $517,000 in cash.
As shown in Illustration 12-10, to adjust net income to net cash provided by operating activities, the company adds to net income the decrease of $10,000 in accounts receivable.
When the Accounts Receivable balance increases, cash receipts are lower than revenue recorded under the accrual basis. Therefore, the company deducts from net income the amount of the increase in accounts receivable, to arrive at net cash provided by operating activities.
INCREASE IN INVENTORY. Computer Services Company's inventory increased $5,000 (from $10,000 to $15,000) during the period. The change in the Inventory account reflects the difference between the amount of inventory purchased and the amount sold. For Computer Services, this means that the cost of merchandise purchased exceeded the cost of goods sold by $5,000. As a result, cost of goods sold does not reflect $5,000 of cash payments made for merchandise. The company deducts from net income this inventory increase of $5,000 during the period, to arrive at net cash provided by operating activities (see Illustration 12-10). If inventory decreases, the company adds to net income the amount of the change, to arrive at net cash provided by operating activities.
INCREASE IN PREPAID EXPENSES. Computer Services' prepaid expenses increased during the period by $4,000. This means that cash paid for expenses is higher than expenses reported on an accrual basis. In other words, the company has made cash payments in the current period but will not charge expenses to income until future periods (as charges to the income statement). To adjust net income to net cash provided by operating activities, the company deducts from net income the $4,000 increase in prepaid expenses (see Illustration 12-10).
If prepaid expenses decrease, reported expenses are higher than the expenses paid. Therefore, the company adds to net income the decrease in prepaid expense, to arrive at net cash provided by operating activities.
CHANGES IN CURRENT LIABILITIES. The adjustments required for changes in current liability accounts are as follows. Add to net income increases in current liability accounts, and deduct from net income decreases in current liability accounts, to arrive at net cash provided by operating activities.
INCREASE IN ACCOUNTS PAYABLE. For Computer Services Company, accounts payable increased by $16,000 (from $12,000 to $28,000) during the period. That means the company received $16,000 more in goods than it actually paid for. As shown in Illustration 12-11 (below), to adjust net income to determine net cash provided by operating activities, the company adds to net income the $16,000 increase in the Accounts Payable account.
DECREASE IN INCOME TAXES PAYABLE. When a company incurs income tax expense but has not yet paid its taxes, it records income taxes payable. A change in the Income Taxes Payable account reflects the difference between income tax expense incurred and income tax actually paid. Computer Services' Income Taxes Payable account decreased by $2,000. That means the $47,000 of income tax expense reported on the income statement was $2,000 less than the amount of taxes paid during the period of $49,000. As shown in Illustration 12-11, to adjust net income to a cash basis, the company must reduce net income by $2,000.
Illustration 12-11 shows that after starting with net income of $145,000, the sum of all of the adjustments to net income was $27,000. This resulted in net cash provided by operating activities of $172,000.
As shown in the previous illustrations, the statement of cash flows prepared by the indirect method starts with net income. Items are then added or deducted to arrive at net cash provided by operating activities. The required adjustments are of three types:
Illustration 12-12 provides a summary of these changes.
Illustration 12-12 Adjustments required to convert net income to net cash provided by operating activities
ANATOMY OF A FRAUD
For more than a decade, the top executives at the Italian dairy products company Parmalat engaged in multiple frauds that overstated cash and other assets by more than $1 billion while understating liabilities by between $8 and $12 billion. Much of the fraud involved creating fictitious sources and uses of cash. Some of these activities incorporated sophisticated financial transactions with subsidiaries created with the help of large international financial institutions. However, much of the fraud employed very basic, even sloppy, forgery of documents. For example, when outside auditors requested confirmation of bank accounts (such as a fake $4.8 billion account in the Cayman Islands), documents were created on scanners, with signatures that were cut and pasted from other documents. These were then passed through a fax machine numerous times to make them look real (if difficult to read). Similarly, fictitious bills were created in order to divert funds to other businesses owned by the Tanzi family (who controlled Parmalat).
Total take: Billions of dollars
THE MISSING CONTROL
Independent internal verification. Internal auditors at the company should have independently verified bank accounts and major transfers of cash to outside companies that were controlled by the Tanzi family.
Do it!
NET CASH PROVIDED BY OPERATING ACTIVITIES
Josh's PhotoPlus reported net income of $73,000 for 2014. Included in the income statement were depreciation expense of $7,000 and a gain on disposal of plant assets of $2,500. Josh's comparative balance sheets show the following balances.
Calculate net cash provided by operating activities for Josh's PhotoPlus.
Action Plan
Solution
Related exercise material: BE12-5, BE12-6, BE12-7, 12-2, E12-4, and E12-5.
ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY ACCOUNTS AND RECORD AS INVESTING AND FINANCING ACTIVITIES, OR DISCLOSE AS NONCASH TRANSACTIONS
Helpful Hint The investing and financing activities are measured and reported the same under both the direct and indirect methods.
INCREASE IN LAND. As indicated from the change in the Land account and the additional information, Computer Services Company purchased land of $110,000 by directly exchanging bonds for land. The exchange of bonds payable for land has no effect on cash. But, it is a significant noncash investing and financing activity that merits disclosure in a separate schedule. (See Illustration 12-14.)
Ethics Note Because investors and management bonus contracts often focus on cash flow from operations, some managers have taken unethical actions to artificially increase cash flow from operations. For example, Dynegy restated its statement of cash flows because it had improperly included in operating activities $300 million that should have been reported as financing activities. This increased cash from operating activities by 37%.
INCREASE IN BUILDINGS. As the additional data indicate, Computer Services Company acquired an office building for $120,000 cash. This is a cash outflow reported in the investing activities section. (See Illustration 12-14.)
INCREASE IN EQUIPMENT. The Equipment account increased $17,000. The additional information explains that this was a net increase that resulted from two transactions: (1) a purchase of equipment of $25,000, and (2) the sale for $4,000 of equipment costing $8,000. These transactions are both investing activities. The company should report each transaction separately. Thus, it reports the purchase of equipment as an outflow of cash for $25,000. It reports the sale as an inflow of cash for $4,000. The T-account below shows the reasons for the change in this account during the year.
The following entry shows the details of the equipment sale transaction.
INCREASE IN BONDS PAYABLE. The Bonds Payable account increased $110,000. As indicated in the additional information, the company acquired land by directly exchanging bonds for land. It reports this noncash transaction in a separate schedule at the bottom of the statement.
Helpful Hint When companies issue stocks or bonds for cash, the actual proceeds will appear in the statement of cash flows as a financing inflow (rather than the par value of the stocks or face value of bonds).
INCREASE IN COMMON STOCK. The balance sheet reports an increase in Common Stock of $20,000. The additional information section notes that this increase resulted from the issuance of new shares of stock. This is a cash inflow reported in the financing activities section.
INCREASE IN RETAINED EARNINGS. Retained earnings increased $116,000 during the year. This increase can be explained by two factors: (1) Net income of $145,000 increased retained earnings and (2) dividends of $29,000 decreased retained earnings. The company adjusts net income to net cash provided by operating activities in the operating activities section. Payment of the dividends (not the declaration) is a cash outflow that the company reports as a financing activity.
Using the previous information, we can now prepare a statement of cash flows for 2014 for Computer Services Company, as shown in Illustration 12-14.
COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH FLOWS WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE
Illustration 12-14 indicates that the net change in cash during the period was an increase of $22,000. This agrees with the change in Cash account reported on the balance sheet in Illustration 12-5 (page 634).
Accounting Across the Organization
Burning Through Our Cash
Kodak used to dominate the market for photographic film—back when most cameras used film. But when digital cameras arrived, the company's cash flows steadily declined. Investors began to wonder whether Kodak's cash would run out before the company came up with an alternative source of income. Eventually, the company was forced to sell plant assets and intangibles such as patents in order to supplement its cash from operating activities. Finally, Kodak decided to borrow money against its line of credit. Investors in Kodak's stocks and bonds interpreted this as a desperate move (because it further increased the company's debt). The price of its stock and its bonds plummeted. Within months, Kodak had filed for bankruptcy.
Source: Dana Mattioli and Matt Marzemsky, “Clock Ticks as Kodak Burns Cash,” Wall Street Journal (September 27, 2011).
What impact did Kodak's sale of plant assets have on its net cash provided by investing activities? (See page 684.)
LEARNING OBJECTIVE 5
Use the statement of cash flows to evaluate a company.
Traditionally, investors and creditors used ratios based on accrual accounting. These days, cash-based ratios are gaining increased acceptance among analysts. In this section, we review free cash flow and introduce two new measures.
In the statement of cash flows, net cash provided by operating activities is intended to indicate the cash-generating capability of the company. Analysts have noted, however, that cash provided by operating activities fails to take into account that a company must invest in new fixed assets just to maintain its current level of operations. Companies also must at least maintain dividends at current levels to satisfy investors. As we discussed in Chapter 2, the measurement of free cash flow provides additional insight regarding a company's cash-generating ability. Free cash flow describes the net cash provided by operating activities after adjustment for capital expenditures and dividends.
Consider the following example. Suppose that MPC produced and sold 10,000 personal computers this year. It reported $100,000 cash provided by operating activities. In order to maintain production at 10,000 computers, MPC invested $15,000 in equipment. It chose to pay $5,000 in dividends. Its free cash flow was $80,000 ($100,000 − $15,000 − $5,000). The company could use this $80,000 either to purchase new assets, pay off debt, or pay an $80,000 dividend. In practice, free cash flow is often calculated with the formula in Illustration 12-15. Alternative definitions also exist.
Illustration 12-16 provides basic information excerpted from the 2011 statement of cash flows of Apple (prior to the payment of its first dividends).
Apple's free cash flow is calculated as shown in Illustration 12-17 (in millions). Apple generated approximately $30 billion of free cash flow. This is a tremendous amount of cash generated in a single year. It is available for the acquisition of new assets, the buyback and retirement of stock or debt, or the payment of dividends.
Also note that Apple's cash from operations of $37.5 billion exceeds its 2011 net income of $25.9 billion by $11 billion. This lends additional credibility to Apple's income number as an indicator of potential future performance. If anything, Apple's net income might understate its actual performance. Microsoft's free cash flow for 2011 was $19.5 billion, also an incredible amount of cash.
Do it!
FREE CASH FLOW
Chicago Corporation issued the following statement of cash flows for 2012.
(a) Compute free cash flow for Chicago Corporation. (b) Explain why free cash flow often provides better information than “Net cash provided by operating activities.”
Action Plan
Solution
(a) Free cash flow = $29,300 − $19,000 − $9,000 = $1,300
(b) Net cash provided by operating activities fails to take into account that a company must invest in new plant assets just to maintain the current level of operation. Companies must also maintain dividends at current levels to satisfy investors. The measurement of free cash flow provides additional insight regarding a company's cash-generating ability.
Related exercise material: BE12-9, BE12-10, BE12-11, BE12-12, 12-3, E12-9, and E12-10.
DECISION TOOLKIT
Cash flow is closely monitored by analysts and investors for many reasons and in a variety of ways. One measure that is gaining increased attention is “price to cash flow.” This is a variant of the price to earnings (P-E) ratio, which has been a staple of analysts for a long time. The difference is that rather than divide the company's stock price by its earnings per share (an accrual-accounting–based number), the price to cash flow ratio divides the company's stock price by its cash flow per share. A high measure suggests that the stock price is high relative to the company's ability to generate cash. A low measure indicates that the company's stock might be a bargain.
The average price to cash flow ratio for companies in the Standard and Poor's 500-stock index was recently 12.1, when the average price-earnings ratio was 19.9. The following table provides values for some well-known companies in a recent year. While you should not use this measure as the sole factor in choosing a stock, it can serve as a useful screen by which to identify companies that merit further investigation.
Previous chapters have presented ratios used to analyze a company's liquidity and solvency. Many of those ratios used accrual-based numbers from the income statement and balance sheet. In this section, we focus on ratios that are cash-based rather than accrual-based. That is, instead of using numbers from the income statement, these ratios use numbers from the statement of cash flows.
As discussed earlier, many analysts are critical of accrual-based numbers because they feel that the adjustment process allows too much management discretion. These analysts like to supplement accrual-based analysis with measures that use the statement of cash flows. One disadvantage of these cash-based measures is that, unlike the more commonly employed accrual-based measures, there are no readily available industry averages for comparison. In the following discussion, we use cash flow-based ratios to analyze Apple. In addition to the cash flow information provided in Illustration 12-16 (page 643), we need the following information related to Apple.
Liquidity is the ability to pay obligations expected to become due within the next year. In Chapter 2, you learned that one measure of liquidity is the current ratio: current assets divided by current liabilities. A disadvantage of the current ratio is that it uses year-end balances of current asset and current liability accounts. These year-end balances may not be representative of the company's position during most of the year.
A ratio that partially corrects this problem is the current cash debt coverage. It is computed as net cash provided by operating activities divided by average current liabilities. Because net cash provided by operating activities involves the entire year rather than a balance at one point in time, this ratio is often considered a better representation of liquidity on the average day. In general, a value below .40 times is cause for additional investigation of a company's liquidity. Illustration 12-18 shows the current cash debt coverage for Apple, with comparative numbers for Microsoft. For comparative purposes, we have also provided each company's current ratio.
Apple's net cash provided by operating activities is 1.54 times its average current liabilities. Microsoft's ratio of .98 times is lower than that of Apple. Both companies far exceed the threshold of .40 times. Keep in mind that both Apple and Microsoft have extraordinary cash positions. For example, many large companies now have current ratios in the range of 1.0. By this standard, Apple's current ratio of 1.60:1 and Microsoft's current ratio of 2.60:1 are both strong.
Solvency is the ability of a company to survive over the long term. A measure of solvency that uses cash figures is the cash debt coverage. It is computed as the ratio of net cash provided by operating activities to total debt as represented by average total liabilities. This ratio indicates a company's ability to repay its liabilities from cash generated from operations—that is, without having to liquidate productive assets such as property, plant, and equipment. A general rule of thumb is that a cash debt coverage below .20 times is cause for additional investigation.
Illustration 12-19 shows the cash debt coverage for Apple and Microsoft for 2011. For comparative purposes, we have also provided the debt to assets ratios for each company.
Because Apple has long-term obligations, its cash debt coverage is lower than its current cash debt coverage. Obviously, Apple is very solvent. Microsoft's cash debt coverage of .59 times is not as strong as Apple's but still far exceeds the .20 threshold. Neither the cash nor accrual measures suggest any cause for concern regarding the solvency of either company.
DECISION TOOLKIT
We Aren't Going to Fail—Really
When an auditor determines that a company is at risk of failing, the auditor notes this concern about the company's ability to continue as a going concern in its audit opinion. Interestingly, during the first quarter of a recent year, 42% of the companies that filed to go public had such warnings in their audit opinions. At first glance, it would seem strange that a company that is at risk of failing would decide to issue shares to the public. Analysts explained that lenders were reluctant to grant loans due to a very low appetite for risk during and after the financial crisis. As a result, companies that might otherwise have borrowed money to supplement their net cash from operating activities were instead forced to try to raise money by issuing stock.
Source: Maxwell Murphy, “The Big Number: 42,” Wall Street Journal (April 23, 2012).
Do you think that issuing stock would be a cost-efficient way for these companies to raise funds? (See page 684.)
DECISION TOOLKIT A SUMMARY
LEARNING OBJECTIVE 6
Prepare a statement of cash flows using the direct method.
To explain and illustrate the direct method, we will use the transactions of Computer Services Company for 2014, to prepare a statement of cash flows. Illustration 12A-1 (page 650) presents information related to 2014 for Computer Services Company.
Illustration 12A-1 Comparative balance sheets, income statement, and additional information for Computer Services Company
To prepare a statement of cash flows under the direct approach, we will apply the three steps outlined in Illustration 12-4 (page 633).
DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS
Under the direct method, companies compute net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. To simplify and condense the operating activities section, companies report only major classes of operating cash receipts and cash payments. For these major classes, the difference between cash receipts and cash payments is the net cash provided by operating activities. These relationships are as shown in Illustration 12A-2.
An efficient way to apply the direct method is to analyze the items reported in the income statement in the order in which they are listed. We then determine cash receipts and cash payments related to these revenues and expenses. The following pages present the adjustments required to prepare a statement of cash flows for Computer Services Company using the direct approach.
CASH RECEIPTS FROM CUSTOMERS. The income statement for Computer Services Company reported sales revenue from customers of $507,000. How much of that was cash receipts? To answer that, companies need to consider the change in accounts receivable during the year. When accounts receivable increase during the year, revenues on an accrual basis are higher than cash receipts from customers. Operations led to revenues, but not all of these revenues resulted in cash receipts.
To determine the amount of cash receipts, the company deducts from sales revenue the increase in accounts receivable. On the other hand, there may be a decrease in accounts receivable. That would occur if cash receipts from customers exceeded sales revenue. In that case, the company adds to sales revenue the decrease in accounts receivable. For Computer Services Company, accounts receivable decreased $10,000. Thus, cash receipts from customers were $517,000, computed as shown in Illustration 12A-3.
Computer Services can also determine cash receipts from customers from an analysis of the Accounts Receivable account, as shown in Illustration 12A-4.
Illustration 12A-5 shows the relationships among cash receipts from customers, sales revenue, and changes in accounts receivable.
CASH PAYMENTS TO SUPPLIERS. Computer Services Company reported cost of goods sold of $150,000 on its income statement. How much of that was cash payments to suppliers? To answer that, it is first necessary to find purchases for the year. To find purchases, companies adjust cost of goods sold for the change in inventory. When inventory increases during the year, purchases for the year have exceeded cost of goods sold. As a result, to determine the amount of purchases, the company adds to cost of goods sold the increase in inventory.
In 2014, Computer Services Company's inventory increased $5,000. It computes purchases as follows.
After computing purchases, a company can determine cash payments to suppliers. This is done by adjusting purchases for the change in accounts payable. When accounts payable increase during the year, purchases on an accrual basis are higher than they are on a cash basis. As a result, to determine cash payments to suppliers, a company deducts from purchases the increase in accounts payable. On the other hand, if cash payments to suppliers exceed purchases, there may be a decrease in accounts payable. In that case, a company adds to purchases the decrease in accounts payable. For Computer Services Company, cash payments to suppliers were $139,000, computed as follows.
Computer Services also can determine cash payments to suppliers from an analysis of the Accounts Payable account, as shown in Illustration 12A-8.
Illustration 12A-9 shows the relationships among cash payments to suppliers, cost of goods sold, changes in inventory, and changes in accounts payable.
CASH PAYMENTS FOR OPERATING EXPENSES. Computer Services reported on its income statement operating expenses of $111,000. How much of that amount was cash paid for operating expenses? To answer that, we need to adjust this amount for any changes in prepaid expenses and accrued expenses payable. For example, if prepaid expenses increased during the year, cash paid for operating expenses is higher than operating expenses reported on the income statement. To convert operating expenses to cash payments for operating expenses, a company adds the increase in prepaid expenses to operating expenses. On the other hand, if prepaid expenses decrease during the year, it deducts the decrease from operating expenses.
Companies must also adjust operating expenses for changes in accrued expenses payable. When accrued expenses payable increase during the year, operating expenses on an accrual basis are higher than they are in a cash basis. As a result, to determine cash payments for operating expenses, a company deducts from operating expenses an increase in accrued expenses payable. On the other hand, a company adds to operating expenses a decrease in accrued expenses payable because cash payments exceed operating expenses.
Computer Services Company's cash payments for operating expenses were $115,000, computed as follows.
Illustration 12A-11 (page 654) shows the relationships among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable.
DEPRECIATION EXPENSE AND LOSS ON DISPOSAL OF PLANT ASSETS. Computer Services' depreciation expense in 2014 was $9,000. Depreciation expense is not shown on a statement of cash flows under the direct method because it is a noncash charge. If the amount for operating expenses includes depreciation expense, operating expenses must be reduced by the amount of depreciation to determine cash payments for operating expenses.
The loss on disposal of plant assets of $3,000 is also a noncash charge. The loss on disposal of plant assets reduces net income, but it does not reduce cash. Thus, the loss on disposal of plant assets is not shown on the statement of cash flows under the direct method.
Other charges to expense that do not require the use of cash, such as the amortization of intangible assets, depletion expense, and bad debt expense, are treated in the same manner as depreciation.
CASH PAYMENTS FOR INTEREST. Computer Services reported on the income statement interest expense of $42,000. Since the balance sheet did not include an accrual for interest payable for 2013 or 2014, the amount reported as expense is the same as the amount of interest paid.
CASH PAYMENTS FOR INCOME TAXES. Computer Services reported income tax expense of $47,000 on the income statement. Income taxes payable, however, decreased $2,000. This decrease means that income taxes paid were more than income taxes reported in the income statement. Cash payments for income taxes were, therefore, $49,000 as shown below.
Illustration 12A-13 shows the relationships among cash payments for income taxes, income tax expense, and changes in income taxes payable.
The operating activities section of the statement of cash flows of Computer Services Company is shown in Illustration 12A-14.
When a company uses the direct method, it must also provide in a separate schedule (not shown here) the net cash flows from operating activities as computed under the indirect method.
ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY ACCOUNTS AND RECORD AS INVESTING AND FINANCING ACTIVITIES, OR DISCLOSE AS NONCASH TRANSACTIONS
Helpful Hint The investing and financing activities are measured and reported the same under both the direct and indirect methods.
INCREASE IN LAND. As indicated from the change in the Land account and the additional information, Computer Services Company purchased land of $110,000 by directly exchanging bonds for land. The exchange of bonds payable for land has no effect on cash. But, it is a significant noncash investing and financing activity that merits disclosure in a separate schedule. (See Illustration 12A-16.)
INCREASE IN BUILDINGS. As the additional data indicate, Computer Services Company acquired an office building for $120,000 cash. This is a cash outflow reported in the investing activities section. (See Illustration 12A-16.)
INCREASE IN EQUIPMENT. The Equipment account increased $17,000. The additional information explains that this was a net increase that resulted from two transactions: (1) a purchase of equipment of $25,000, and (2) the sale for $4,000 of equipment costing $8,000. These transactions are investing activities. The company should report each transaction separately. The statement in Illustration 12A-16 reports the purchase of equipment as an outflow of cash for $25,000. It reports the sale as an inflow of cash for $4,000. The T-account below shows the reasons for the change in this account during the year.
The following entry shows the details of the equipment sale transaction.
INCREASE IN BONDS PAYABLE. The Bonds Payable account increased $110,000. As indicated in the additional information, the company acquired land by directly exchanging bonds for land. Illustration 12A-16 reports this noncash transaction in a separate schedule at the bottom of the statement.
INCREASE IN COMMON STOCK. The balance sheet reports an increase in Common Stock of $20,000. The additional information section notes that this increase resulted from the issuance of new shares of stock. This is a cash inflow reported in the financing activities section in Illustration 12A-16.
Helpful Hint When companies issue stocks or bonds for cash, the actual proceeds will appear in the statement of cash flows as a financing inflow (rather than the par value of the stocks or face value of bonds).
INCREASE IN RETAINED EARNINGS. Retained earnings increased $116,000 during the year. This increase can be explained by two factors: (1) Net income of $145,000 increased retained earnings and (2) dividends of $29,000 decreased retained earnings. The company adjusts net income to net cash provided by operating activities in the operating activities section. Payment of the dividends (not the declaration) is a cash outflow that the company reports as a financing activity in Illustration 12A-16.
Illustration 12A-16 (page 656) shows the statement of cash flows for Computer Services Company.
COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH FLOWS WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE
Illustration 12A-16 indicates that the net change in cash during the period was an increase of $22,000. This agrees with the change in balances in the Cash account reported on the balance sheets in Illustration 12A-1 (page 650).
6. Prepare a statement of cash flows using the direct method. The preparation of the statement of cash flows involves three major steps: (1) Determine net cash provided/used by operating activities by converting net income from an accrual basis to a cash basis. (2) Analyze changes in noncurrent asset and liability accounts and record as investing and financing activities, or disclose as noncash transactions. (3) Compare the net change in cash on the statement of cash flows with the change in the Cash account reported on the balance sheet to make sure the amounts agree. The direct method reports cash receipts less cash payments to arrive at net cash provided by operating activities.
LEARNING OBJECTIVE 7
Use the T-account approach to prepare a statement of cash flows.
Many people like to use T-accounts to provide structure to the preparation of a statement of cash flows. The use of T-accounts is based on the accounting equation that you learned in Chapter 1. The basic equation is:
Now, let's rewrite the left-hand side as:
Next, rewrite the equation by subtracting Noncash Assets from each side to isolate Cash on the left-hand side:
Finally, if we insert the Δ symbol (which means “change in”), we have:
What this means is that the change in cash is equal to the change in all of the other balance sheet accounts. Another way to think about this is that if we analyze the changes in all of the noncash balance sheet accounts, we will explain the change in the Cash account. This, of course, is exactly what we are trying to do with the statement of cash flows.
To implement this approach, first prepare a large Cash T-account with sections for operating, investing, and financing activities. Then, prepare smaller T-accounts for all of the other noncash balance sheet accounts. Insert the beginning and ending balances for each of these accounts. Once you have done this, then walk through the steps outlined in Illustration 12-4 (page 633). As you walk through the steps, enter debit and credit amounts into the affected accounts. When all of the changes in the T-accounts have been explained, you are done. To demonstrate, we will apply this approach to the example of Computer Services Company that is presented in the chapter. Each of the adjustments in Illustration 12B-1 is numbered so you can follow them through the T-accounts.
At this point, all of the changes in the noncash accounts have been explained. All that remains is to subtotal each section of the Cash T-account and compare the total change in cash with the change shown on the balance sheet. Once this is done, the information in the Cash T-account can be used to prepare a statement of cash flows.
7. Use the T-account approach to prepare a statement of cash flows. To use T-accounts to prepare the statement of cash flows: (1) prepare a large Cash T-account with sections for operating, investing, and financing activities; (2) prepare smaller T-accounts for all other noncash accounts; (3) insert beginning and ending balances for all accounts; and (4) follows the steps in Illustration 12-4 (page 633), entering debit and credit amounts as needed.
Glossary
Cash debt coverage (p. 646) A cash-based ratio used to evaluate solvency, calculated as net cash provided by operating activities divided by average total liabilities.
Current cash debt coverage (p. 645) A cash-based ratio used to evaluate liquidity, calculated as net cash provided by operating activities divided by average current liabilities.
Direct method (p. 633) A method of determining net cash provided by operating activities by adjusting each item in the income statement from the accrual basis to the cash basis. The direct method shows operating cash receipts and payments.
Financing activities (p. 627) Cash flow activities that include (a) obtaining cash from issuing debt and repaying the amounts borrowed and (b) obtaining cash from stockholders, repurchasing shares, and paying dividends.
Free cash flow (p. 642) Net cash provided by operating activities after adjusting for capital expenditures and dividends paid.
Indirect method (p. 632) A method of preparing a statement of cash flows in which net income is adjusted for items that do not affect cash, to determine net cash provided by operating activities.
Investing activities (p. 627) Cash flow activities that include (a) cash transactions that involve the purchase or disposal of investments and property, plant, and equipment using cash and (b) lending money and collecting the loans.
Operating activities (p. 627) Cash flow activities that include the cash effects of transactions that create revenues and expenses and thus enter into the determination of net income.
Product life cycle (p. 630) A series of phases in a product's sales and cash flows over time. These phases, in order of occurrence, are introductory, growth, maturity, and decline.
Statement of cash flows (p. 626) A basic financial statement that provides information about the cash receipts and cash payments of an entity during a period, classified as operating, investing, and financing activities, in a format that reconciles the beginning and ending cash balances.
Do it! Comprehensive
The income statement for Kosinski Manufacturing Company contains the following condensed information.
Included in operating expenses is a $24,000 loss resulting from the sale of machinery for $270,000 cash. Machinery was purchased at a cost of $750,000. The following balances are reported on Kosinski's comparative balance sheet at December 31.
Income tax expense of $353,000 represents the amount paid in 2014. Dividends declared and paid in 2014 totaled $200,000.
Instructions
(a) Prepare the statement of cash flows using the indirect method.
*(b) Prepare the statement of cash flows using the direct method.
Solution to Comprehensive
Self-Test, Brief Exercises, Exercises, Problem Set A, and many more resources are available for practice in WileyPLUS.
Note: All Questions, Exercises, and Problems marked with an asterisk relate to material in the appendices to the chapter.
Self-Test Questions
Answers are on page 684.
(LO 1)
1. Which of the following is incorrect about the statement of cash flows?
(a) It is a fourth basic financial statement.
(b) It provides information about cash receipts and cash payments of an entity during a period.
(c) It reconciles the ending cash account balance to the balance per the bank statement.
(d) It provides information about the operating, investing, and financing activities of the business.
(LO 1, 2)
2. Which of the following will not be reported in the statement of cash flows?
(a) The net change in plant assets during the year.
(b) Cash payments for plant assets during the year.
(c) Cash receipts from sales of plant assets during the year.
(d) Sources of financing during the period.
(LO 2)
3. The statement of cash flows classifies cash receipts and cash payments by these activities:
(a) operating and nonoperating.
(b) operating, investing, and financing.
(c) financing, operating, and nonoperating.
(d) investing, financing, and nonoperating.
(LO 2)
4. Which is an example of a cash flow from an operating activity?
(a) Payment of cash to lenders for interest.
(b) Receipt of cash from the sale of capital stock.
(c) Payment of cash dividends to the company's stockholders.
(d) None of the above.
(LO 2)
5. Which is an example of a cash flow from an investing activity?
(a) Receipt of cash from the issuance of bonds payable.
(b) Payment of cash to repurchase outstanding capital stock.
(c) Receipt of cash from the sale of equipment.
(d) Payment of cash to suppliers for inventory.
(LO 2)
6. Cash dividends paid to stockholders are classified on the statement of cash flows as:
(a) operating activities.
(b) investing activities.
(c) a combination of (a) and (b).
(d) financing activities.
(LO 2)
7. Which is an example of a cash flow from a financing activity?
(a) Receipt of cash from sale of land.
(b) Issuance of debt for cash.
(c) Purchase of equipment for cash.
(d) None of the above
(LO 2)
8. Which of the following is incorrect about the statement of cash flows?
(a) The direct method may be used to report cash provided by operating activities.
(b) The statement shows the net cash provided (used) for three categories of activity.
(c) The operating activities section is the last section of the statement.
(d) The indirect method may be used to report net cash provided by operating activities.
(LO 3)
9. During the introductory phase of a company's life cycle, one would normally expect to see:
(a) negative cash from operations, negative cash from investing, and positive cash from financing.
(b) negative cash from operations, positive cash from investing, and positive cash from financing.
(c) positive cash from operations, negative cash from investing, and negative cash from financing.
(d) positive cash from operations, negative cash from investing, and positive cash from financing.
Questions 10 through 12 apply only to the indirect method.
(LO 4)
10. Net income is $132,000, accounts payable increased $10,000 during the year, inventory decreased $6,000 during the year, and accounts receivable increased $12,000 during the year. Under the indirect method, what is net cash provided by operating activities?
(a) $102,000.
(b) $112,000.
(c) $124,000.
(d) $136,000.
(LO 4)
11. Items that are added back to net income in determining net cash provided by operating activities under the indirect method do not include:
(a) depreciation expense.
(b) an increase in inventory.
(c) amortization expense.
(d) loss on sale of equipment.
(LO 4)
12. The following data are available for Bill Mack Corporation.
Net cash provided by operating activities is:
(a) $160,000.
(b) $220,000.
(c) $240,000.
(d) $280,000.
13. The following are data concerning cash received or paid from various transactions for Orange Peels Corporation.
Net cash provided by investing activities is:
(a) $120,000.
(b) $130,000.
(c) $150,000.
(d) $190,000.
(LO 4, 6)
14. The following data are available for Retique!
Net cash provided by financing activities is:
(a) $90,000.
(b) $130,000.
(c) $160,000.
(d) $170,000.
(LO 5)
15. The cash debt coverage is:
(a) a measure of liquidity.
(b) a measure of profitability.
(c) net income divided by average total liabilities.
(d) a measure of solvency.
(LO 5)
16. Free cash flow provides an indication of a company's ability to:
(a) generate net income.
(b) generate cash to pay dividends.
(c) generate cash to invest in new capital expenditures.
(d) Both (b) and (c).
Questions 17 and 18 apply only to the direct method.
(LO 6)
*17. The beginning balance in accounts receivable is $44,000, the ending balance is $42,000, and sales during the period are $129,000. What are cash receipts from customers?
(a) $127,000.
(b) $129,000.
(c) $131,000.
(d) $141,000.
(LO 6)
*18. Which of the following items is reported on a statement of cash flows prepared by the direct method?
(a) Loss on disposal of plant asset.
(b) Increase in accounts receivable.
(c) Depreciation expense.
(d) Cash payments to suppliers.
Go to the book's companion website, www.wiley.com/college/kimmel, to access additional Self-Test Questions.
Questions
1.
(a) What is a statement of cash flows?
(b) Mark Paxson maintains that the statement of cash flows is an optional financial statement. Do you agree? Explain.
2. What questions about cash are answered by the statement of cash flows?
3. Distinguish among the three activities reported in the statement of cash flows.
4.
(a) What are the sources (inflows) of cash in a statement of cash flows?
(b) What are the uses (outflows) of cash?
5. Why is it important to disclose certain noncash transactions? How should they be disclosed?
6. Diane Hollowell and Terry Parmenter were discussing the format of the statement of cash flows of Snowbarger Co. At the bottom of Snowbarger's statement of cash flows was a separate section entitled “Noncash investing and financing activities.” Give three examples of significant noncash transactions that would be reported in this section.
7. Why is it necessary to use comparative balance sheets, a current income statement, and certain transaction data in preparing a statement of cash flows?
8.
(a) What are the phases of the corporate life cycle?
(b) What effect does each phase have on the numbers reported in a statement of cash flows?
9. Based on its statement of cash flows, in what stage of the product life cycle is Tootsie Roll Industries?
10. Contrast the advantages and disadvantages of the direct and indirect methods of preparing the statement of cash flows. Are both methods acceptable? Which method is preferred by the FASB? Which method is more popular?
11. When the total cash inflows exceed the total cash outflows in the statement of cash flows, how and where is this excess identified?
12. Describe the indirect method for determining net cash provided (used) by operating activities.
13. Why is it necessary to convert accrual-basis net income to cash-basis net income when preparing a statement of cash flows?
14. The president of Selby Company is puzzled. During the last year, the company experienced a net loss of $800,000, yet its cash increased $300,000 during the same period of time. Explain to the president how this could occur.
15. Identify five items that are adjustments to convert net income to net cash provided by operating activities under the indirect method.
16. Why and how is depreciation expense reported in a statement of cash flows prepared using the indirect method?
17. Why is the statement of cash flows useful?
18. During 2014, Markowitz Company exchanged $1,700,000 of its common stock for land. Indicate how the transaction would be reported on a statement of cash flows, if at all.
19. Give examples of accrual-based and cash-based ratios to measure each of these characteristics of a company:
(a) Liquidity.
(b) Solvency.
*20. Describe the direct method for determining net cash provided by operating activities.
*21. Give the formulas under the direct method for computing (a) cash receipts from customers and (b) cash payments to suppliers.
*22. Detwiler Inc. reported sales of $2 million for 2014. Accounts receivable decreased $150,000 and accounts payable increased $300,000. Compute cash receipts from customers, assuming that the receivable and payable transactions are related to operations.
*23. In the direct method, why is depreciation expense not reported in the cash flows from operating activities section?
Brief Exercises
Indicate statement presentation of selected transactions.
(LO 2), K
BE12-1 Each of these items must be considered in preparing a statement of cash flows for Irvin Co. for the year ended December 31, 2014. For each item, state how it should be shown in the statement of cash flows for 2014.
(a) Issued bonds for $200,000 cash.
(b) Purchased equipment for $180,000 cash.
(c) Sold land costing $20,000 for $20,000 cash.
(d) Declared and paid a $50,000 cash dividend.
Classify items by activities.
(LO 2), C
BE12-2 Classify each item as an operating, investing, or financing activity. Assume all items involve cash unless there is information to the contrary.
(a) Purchase of equipment.
(b) Sale of building.
(c) Redemption of bonds.
(d) Depreciation.
(e) Payment of dividends.
(f) Issuance of capital stock.
Identify financing activity transactions.
(LO 2), AP
BE12-3 The following T-account is a summary of the cash account of Kemper Company.
What amount of net cash provided (used) by financing activities should be reported in the statement of cash flows?
Answer questions related to the phases of product life cycle.
(LO 3), C
BE12-4
(a) Why is net cash provided by operating activities likely to be lower than reported net income during the growth phase?
(b) Why is net cash from investing activities often positive during the late maturity phase and during the decline phase?
Compute net cash provided by operating activities—indirect method.
(LO 4), AP
BE12-5 Manuel, Inc. reported net income of $2.5 million in 2014. Depreciation for the year was $160,000, accounts receivable decreased $350,000, and accounts payable decreased $280,000. Compute net cash provided by operating activities using the indirect approach.
Compute net cash provided by operating activities—indirect method.
(LO 4), AP
BE12-6 The net income for Freeman Co. for 2014 was $280,000. For 2014, depreciation on plant assets was $70,000, and the company incurred a loss on disposal of plant assets of $28,000. Compute net cash provided by operating activities under the indirect method, assuming there were no other changes in the company's accounts.
Compute net cash provided by operating activities—indirect method.
(LO 4), AP
BE12-7 The comparative balance sheets for Lowery Company show these changes in noncash current asset accounts: accounts receivable decrease $80,000, prepaid expenses increase $28,000, and inventories increase $40,000. Compute net cash provided by operating activities using the indirect method, assuming that net income is $186,000.
BE12-8 The T-accounts for Equipment and the related Accumulated Depreciation—Equip. for Coldsmith Company at the end of 2014 are shown here.
In addition, Coldsmith Company's income statement reported a loss on the disposal of plant assets of $3,500. What amount was reported on the statement of cash flows as “cash flow from sale of equipment”?
Calculate cash-based ratios.
(LO 5), AP
BE12-9 Suppose during 2014, Cypress Semiconductor Corporation reported net cash provided by operating activities of $89,303,000, cash used in investing of $43,126,000, and cash used in financing of $7,368,000. In addition, cash spent for fixed assets during the period was $25,823,000. Average current liabilities were $251,522,000, and average total liabilities were $286,214,500. No dividends were paid. Calculate these values:
(a) Free cash flow.
(b) Current cash debt coverage.
(c) Cash debt coverage.
Calculate cash-based ratios.
(LO 5), AP
BE12-10 Flowers Corporation reported net cash provided by operating activities of $412,000, net cash used by investing activities of $250,000, and net cash provided by financing activities of $70,000. In addition, cash spent for capital assets during the period was $200,000. Average current liabilities were $150,000, and average total liabilities were $225,000. No dividends were paid. Calculate these values:
(a) Free cash flow.
(b) Current cash debt coverage.
(c) Cash debt coverage.
Calculate cash-based ratios.
(LO 5), AP
BE12-11 Suppose Canwest Global Communications Corp. reported net cash used by operating activities of $104,539,000 and sales revenue of $2,867,459,000 during 2014. Cash spent on plant asset additions during the year was $79,330,000. Calculate free cash flow.
Calculate and analyze free cash flow.
(LO 5), AN
BE12-12 The management of Unruh Inc. is trying to decide whether it can increase its dividend. During the current year, it reported net income of $875,000. It had net cash provided by operating activities of $734,000, paid cash dividends of $92,000, and had capital expenditures of $310,000. Compute the company's free cash flow, and discuss whether an increase in the dividend appears warranted. What other factors should be considered?
Compute receipts from customers—direct method.
(LO 6), AP
*BE12-13 Suppose Columbia Sportswear Company had accounts receivable of $299,585,000 at January 1, 2014, and $226,548,000 at December 31, 2014. Assume sales revenue was $1,244,023,000 for the year 2014. What is the amount of cash receipts from customers in 2014?
Compute cash payments for income taxes—direct method.
(LO 6), AP
*BE12-14 Kolmer Corporation reported income taxes of $370,000,000 on its 2014 income statement and income taxes payable of $277,000,000 at December 31, 2013, and $528,000,000 at December 31, 2014. What amount of cash payments were made for income taxes during 2014?
Compute cash payments for operating expenses—direct method.
(LO 6), AP
*BE12-15 Sellers Corporation reports operating expenses of $90,000, excluding depreciation expense of $15,000 for 2014. During the year, prepaid expenses decreased $7,200 and accrued expenses payable increased $4,400. Compute the cash payments for operating expenses in 2014.
Do it! Review
Classify transactions by type of cash flow activity.
(LO 2), C
12-1 Morray Corporation had the following transactions.
Classify each of these transactions by type of cash flow activity (operating, investing, or financing).
Calculate net cash from operating activities.
(LO 4), AP
12-2 RL Photography reported net income of $100,000 for 2014. Included in the income statement were depreciation expense of $6,300, patent amortization expense of $4,000, and a gain on disposal of plant assets of $3,600. RL's comparative balance sheets show the following balances.
Calculate net cash provided by operating activities for RL Photography.
Compute and discuss free cash flow.
(LO 5), AP
12-3 Edelman Corporation issued the following statement of cash flows for 2014.
(a) Compute free cash flow for Edelman Corporation.
(b) Explain why free cash flow often provides better information than “Net cash provided by operating activities.”
Exercises
Classify transactions by type of activity.
(LO 2), C
E12-1 Putnam Corporation had these transactions during 2014.
(a) Purchased a machine for $30,000, giving a long-term note in exchange.
(b) Issued $50,000 par value common stock for cash.
(c) Issued $200,000 par value common stock upon conversion of bonds having a face value of $200,000.
(d) Declared and paid a cash dividend of $13,000.
(e) Sold a long-term investment with a cost of $15,000 for $15,000 cash.
(f) Collected $16,000 of accounts receivable.
(g) Paid $18,000 on accounts payable.
Analyze the transactions and indicate whether each transaction resulted in a cash flow from operating activities, investing activities, financing activities, or noncash investing and financing activities.
Classify transactions by type of activity.
(LO 2), C
E12-2 An analysis of comparative balance sheets, the current year's income statement, and the general ledger accounts of Judd Corp. uncovered the following items. Assume all items involve cash unless there is information to the contrary.
(a) Payment of interest on notes payable.
(b) Exchange of land for patent.
(c) Sale of building at book value.
(d) Payment of dividends.
(e) Depreciation.
(f) Conversion of bonds into common stock.
(g) Receipt of interest on notes receivable.
(h) Issuance of capital stock.
(i) Amortization of patent.
(j) Issuance of bonds for land.
(k) Purchase of land.
(l) Receipt of dividends on investment in stock.
(m) Loss on disposal of plant assets.
(n) Retirement of bonds.
Instructions
Indicate how each item should be classified in the statement of cash flows using these four major classifications: operating activity (indirect method), investing activity, financing activity, and significant noncash investing and financing activity.
Identify phases of product life cycle.
(LO 3), C
E12-3 The information in the table is from the statement of cash flows for a company at four different points in time (A, B, C, and D). Negative values are presented in parentheses.
Instructions
For each point in time, state whether the company is most likely in the introductory phase, growth phase, maturity phase, or decline phase. In each case, explain your choice.
Prepare the operating activities section—indirect method.
(LO 4), AP
E12-4 Cosi Company reported net income of $190,000 for 2014. Cosi also reported depreciation expense of $35,000 and a loss of $5,000 on the disposal of plant assets. The comparative balance sheet shows an increase in accounts receivable of $15,000 for the year, a $17,000 increase in accounts payable, and a $4,000 increase in prepaid expenses.
Instructions
Prepare the operating activities section of the statement of cash flows for 2014. Use the indirect method.
Prepare the operating activities section—indirect method.
(LO 4), AP
E12-5 The current sections of Sanford Inc.'s balance sheets at December 31, 2013 and 2014, are presented here. Sanford's net income for 2014 was $153,000. Depreciation expense was $27,000.
Instructions
Prepare the net cash provided by operating activities section of the company's statement of cash flows for the year ended December 31, 2014, using the indirect method.
E12-6 The following information is available for Ramos Corporation for the year ended December 31, 2014.
Instructions
Prepare a statement of cash flows using the indirect method.
Prepare partial statement of cash flows—indirect method.
(LO 4), AN
E12-7 The three accounts shown below appear in the general ledger of Lauber Corp. during 2014.
Instructions
From the postings in the accounts, indicate how the information is reported on a statement of cash flows using the indirect method. The loss on disposal of plant assets was $8,000. (Hint: Cost of equipment constructed is reported in the investing activities section as a decrease in cash of $53,000.)
Prepare a statement of cash flows—indirect method, and compute cash-based ratios.
(LO 4, 5), AP
E12-8 Shown below and on the next page are comparative balance sheets for Schmitt Company.
Additional information:
Instructions
(a) Prepare a statement of cash flows for 2014 using the indirect method.
(b) Compute these cash-based ratios:
(1) Current cash debt coverage.
(2) Cash debt coverage.
Compare two companies by using cash-based ratios.
(LO 5), AN
E12-9 Suppose presented below is 2014 information for PepsiCo, Inc. and The Coca-Cola Company.
Instructions
Using the cash-based measures presented in this chapter, compare the (a) liquidity and (b) solvency of the two companies.
Compare two companies by using cash-based ratios.
(LO 5), AN
E12-10 Information for two companies in the same industry, Patton Corporation and Sager Corporation, is presented here.
Instructions
Using the cash-based measures presented in this chapter, compare the (a) liquidity and (b) solvency of the two companies.
Compute cash provided by operating activities—direct method.
(LO 6), AP
*E12-11 Metzger Company completed its first year of operations on December 31, 2014. Its initial income statement showed that Metzger had sales revenue of $198,000 and operating expenses of $83,000. Accounts receivable and accounts payable at year-end were $60,000 and $23,000, respectively. Assume that accounts payable related to operating expenses. Ignore income taxes.
Compute net cash provided by operating activities using the direct method.
Compute cash payments—direct method.
(LO 6), AP
*E12-12 Suppose the 2014 income statement for McDonald's Corporation shows cost of goods sold $5,178.0 million and operating expenses (including depreciation expense of $1,216.2 million) $10,725.7 million. The comparative balance sheet for the year shows that inventory decreased $5.3 million, prepaid expenses increased $42.2 million, accounts payable (merchandise suppliers) increased $15.6 million, and accrued expenses payable increased $199.8 million.
Instructions
Using the direct method, compute (a) cash payments to suppliers and (b) cash payments for operating expenses.
Compute cash flow from operating activities—direct method.
(LO 6), AP
*E12-13 The 2014 accounting records of Rogan Transport reveal these transactions and events.
Instructions
Prepare the cash flows from operating activities section using the direct method.
Prepare statement of cash flows—direct method.
(LO 6), AP
*E12-14 The following information is available for Taliaferro Corp. for 2014.
Instructions
Prepare a statement of cash flows using the direct method.
Calculate cash flows—direct method.
(LO 6), AN
*E12-15 The following information is taken from the 2014 general ledger of Praeger Company.
In each case, compute the amount that should be reported in the operating activities section of the statement of cash flows under the direct method.
Exercises: Set B and Challenge Exercises
Visit the book's companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Exercise Set B and Challenge Exercises.
Problems: Set A
Distinguish among operating, investing, and financing activities.
(LO 2), C
P12-1A You are provided with the following transactions that took place during a recent fiscal year.
Instructions
Complete the table, indicating whether each item (1) affects operating (O) activities, investing (I) activities, financing (F) activities, or is a noncash (NC) transaction reported in a separate schedule, and (2) represents a cash inflow or cash outflow or has no cash flow effect. Assume use of the indirect approach.
Determine cash flow effects of changes in equity accounts.
(LO 4), AN
P12-2A The following account balances relate to the stockholders’ equity accounts of Smoltz Corp. at year-end.
A small stock dividend was declared and issued in 2014. The market price of the shares was $8,800. Cash dividends were $20,000 in both 2014 and 2013. The common stock has no par or stated value.
Instructions
(a) What was the amount of net income reported by Smoltz Corp. in 2014?
(b) Determine the amounts of any cash inflows or outflows related to the common stock and dividend accounts in 2014.
(c) Indicate where each of the cash inflows or outflows identified in (b) would be classified on the statement of cash flows.
P12-3A The income statement of Paxson Company is presented here.
Additional information:
Instructions
Prepare the operating activities section of the statement of cash flows for the year ended November 30, 2014, for Paxson Company, using the indirect method.
Prepare the operating activities section—direct method.
(LO 6), AP
*P12-4A Data for Paxson Company are presented in P12-3A.
Instructions
Prepare the operating activities section of the statement of cash flows using the direct method.
Prepare the operating activities section—indirect method.
(LO 4), AP
P12-5A Thornton Company's income statement contained the condensed information below.
Thornton's balance sheet contained the comparative data at December 31.
Accounts payable pertain to operating expenses.
Instructions
Prepare the operating activities section of the statement of cash flows using the indirect method.
*P12-6A Data for Thornton Company are presented in P12-5A.
Instructions
Prepare the operating activities section of the statement of cash flows using the direct method.
Prepare a statement of cash flows—indirect method, and compute cash-based ratios.
(LO 4, 5), AP
P12-7A Presented below are the financial statements of Kurtzel Company.
Additional data:
Instructions
(a) Prepare a statement of cash flows using the indirect method.
(b) Compute these cash-based measures:
(1) Current cash debt coverage.
(2) Cash debt coverage.
(3) Free cash flow.
Prepare a statement of cash flows—direct method, and compute cash-based ratios.
(LO 5, 6), AP
*P12-8A Data for Kurtzel Company are presented in P12-7A. Further analysis reveals the following.
(a) Prepare a statement of cash flows for Kurtzel Company using the direct method.
(b) Compute these cash-based measures:
(1) Current cash debt coverage.
(2) Cash debt coverage.
(3) Free cash flow.
Prepare a statement of cash flows—indirect method.
(LO 4), AP
P12-9A Condensed financial data of Odgers Inc. follow.
Additional information:
Instructions
Prepare a statement of cash flows using the indirect method.
Prepare a statement of cash flows—direct method.
(LO 6), AP
*P12-10A Data for Odgers Inc. are presented in P12-9A. Further analysis reveals that accounts payable pertain to merchandise creditors.
Instructions
Prepare a statement of cash flows for Odgers Inc. using the direct method.
P12-11A The comparative balance sheets for Yanik Company as of December 31 are presented below.
Additional information:
Instructions
Prepare a statement of cash flows for the year ended December 31, 2014, using the indirect method.
Identify the impact of transactions on ratios.
(LO 5), C
P12-12A You are provided with the following transactions that took place during the year.
For each transaction listed, indicate whether it will increase (I), decrease (D), or have no effect (NE) on the ratios.
Problems: Set B
Distinguish among operating, investing, and financing activities.
(LO 2), C
P12-1B You are provided with the following transactions that took place during a recent fiscal year.
Instructions
Complete the table indicating whether each item (1) affects operating (O) activities, investing (I) activities, financing (F) activities, or is a noncash (NC) transaction reported in a separate schedule, and (2) represents a cash inflow or cash outflow or has no cash flow effect. Assume use of the indirect approach.
Determine cash flow effects of changes in plant asset accounts.
(LO 4), AN
P12-2B The following selected account balances relate to the plant asset accounts of Lazari Inc. at year-end.
Additional information:
Instructions
(a) Determine the amounts of any cash inflows or outflows related to the plant asset accounts in 2014.
(b) Indicate where each of the cash inflows or outflows identified in (a) would be classified on the statement of cash flows.
P12-3B The income statement of Hubble Company is presented below.
Additional information:
Instructions
Prepare the operating activities section of the statement of cash flows for the year ended December 31, 2014, for Hubble Company, using the indirect method.
Prepare the operating activities section—direct method.
(LO 6), AP
*P12-4B Data for Hubble Company are presented in P12-3B.
Instructions
Prepare the operating activities section of the statement of cash flows using the direct method.
Prepare the operating activities section—indirect method.
(LO 4), AP
P12-5B Mosley Company's income statement contained the condensed information below.
Mosley's balance sheet contained the comparative data at December 31, below.
Accounts payable pertain to operating expenses.
Prepare the operating activities section of the statement of cash flows using the indirect method.
Prepare the operating activities section—direct method.
(LO 6), AP
*P12-6B Data for Mosley Company are presented in P12-5B.
Instructions
Prepare the operating activities section of the statement of cash flows using the direct method.
Prepare a statement of cash flows—indirect method, and compute cash-based ratios.
(LO 4, 5), AP
P12-7B Shown below are the financial statements of Filmore Company.
Additional data:
Instructions
(a) Prepare a statement of cash flows using the indirect method.
(b) Compute these cash-based measures:
(1) Current cash debt coverage.
(2) Cash debt coverage.
(3) Free cash flow.
Prepare a statement of cash flows—direct method, and compute cash-based ratios.
(LO 5, 6), AP
*P12-8B Data for Filmore Company are presented in P12-7B. Further analysis reveals the following.
Instructions
(a) Prepare a statement of cash flows using the direct method.
(b) Compute these cash-based measures:
(1) Current cash debt coverage.
(2) Cash debt coverage.
(3) Free cash flow.
Prepare a statement of cash flows—indirect method.
(LO 4), AP
P12-9B Condensed financial data of Turner Inc. follow.
Instructions
Prepare a statement of cash flows using the indirect method.
Prepare a statement of cash flows—direct method.
(LO 6), AP
*P12-10B Data for Turner Inc. are presented in P12-9B. Further analysis reveals that accounts payable pertain to merchandise creditors.
Instructions
Prepare a statement of cash flows for Turner Inc. using the direct method.
Prepare a statement of cash flows—indirect method.
(LO 4), AP
P12-11B The comparative balance sheets for Berkler Company as of December 31 are presented below.
Additional information:
Instructions
Prepare a statement of cash flows for the year ended December 31, 2014, using the indirect method.
P12-12B You are provided with the following transactions that took place during the year.
Instructions
For each transaction listed above, indicate whether it will increase (I), decrease (D), or have no effect (NE) on the ratios.
Problems: Set C
Visit the book's companion website, at www.wiley.com/college/kimmel, and choose the Student Companion site to access Problem Set C.
Continuing Cookie Chronicle
(Note: This is a continuation of the Cookie Chronicle from Chapters 1 through 11.)
CCC12 Natalie has prepared the balance sheet and income statement of Cookie & Coffee Creations Inc. and would like you to prepare the statement of cash flows.
Go to the book's companion website, at www.wiley.com/college/kimmel, to find the completion of this problem.
Broadening Your Perspective
Financial Reporting and Analysis
FINANCIAL REPORTING PROBLEM: Tootsie Roll Industries, Inc.
BYP12-1 The financial statements of Tootsie Roll Industries are presented in Appendix A.
Instructions
Answer the following questions.
(a) What was the amount of net cash provided by operating activities for 2011? For 2010?
(b) What was the amount of increase or decrease in cash and cash equivalents for the year ended December 31, 2011?
(c) Which method of computing net cash provided by operating activities does Tootsie Roll use?
(d) From your analysis of the 2011 statement of cash flows, was the change in accounts receivable a decrease or an increase? Was the change in inventories a decrease or an increase? Was the change in accounts payable a decrease or an increase?
(e) What was the net cash used by investing activities for 2011?
(f) What was the amount of interest paid in 2011? What was the amount of income taxes paid in 2011?
COMPARATIVE ANALYSIS PROBLEM: Tootsie Roll vs. Hershey
BYP12-2 The financial statements of The Hershey Company are presented in Appendix B, following the financial statements for Tootsie Roll Industries in Appendix A.
Instructions
(a) Based on the information in these financial statements, compute these 2011 ratios for each company:
(1) Current cash debt coverage.
(2) Cash debt coverage.
(b) What conclusions about the management of cash can you draw from these data?
RESEARCH CASES
BYP12-3 The March 4, 2010, edition of the Wall Street Journal Online contains an article by Jeffrey McCracken and Tom McGinty entitled “With Fistfuls of Cash, Firms on Hunt.”
Instructions
Read the article and answer the following questions.
(a) How much cash did the nonfinancial (that is, nonbank-like) firms in the Standard and Poor's 500 have at the end of 2009? How big an increase in cash did this represent over the prior year?
(b) What reasons are given in the article for why companies might not want to keep hoarding cash?
(c) What steps did Alcoa take to try to increase the company's cash? Were these efforts successful?
(d) Often, companies issue shares of stock to acquire other companies. This represents a significant noncash transaction. At the time the article was written, why were many companies using cash rather than stock to acquire other companies?
(e) In addition to acquisitions, what other steps can companies take to reduce their cash balances?
BYP12-4 The November 23, 2011, edition of the Wall Street Journal Online contains an article by John Jannarone entitled “Backlash from Netflix Buybacks.”
Instructions
Read the article and answer the following questions.
(a) What was the stock price for the shares of common stock issued by Netflix in the article? What was the price of the stock a few months previously?
(b) Why did Netflix issue new shares at a time when its stock price was so depressed relative to previous valuations for its stock?
(c) What previous actions had Netflix taken to reduce its cash balance?
(d) What does the article say is the lesson that growth companies should learn from the Netflix example?
INTERPRETING FINANCIAL STATEMENTS
BYP12-5 The incredible growth of Amazon.com has put fear into the hearts of traditional retailers. Its stock price has soared to amazing levels. However, in 2001 many investors were very concerned about whether Amazon would survive since it had never earned a profit and it was burning through cash. Some investors sold, but others decided to hold on to their investment in the company's stock. The following information is taken from the 2001 and 2004 financial statements of Amazon.
Instructions
(a) Calculate the current ratio and current cash debt coverage for Amazon for 2001 and 2004, and discuss its comparative liquidity.
(b) Calculate the cash debt coverage and the debt to assets ratio for Amazon for 2001 and 2004, and discuss its comparative solvency.
(c) Amazon has avoided purchasing large warehouses. Instead, it has used those of others. In order to increase customer satisfaction, Amazon may have to build its own warehouses. Calculate free cash flow for Amazon for 2001 and 2004, and discuss its ability to purchase warehouses and to finance expansion from internally generated cash.
(d) Based on your findings in parts (a) through (c), can you conclude whether or not Amazon's amazing stock price is justified?
REAL-WORLD FOCUS
BYP12-6 Purpose: Use the Internet to view SEC filings.
Address: biz.yahoo.com/i, or go to www.wiley.com/college/kimmel
Steps
Instructions
Answer the following questions.
(a) What company did you select?
(b) What is its stock symbol? What is its selling price?
(c) What recent SEC filings are available for your viewing?
(d) Which filing is the most recent? What is the date?
Critical Thinking
DECISION-MAKING ACROSS THE ORGANIZATION
BYP12-7 Ken Pember and Robyn Mays are examining the following statement of cash flows for Gilbert Company for the year ended January 31, 2014.
Ken claims that Gilbert's statement of cash flows is an excellent portrayal of a superb first year with cash increasing $95,000. Robyn replies that it was not a superb first year. Rather, she says, the year was an operating failure, that the statement is presented incorrectly, and that $95,000 is not the actual increase in cash. The cash balance at the beginning of the year was $140,000.
Instructions
With the class divided into groups, answer the following.
(a) Using the data provided, prepare a statement of cash flows in proper form using the indirect method. The only noncash items in the income statement are depreciation and the gain from the sale of the investment.
(b) With whom do you agree, Ken or Robyn? Explain your position.
COMMUNICATION ACTIVITY
BYP12-8 Jack Werth, the owner-president of Computer Services Company, is unfamiliar with the statement of cash flows that you, as his accountant, prepared. He asks for further explanation.
Instructions
Write him a brief memo explaining the form and content of the statement of cash flows as shown in Illustration 12-14 (page 641).
ETHICS CASE
BYP12-9 Templeton Automotive Corp. is a medium-sized wholesaler of automotive parts. It has 10 stockholders who have been paid a total of $1 million in cash dividends for 8 consecutive years. The board's policy requires that, for this dividend to be declared, net cash provided by operating activities as reported in Templeton Automotive's current year's statement of cash flows must exceed $1 million. President and CEO Rick Hanigan's job is secure so long as he produces annual operating cash flows to support the usual dividend.
At the end of the current year, controller Nick Korte presents president Rick Hanigan with some disappointing news. The net cash provided by operating activities is calculated by the indirect method to be only $970,000. The president says to Nick, “We must get that amount above $1 million. Isn't there some way to increase operating cash flow by another $30,000?” Nick answers, “These figures were prepared by my assistant. I'll go back to my office and see what I can do.” The president replies, “I know you won't let me down, Nick.”
Upon close scrutiny of the statement of cash flows, Nick concludes that he can get the operating cash flows above $1 million by reclassifying a $60,000, 2-year note payable listed in the financing activities section as “Proceeds from bank loan—$60,000.” He will report the note instead as “Increase in payables—$60,000” and treat it as an adjustment of net income in the operating activities section. He returns to the president, saying, “You can tell the board to declare their usual dividend. Our net cash flow provided by operating activities is $1,030,000.” “Good man, Nick! I knew I could count on you,” exults the president.
Instructions
(a) Who are the stakeholders in this situation?
(b) Was there anything unethical about the president's actions? Was there anything unethical about the controller's actions?
(c) Are the board members or anyone else likely to discover the misclassification?
BYP12-10 In this chapter, you learned that companies prepare a statement of cash flows in order to keep track of their sources and uses of cash and to help them plan for their future cash needs. Planning for your own short- and long-term cash needs is every bit as important as it is for a company.
Instructions
Read the article “Financial ‘Uh-oh’? No Problem,” at www.fool.com/savings/shortterm/02.htm, and answer the following questions.
(a) Describe the three factors that determine how much money you should set aside for short-term needs.
(b) How many months of living expenses does the article suggest to set aside?
(c) Estimate how much you should set aside based upon your current situation. Are you closer to Cliff's scenario or to Prudence's?
FASB CODIFICATION ACTIVITY
BYP12-11 If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to the following. Use the Master Glossary to determine the proper definitions.
(a) What are cash equivalents?
(b) What are financing activities?
(c) What are investing activities?
(d) What are operating activities?
(e) What is the primary objective for the statement of cash flow? Is working capital the basis for meeting this objective?
(f) Do companies need to disclose information about investing and financing activities that do not affect cash receipts or cash payments? If so, how should such information be disclosed?
Answers to Insight and Accounting Across the Organization Questions
p. 629 Net What? Q: In general, why do differences exist between net income and net cash provided by operating activities? A: The differences are explained by differences in the timing of the reporting of revenues and expenses under accrual accounting versus cash. Under accrual accounting, companies report revenues when the performance obligation is satisfied, even if cash hasn't been received, and they report expenses when incurred, even if cash hasn't been paid.
p. 631 Operating with Negative Cash Q: Why do companies have negative net cash provided by operating activities during the introductory phase? A: During the introductory phase, companies usually spend more on inventory than the amount expensed for cost of goods sold because they are building up inventory and their cash collections frequently lag the amount reported for sales. Therefore, even if companies are reporting positive net income, they frequently report negative net cash provided by operating activities.
p. 642 Burning Through Our Cash Q: What impact did Kodak's sale of plant assets have on its net cash provided by investing activities? A: Kodak sold its plant assets to increase its net cash provided by investing activities. This net cash increase allowed Kodak to then invest in new product ideas.
p. 647 We Aren't Going to Fail—Really Q: Do you think that issuing stock would be a cost-efficient way for these companies to raise funds? A: When investors are exposed to more risk, they demand a higher return. In the case of stock investments, this means that the investors will pay a lower price in order to get a higher return. Since these companies are at risk of failing, this is a particularly risky investment. As a result, the cash received for new shares would be really low. Therefore, this would not be an efficient source of cash. However, the companies need cash to avoid failing, so they have no choice.
Answers to Self-Test Questions
Compare the accounting procedures for the statement of cash flows under GAAP and IFRS.
As in GAAP, the statement of cash flows is a required statement for IFRS. In addition, the content and presentation of an IFRS statement of cash flows is similar to the one used for GAAP. However, the disclosure requirements related to the statement of cash flows are more extensive under GAAP. IAS 7 (“Cash Flow Statements”) provides the overall IFRS requirements for cash flow information.
KEY POINTS
LOOKING TO THE FUTURE
Presently, the FASB and the IASB are involved in a joint project on the presentation and organization of information in the financial statements. One interesting approach, revealed in a published proposal from that project, is that in the future the income statement and balance sheet would adopt headings similar to those of the statement of cash flows. That is, the income statement and balance sheet would be broken into operating, investing, and financing sections.
With respect to the statement of cash flows specifically, the notion of cash equivalents will probably not be retained. That is, cash equivalents will not be combined with cash but instead will be reported as a form of highly liquid, low-risk investment. The definition of cash in the existing literature would be retained, and the statement of cash flows would present information on changes in cash only. In addition, the FASB favors presentation of operating cash flows using the direct method only. However, the majority of IASB members express a preference for not requiring use of the direct method of reporting operating cash flows. The two Boards will have to resolve their differences in this area in order to issue a converged standard for the statement of cash flows.
IFRS PRACTICE
IFRS SELF-TEST QUESTIONS
(a) only a financing activity.
(b) a financing activity or an investing activity.
(c) a financing activity or an operating activity.
(d) only an operating activity.
(a) be reported in the section to which they relate, that is, a noncash investing activity would be reported in the investing section.
(b) be disclosed in the notes to the financial statements.
(c) do not need to be reported.
(d) be treated in a fashion similar to cash equivalents.
(a) the income statement and balance sheet will have headings of operating, investing, and financing, much like the statement of cash flows.
(b) cash and cash equivalents will be combined in a single line item.
(c) the IASB will not allow companies to use the direct approach to the statement of cash flows.
(d) None of the above.
(a) taxes are always treated as an operating activity.
(b) the income statement uses the headings operating, investing, and financing.
(c) dividends received can be either an operating or investing activity.
(d) dividends paid can be either an operating or investing activity.
(a) Under IFRS, the statement of cash flows is optional.
(b) IFRS requires use of the direct approach in preparing the statement of cash flows.
(c) The majority of companies following GAAP and the majority following IFRS employ the indirect approach to the statement of cash flows.
(d) Cash and cash equivalents are reported as separate line items under IFRS.
IFRS CONCEPTS AND APPLICATION
IFRS 12-1 Discuss the differences that exist in the treatment of bank overdrafts under GAAP and IFRS.
IFRS12-2 Describe the treatment of each of the following items under IFRS versus GAAP.
(a) Interest paid.
(b) Interest received.
(c) Dividends paid.
(d) Dividends received.
IFRS 12-3 Explain how the treatment of cash equivalents will probably change in the future.
INTERNATIONAL FINANCIAL REPORTING PROBLEM: Zetar plc
IFRS12-4 The financial statements of Zetar plc are presented in Appendix C. The company's complete annual report, including the notes to its financial statements, is available in the Investors section at www.zetarplc.com.
Instructions
Use the company's annual report to answer the following questions.
(a) In which section (operating, investing, or financing) does Zetar report interest paid?
(b) Explain why the amount that Zetar reports for cash and cash equivalents in its statement of cash flows is negative.
(c) If Zetar reported under GAAP rather than IFRS, how would its treatment of bank overdrafts differ?
(d) Zetar's statement of cash flows reports negative “net movement in working capital” in 2011 of £(6,040) (in thousands). According to the statement of cash flows, what were the components of this “net movement”?
Answers to IFRS Self-Test Questions
Remember to go back to The Navigator box on the chapter opening page and check off your completed work.