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When you are finished studying this chapter, you should be able to: 1. Explain the importance of the statementof cashflows and the three classifications of cash on the statementof cash flows. 2. Bxplain the difference between the direct method and the indirect method of preparing the statementof cash flows. 3" Convert accrual amountsto cash amounts. 4. Prepare the cashflows from operating activities section of the statementof cash flows using the direct method. 5. Prepare the cashflows from operating activities section of the statementof cash flows using the indirect method. 6. Preparethe cashflows from investingactivities section and the cashflows fromfinancing activities section of the statementof cash flows. 7" Perform general analysis of the statementof cashflows and calculate free cashflow. fi, Use the statementof cashflows and the related controls to evaluatethe risk of investing in a firm. 427

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CHAPTER 9 . PREPARI NG AND ANALYZI N GT H E S T A T E M E N T o F C A S HF L o Ws

Fraudis not restricted to publicly-held companies and privatelyEventhe publicsectoris subject owned companies. to fraud. Ethical behavior is needed everywherel Here are just a few of the problemsuncovered in an examinationof the records of HempDistrictNo. 1 in Nassau steadSanitary Countyin New York. Nonexistent time sheets for sanitation workers.Poorcontrols over nearly$1 million in cashreceipts. A phantom garbagetruck that had officiallybeen "disposed of" but was nonetheless seenrumbling down the street."Unreasonable" billsfor out-of-state conferencesincluding a $576 steak dinner for four. (Source: "Tale of the FiveHatted Accountant,"byVivian S.Toy, Ihe NewYorkTimes,September18, 2005,p. 3, Sec1411.)

L"(}"1 Ex plain t he im por ta n c e of the statementof cashflows and the three classifications of cashon the statementof cashflows.

Thelmportance of the Statement of Cash Flows


The statementof cashflows-one of the four financial statements a company must prepare as part of generally acceptedaccounting principles (GAAP)-shows all the cash the company hasreceivedand all the cashthe company has disbursedduring the accountingperiod. Each cash flow relates to one of three businessactivities-operating, investing, or financing activities. Exhibit 9.1 shows a summary of the information presentedon the statement of cashflows. Thousandsof companiesgo bankrupteachyear because they fail to plan their cashflows effectively.When the time comes to pay their bills, they do not have enough cash on hand. Preparing a cash budget is a crucial activity for all companies.It is more complicated than just estimatingcashinflows and outflows for the accountingperiod. The sourcesof cashand the uses of cash must be estimatedin detail-both the amounts of cash and when cash is needed.Each month, projected cash inflows and outflows must be budgetedby source and use.With this level of detail, a company can plan aheadfor any cash shortageby (1) securing a line of credit from a local bank, (2) bonowing the money,or (3) altering the timing of (postponingpurchases). its receipts(tightening up credit policies) or disbursements A cash budget is a detailedplan of a company's estimatedcash receiptsand estimated cash disbursements, with very specific forecastsof the sources,uses,and the timing of the cashflows. The budgetedcashflows in the cashbudgetcan thenbe comparedwith actualcash flows, and the comparisonis the basisfor planning and evaluatingperformance.To compare the actualcashflows for an accountingperiod with the period's cashbudget,a companymust produce details about the actual sourcesof cashand actual usesof cashfrom the company's records.Comparing actualcashflows with budgetedcashflows getsa companyready to prepare the next period's budgetedcashflows. Even though the focus of financial reportingis fi-

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Large U.S. companies have lotsof cashl Cashis pilingup at manylargeU.S. firms. According to lhe WallStreet Journal ("Capital " p. Pains: BigCash Hoards, bylanMcDonald, July 21,2006, C1),the 174S&P (a sector Industrials financial that excludes firms) hadover$295billion in cash in the firstquarter of 2006 "Thatamount equals morethan7okof the companies'stockmarket value, the highest level in nearly two decades."

O F C A S HF L O WS . TW O M ETHO DSO F PR E P A R I N G GH E S T A T E M E N T A N D P R E S E N T I NT CHA PTERg

429

EXHIBIT9.1 The Statement of Cash Flows


A firm's statementof cash flows will include every cash inflow and outflow. The cash flows are divided into three categories:operating, investing, and financing.

Operating
Cash related to the day-to-day activities of mnning the business-revenue and expense trarsactrons

Investing
Cashrelated to buying and selling assetsthat the firm plans to use for longer than one year

Financing
Cash receipts and disbursements related to loans (principal only); cash contributions from and distributions to owners

Types of transactions

Examples Inflows Cashcollections from customers Cashpaid to vendors for inventory Current assetsand current liabilities Cashproceedsfrom the sale of Iand or building Cashpaid for new land or building Long-termassets Cashproceedsfrom a new stock issue Cashdividendspaid to shareholders Long-termliabilities and shareholder'sequity

Outflows Cash flows are generally related to these balance sheet accounts

and investors,the information aboutcashflows is equally nancial statements for shareholders of a company. useful to managers Since Tom startedhis T-shirt businessin January2006, we have preparedthe four bafor his businessevery month, including the statementof cashflows. sic financial statements prepared the statementof cash flows has been to The way we have 1. Identify every cash transactionon our accounting equation worksheet,and then 2. Classify eachcashamountas one ofthree types:operating,investing,or financing. When we use a separatecolumn in the accounting equation worksheetfor cash transactions, we simply take each addition of cash and each subtraction of cash; then we classify eachcashflow as cashfrom operating activities, cashfrom investing activities, or cash from financing activities. Becausea real company has a much more complex accounting system,neededto handle thousandsor millions of transactions,examining eachtransaction is not a feasible way for a company to preparethe statementof cash flows. In this chapter, we will discusshow the statementis actually prepared.

The direct method shows every cashinflow and outflow to prepare the statement of cashflows. The indirect method starts with net incomeand makes for itemsthat are adjustments not cashto preparethe statement of cashflows.

andPresenting of Preparing TwoMethods Flows of Cash the Statement


GAAP describestwo ways of preparing the statementof cashflows: the direct method and the indirect method. Thesetwo methodsare namedfor the way in which the operating section of the statement of cash flows-cash from operating activities-is prepared, either directly-by converting every number on the income statement to its cash amount-or indirectly-by startingwith net income and adjustingit until you have the net cashfrom operating activities. For the other two sections,investing and financing, there is only one way to compute the cashflows: The transactionsare directly identified. Thus, in any discussion

-E-.{}.} Explain the difference between the direct method a n d t h e i n d i r e c t m e t h od o f preparing the statement of cash flows.

CHAPTER 9 . PREPARI NG AND ANALYZI N GT H E S T A T E M E N T O F C A S HF L O WS

EXHIBIT9.2 Comparisonof the Direct and Indirect Methods for the Statement of CashFlows Statement of Cash Flows
(cashfrom operatingactivities only)

Direct Method
Cash from operating activities: Cash collected from customers . . . . Cash paid for supplies Cash paid to vendors for inventory . Net cash from operating activities

Indirect Method
$500 (30) (200) $270
Cash from operating activities: Net income - increase in accounts receivable - increase in supplies + increase in accounts payable . . Net cash from operating activities

$330 (100) (10) 50 $270

Both methods result in the sametotal cash from operating activities.

about different methodsof preparing a statementof cash flows, the difference between the direct method and the indirect method applies only to cashfrom operating activities. Before we discussthe two different methodsin detail, we will look at a simple example of the difference between thesemethods of preparing the statementof cash flows. We will start with the fust month of businessfor a simple company with the following transactions. 1. Purchaseof inventory for $250-paid cash of $200 to vendor with the remaining $50 on account (accountspayable) 2. Salesof all inventoryfor $600-$500 for cashand $100 on account(accounts receivable) 3. Purchaseof suppliesfor cashof $3O-used $20 worth of them, with $ 10 worth remaining for next month Net income is calculated as follows.

$600 Sales

$2so
Cost of goodssold

$20
Suppliesexpense

$330
Net income

Cash collected and disbursedis calculatednext.

$500
Cash sales

$200
Inventory purchases

$30
Supplies purchase

5270
Net cash flow

This changefrom accrual basis numbersto cashbasis numberscan be done in the two ways shown in Exhibit 9.2-direct or indirect. The direct method examineseach item on the income statement,one by one. In contrast,the indirect method is more mechanical:Net income is adjustedfor all the changesin the current assetsand current liabilities, excluding cash and noncashitems from the income statement. You may want to study the transactions and the exhibit again after you learn more about how to preparethe statements. Notice the only cashflows in this example are cash flows from operating activities; and both methods produce the sameamount of net cash from operating activities. Both methodsof preparing the operating sectionof the statementof cashflows require information about the underlying fransactions so the cashcan be separated from the accrual accounting numbers. For example, the amount of sales must be examined to get the actual cashcollectedfrom making those sales.Suppliesexpense must be examinedto get the actual cashpaid for supplies.Doing this convertsaccrual-based amountsto cash-based amounts.

Your Turn 9-l


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What is the major differencebetween the direct and indirect methods of presenting the statement of cashflows? What are the similarities?

C A S HB A 5 I SA C C O U N T I N G VERSUS ACCOUNTING 9 . ACCRUAL CHAPTER

431

Convertaccrualamountsto As you know, companiesthat follow GAAP maintain their accountingrecordsusing the ac- cashamounts. crual basis. Preparing the statementof cash flows is actually converting the records of the businessto cashbasis.That is what you seein Exhibit9.2.There are many reasonswhy accrual basis accounting and cashbasis accounting are not generally the same. For example, a company will record a sale and recognize the revenue on the income statementwhen the merchandiseis shippedor delivered.Does the company always receive the cash at that time? No. Thus, the amount of revenueearnedfrom salesfor an accounting period may not be the same as the amount of cash collected during the period. At the end customers of the accountingperiod, when the company is preparingits financial statements, receivable. accounts outstanding may be money-there may still owe the company some That is one reasonthe cashcollected from salesmight not equal the amount of the salesfor a specific accountingperiod. Also, the company may have collected cashduring the current period from salesmade during the prior accountingperiod-accounts receivablefrom the prior year may havebeen collected in the current year. Thus, to calculate the cash collected from customersfor the statementof cash flows, we must consider and make an adjustment for the change in accounts receivable. Supposea company begat}O}7 with accountsreceivableof $500. These accountsreceivable were recorded during 2006, when the revenuefrom the saleswas recognized.All salesare made on credit; and during 2007, t}recompany had salesof $3,000. At the end of 2007,thebalance in accountsreceivablewas $600. How much cashwas collected from customers during 2007?Becauseaccountsreceivablestartedwith a balanceof $500 and ended with a balanceof $600, the increaserepresentssalesthat have not been collected from the customers.Therefore, although salesamountedto $3,000, only $2,900 worth of those sales must have been collected in cash. Another way to think about it is first to supposethat customerspaid off their old accounts of $500. If total saleswere $3,000 and if an ending accountsreceivablebalancewas $600, then $2,400 of the current salesmust have been collected. The beginning balance of $500 was collected plus current salesof $2,400 have been collected-making the total cash collected from customersduring the period equal to $2,900. This is the sort of reasoning that must be applied to each item on the income statementto preparethe statementof cash flows using the direct method. The amount for every item on the income statementis potentially different from the cash paid or received for it. As we just discussed,the dollar amount of salesis potentially different from cash collected from customers.Cost of goods sold is potentially different from cash paid for inventory. Insuranceexpenseis potentially different from the cash paid to the insurancecompany-and so on, for all items on the income statement. The changein a current assetor a current liability will reflect the difference between the accrual-basedincome statementamount and the cash amount. Consider an expenseon the income statement. Supposesalary expenseis shown on the year's income statement of cashflows, we want to show cashpaid to employeesas as $75.000.For the statement an operating cash outflow. What could make salary expensedifferent from cash paid to employees? First, we could have paid some employeescashthat we owed them from last year.The cash payment would reduce the liability salariespayable. If we did pay some salarieswe owed at the beginning of the year, that cashpaid would be in addition to any current year's salary paid to employees.What else could make cash paid to employeesdifferent from salary expense? We could have incurred salary expensethat will not be paid until next year. In other words, we recognized some salary expensethat did not get paid to the employees' We must have recorded it as salariespayable. In both cases,the difference between salary expense andcashpaid to employeesis reflected in the changein salariespayable from the beginning of the year to the end of the year. This is the sort of reasoningthat must be applied to each current assetand each current liability (excluding cash) on the balance sheet to preparethe statementof cash flows.

Accounting Basis Cash Versus Accounting Accrual

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CHAPTER 9 . PREPARI NG AND ANALYZI N GT H E S T A T E M E N T O F C A S HF L O WS

Supposewe startedthe year with salariespayable of $690. Our salary expensefor the year, as shown on the income statement, is $75,000.If the balancein salariespayableis $500 at year-end,how much cashwas actually paid to employees? First, we must havepaid off the amount we owed at the beginning of the year, $690. Then, becausethe ending balance in salariespayable is $500, we must have paid only $74,500 ($75,000 - $500) ofthe current year's salaryexpense. Thus,the total cashpaid to employees is $75,190($690 + $74,500). Another way to interpret what happenedis to say that we paid the full $75,000 of this year's expensein cashand we paid down our salariespayableby $190 ($690 down to $500). That total is $75.190.

Your Turn 9-2

'Wwgwtr'-',Wk.+',#.tr.ff the year,Robo's sales totaled $50,000. At year-end, Robohad an accounts re-

RoboCompany beganthe year with $25,000 in accounts receivable. During

ceivable How muchcash balance of $15,000. did Robocollect from customers duringthe year?How is that amountof cashclassified on the statement of cashflows?
I "$.4 Preparethe cashflows from ope rati ng activities section of the statementof cash flows usingthe direct met hod.

Preparing the Statement of Cash Flows: DirectMethod


Now you are ready to learn the proceduresfor preparing a statementof cash flows. First, the cash from operating activities section of the statementof cash flows is preparedusing one of the following two methods we have already discussed. 1. Direct method: Each item on the accrual-based income statementis convertedto cash. 2. Indirect method: Net income is the starting point, and adjustmentsare made by adding and subtracting amountsnecessary to convert net income into net cash from operating activities. After you have determinedthe cashflows from operating activities, you determine the cashflows from investing activities and cashflows from financing activities.You will learn about them later in the chapter. The direct method of computing cash flows from operating activities begins with an analysis of the income statement.Item by item, every amount on the statementis analyzed to determine how much cash was actually collected or disbursedrelated to that item. The first item on the income statementis usually revenue.What makesrevenueon the income statementdifferent from cash collected from customers?Any cash collected for salesin previous periods-that is, accountsreceivable-must be counted as cash collected even though it is not included as revenue.Conversely,any sales for the period for which cashhasnot beencollected must be excludedfrom cashcollections. Both cashcollected but not counted as revenueand cash not collected but included in revenuecan be identified by looking at the changein accountsreceivableduring the period. We will use Tom's Weat's third month of business-March-to see how this works. We start at the beginning of the income statement, shown in Exhibit 9.3 (first seen as Exhibit 3.13), for the month and analyzeeach amount to changeit from accrual to cash. Saleson the income statementfor March amountedto $2,000.What we need to know for the statementof cash flows is how much cash was collected from customers during March. We need to seehow accountsreceivable changedduring the month. On March 1, Tom's Wear had $150 worth of accountsreceivable,and on March 31 the firm had $2,000 worth of accountsreceivable.By comparing the balancesheetat the beginning of the month with the balance sheet at the end of the month, both shown in Exhibit 9.4, we can see accounts receivable increasedby $1,850. The amount of the change in accountsreceivable came from the current period's salesnot collected. Analyze what happenedto accountsreceivable.It started with $150. Then during the month, credit salesof $2,000 were made (saleson the income statement).The ending balance in accountsreceivableis $2,000. Thus, the cash collected from customersmust have

METHOD THE STATEMENT O F C A S H F L O WS :D I R E C T CHAPTER 9 . PR E P A R I N G

433

E X HI B I T 9.3
Tom's Wear,Inc. Income Statement For the Month Ended March 31, 2006 lncome Statement for Tom's Wear, Inc. for the Month Ended March 31

Sales revenue Expenses Cost ofgoods sold Depreciation expense Insurance expense Interestexpense N etin co me

$2,ooo
800 100 50 30 .. ..-..

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(e80) $1,020

EXHIBIT9.4 Tom's Wear,Inc. Balance Sheet At March 1 and March 31. 2006
March 3l Cash $ 3,995 Accounts receivable 2,000 Inventory 300 Prepaid insurance 75 Prepaidrent 0 .. Equipment (net of $100 accumulated depreciation) 3,900 March I March 31 March I Accounts payable Otherpayables...... I nte r e s t p a y a b l e . . . . . Notes payable Tota ] I i a b i l i t i e s . . . . . .

Comparative Balance Sheetfor Tom's Wear,Inc.

$6,695
IDU

$o

100 \25 0 0

$ 800 bU 0 30 0 3,000 0 $ 3,030 $ 850


5,000 2,240

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Common stock Retained earnings .. . Total liabilities and shareholder's equity

5,000 L,220 $7,070

Tot alas s et s

...$ 1 0 ,2 7 0 $ 7 ,0 7 0

$10,270

for Tom's Wear been $150 ($2,000 - $1,850).If you go back and look at the transactions during March (in Chapter 3), you will find $150 was exactly the amount of cash the company collected from customers. Continuing down the March income statement,the next item is cost of goods sold of $800. This is the cost of the merchandisesold during the month. How does that compare with the amount of cash paid to vendors during the month? Did Tom's Wear sell anything it bought the previous month from the beginning inventory; or did the company buy more goods in March than it actually sold in March? We need to look at what happenedto the amount of inventory during the month. The beginning inventory balance was $100. The ending inventory balance was $300. That meansTom's Wear bought enough inventory to sell $800 worth and to build up the inventory by an additional $200. Thus, purchasesof inventory must have been $1,000.Did Tom's Wear pay cashfor thesepurchases of inventory? To seehow the purchaseof $1,000 worth of inventory compareswith the cashpaid to vendors,we look at the changein accountspayable (to vendors).The beginning balancein accountspayablewas $800, and the ending balancewas zero.That meansTom's Wear must have paid $1,000 to vendors for the month's purchasesand the $800 owed from February. Thus, the total paid to vendorswas $1,800. The next expenseon the March 31 income statementis depreciationexpense.Depreciation expenseis a noncashexpense.That means we do not have any cash outflow when

CHAPTER 9 . PREPARI NG AND ANALYZI N GT H E S T A T E M E N T O F C A S H F L O WS

EXHIBIT9.5 Cashfrom Operating Activiti es-D i rect tVt-etn oa Tom's Wear,Inc. Parbial Statement of Cash Flows For the Month Ended March 31, 2006

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Cash from operating activities Cash collected from customers Cashpaidtovendors Cashpaidforadvertising Net increase (decrease) in cash from operating activities

150 (1,800) (50)

$(1,700)

we record depreciationexpense.The cash we spendto buy equipment is consideredan investing cash flow, and the periodic depreciationdoes not involve cash.Depreciation is one expensewe can skip when we are calculating cash from operating activities using the direct method. Insuranceexpenseof $50 is shown on the March 31 income statement. How much cash was actually paid for insurance?When a company pays for insurance,the payment is generally recorded as prepaid insurance.Examining the changein prepaid insurancewill help us figure out how much cash was paid for insuranceduring the month. Prepaid insurance started with a balance of $125 and ended with a balance of $75. Becausethe decreasein prepaid insuranceis exactly the sameas the insuranceexpense,Tom's Wear must not have paid for any insurancethis month. All the expensecame from insurancethat was paid for in a previous period. The last expensewe need to consider is interest expense.On the income statementfor March, we seeinterest expenseof $30. Did Tom's Wear pay that in cash?On the balance sheet,the companybeganthe month with no interestpayable and endedthe month with $30 interestpayable.If it startedthe month without owing any interestand endedthe month owing $30, how much of the $30 interest expensedid the company pay for with cash?None. Tom's Wear must not have paid any cash for interest becauseit owes the entire amount of the expenseat year-end. Tom's Wear paid out one more amount of cashrelatedto operating activities during the month. Can you find it? On the March I balancesheet,there is $50 that Tom's Wear owed; it is called other payables.By the end of March, that payablehas beenreducedto zero. Only one thing could have causedthat reduction: a cashpayment to settle the obligation related to advertising.Thus, we will also put the cashoutflow of $50 on the statementof cashflows. To summarize, we have "translated" the accrual amounts found on the income statement to cash amounts for the statementof cash flows. The cash collected from customers was $150.Tom's Wear paid its vendorscashof $1,800.It also paid $50 of other payables. Net cashflow from operatingactivities was $(1,700).The operating sectionof the statement of cash flows using the direct method is shown in Exhibit 9.5. Remember,Exhibit 9.5 shows only the cash flow from operating activities. To explain the entire changein cashfrom March 1 to March 31, the investing and financing cashflows must be included.

Your Turn 9-3


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FlexCompany beganthe year2005with $350of prepaid insurance. For2006, the company's income statement showedinsurance expense of $400. lf Flex Company ended the yearwith $250 of prepaid insurance, how muchcash was paidfor insurance during2006? On the statement of cashflows, how would that cashbe classified?

METHOD O F C A S H F L O WS :I N D I R E C T THE STATEMENT 9 . PREP A R I N G CHAPTER

435

Flows: of Cash Preparing the Statement lndirect Method


that companies Even though the Financial Accounting StandardsBoard (FASB) suggested use the direct method of preparing the statementof cash flows, more than 907oof companies use the indirect method. That is becausemost accountantsthink it is easierto prepare' the statementof cash flows using the indirect method. Also, the requirement that a company using the direct method provide a reconciliation of net income to net cash from operating activities meansmore work for the company using the direct method. Preparing the statementof cash flows using the indirect method-applied just to the operating section of the statementof cashflows-starts with net income. Following net income, any amounts on the income statementthat are noncashmust be added or subtracted to leave only cash amounts.Typical noncash items are depreciation and amortization expensesand any gains or losseson the sale of assets.Remember that a gain or loss on the sale of a long-term assetis not cash; it is the difference betweenthe book value of the asset and the proceedsfrom the sale.(We will include the proceedsfrom the salein the cashfrom investing activities section of the statementof cash flows.) We will start with net income for Tom's Wear for March. Exhibits 9.3 and 9.4 show the numberswe need to preparethe statementof cash flows using the indirect method. The net income for March was $1,020. The first adjustment we make is to add back any noncashexpensessuch as depreciation.For Tom's Wear, we must add back to net income the $100 depreciation expense.When we calculated the net income of $1,020, we subtracted$100 that was not a cash outflow. Thus, we must add it back to net income to changenet income to a cash number. Then, just as you did when you preparedthe statementof cash flows using the direct method, you will evaluateevery amount on the income statementfor its relationship to cash flows. Recall that in the direct method, we use changesin accountsreceivable to convert salesrevenueinto cash collected from customers,and we use changesin inventory and accounts payable to convert cost of goods sold to cash paid to vendors. For the indirect method, if we adjust net income for every changein eachcurrent asset-with the exception of cash-and every changein eachcurrent liability, we will make every adjustmentwe need to convert net income into net cash from operating activities. We will continue preparing the statementof cashflows using the indirect method with Tom's Wear for March. We start with net income of $1,020 and add back any noncashexpenses. Depreciation of $100 is addedback.Then,using Exhibit 9.4,we examineeachcurrent assetaccount and each current liability accountfor changesduring the month. salesfor which we represents increased by $1,850.That increase Accountsreceivable did not collect any cash yet. Thus, we need to subtractthis increasein accountsreceivable from net income to convert net income into a cashnumber. in inventoryof $200.This $200 repis the increase The next changein a current asset resentspurchases made that have not yet been reported as part of cost of goods sold on the income statement because the items havenot beensold. Still, Tom's Wear did pay cash (we cash was paid and make any adjustment when we examine acfor them will assume payable), amount needsto be deductedfrom net income becauseit was a counts so the cash outflow. from $125 to $75. This decreaseof $50 was deductedas Prepaid insurancedecreased insuranceexpenseon the income statement,but it was not a cash outflow this period. This amount must be addedback to net income becauseit was not a cash outflow The last changesin current assetsald current liabilities are the changesin payables. Tom's Wear started the month with $800 of accountspayable and $50 of other payables. Tom's Wear ended the month with a zero amount of each of these.That means $850 was the cashoutflow related to thesetwo amounts.The other current liability is interestpayable. It started the month with no interest payable but ended the month with $30 of interest payable. That is $30 Tom's Wear did not pay out. So the total changein current liabilities is a net decreaseof $820. This $820 amount was not included on the income statementnot deductedin the calculation of net income. Becausethe amount was a cash outflow, we

L"#.5 Preparethe cashflows from ope rati n g activities section of the statementof cash flows usingthe indirect method.

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CHAPTER 9 . PREPARI NG AND ANALYZI N GT H E S T A T E M E N T o F C A S H F L o Ws

EXHIBIT9.5 Cashfrom Operating ActivitiesIndirect Method Tom's Wear, Inc. Partial Statement of Cash Flows For the Month Ended March 31, 2006

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Net income + Depreciation expense - Increase in accounts receivable - Increase in inventory + Decrease in prepaid insurance - Decrease inpayables Net cash from operating actMties

$ 1.020 100 (1,8b0) .. (200) 50 (820)* $(1,700)

*This is comprised payableof $800, ofthe decrease in accounts the decrease in other payables for $50,andthe increase in interestpayable for $30. needto deduct an additional $820 from net income to finish converting net income into cash from operating activities. Look at the operating section of the statementof cash flows for Tom's Wear for March in Exhibit 9.6. The statementstartswith net income and makes all the adjustmentswe discussed.Compare the cash from operating activities section of this statementof cash flows preparedusing the indirect method with the samesectionusing the direct method shown in Exhibit 9.5. The net cash flow from operating activities is the sameno matter how we prepare it-when we preparethe statementby examining every cash transaction,as we did in Chapter 3; when we prepareit using the direct method, as we did earlier in this chapter;and when we prepareit using the indirect method, as we just did. Which way is easierto understand?The presentationproduced by the direct method-the presentation shownin Exhibit 9.5-gives detailsabout cashthat are easierto understand than the details provided by the indirect method. Still, over 90Voof companies today use the indirect method.A changein this practicecould be a real benefit to usersof financial statements.

Your Turn 9-4


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Suppose a company had net income of $50,000 for the year.Depreciation expense, the only noncash item on the income statement, was $7,000. Theonly currentassetthat changed during the year was accounts receivable, which beganthe yearat $6,500 and endedthe yearat $8,500. Theonly currentliapayable, bilitythat changed was salaries whichbeganthe yearat $2,500 and endedthe yearat $3,000. Assume this is all the relevant information. Calculate net cash from operating activities usingthe indirect method.

[,.(J.6 Preparethe cashflows from i nvesting activities section and the cashflows from f i na nci ng activities section of the statementof cash f lows.

Cash from Investing andFinancing Activities


In addition to cash from operating activities, there are two other sectionsof the statement of cash flows: cash from investing activities and cash from financing activities. No matter which method you use to prepare the statementof cash flows, direct or indirect, the cash from investing activities and cash from financing activities sectionsare preparedthe same way-by reviewing noncurrent balance sheet accounts.The primary amounts on the balance sheet to review are property, plant, and equipment; notes payable; bonds payable; common stock; and retained earnings. For Tom's Wear during March, start in the noncurrent assetssection of the balance sheet.The balancesheetat March 31 shows equipment with a cost of $4,000. The carrying value is $3,900 and the accumulateddepreciationis $100, for a total cost of $4,000.The asset representingthis equipment was not on the March I balance sheet,so Tom's Wear must havepurchased$4,000 worth of equipmentduring March. The purchaseof equipmentis an investing cash flow.

. S U MMA R Y ME T TH OD S 437 TN D IN D IR E C OF D IR E CA 9R CH A P TE When we see that a company purchaseda noncurrent asset,we must investigatehow the company paid for the asset.In this case,we find that Tom's Wear paid cash of $1,000 and signed a note for $3,000.We include only the $1,000 cash outflow in the statementof cash flows, but we must add a note disclosing the amount of the equipment purchasefinancedby the note payable. All investing and financing activities must be disclosed,even if there was no cash involved. in non-operatingliNext we review the liabilify sectionof the balancesheetfor changes abilities. Notice that on the balancesheetat March 1, Tom's Wear showsno notes payable. On thebalancesheetatMarch 31, notespayableshowsabalanceof $3,000.ThatmeansTom's Wear borrowed $3,000 during March. Again, when we discoversucha change,we must find out the details ofthe transactionbefore we can decidehow the transactionaffectsthe statement of cashflows. Generally,borrowing money using a note would result in a financing cash inflow. However,in this case,the note was given in exchangefor equipment.Notice that the loan is disclosed,even though the amount is not included on the statementof cash flows. in a financing or investingactivity, it must be disclosedon the Whenevera companyengages statementof cash flows, even though the company never actually received or paid out any It is asif Tom's Wearreceivedthe cash implicit in the transaction. cash.The cashis considered from the loan and immediately turned around and purchasedthe equipment with it. Other transactionswe should look for when preparing the financing section of the statementof cash flows include any principal payments on loans and any new capital contributions-such as stock issued. We should also look for any dividends paid to the stockholders.For Tom's Wear for March 2001, none of thesetransactionstook place. When we put the information about investing activities and financing activities with the cash from operating activities we have already prepared,we have all the information we need in Exhibit 9.7. We used to completethe statement of cashflows. Look at the two statements different methods to preparethe statements,but they are similar in form and amounts. Check it out. The balance sheetsin Exhibit 9.4 show that cash went from $6,695 on in cash.Explaining March 1 to $3,995 on March 31. The differenceis a $2,700 decrease that changein the cash balanceis the purpose of the statementof cash flows.

Methods andIndirect Summary of Direct


There aretwo ways, both ways acceptableusing GAAR to prepareand presentthe statementof cashflows: the direct method and the indirect method. The direct method provides more detail about cashfrom operating activities. It showsthe individual operating cashflows. When a company usesthe direct method, GAAP requires that the company also show a reconciliation of net

EXHIBIT9.74 Tom's Wear,Inc. Statement of Cash Flows For the Month Ended March 31, 2006 Statement of Cash Flows (Direct)

Cash from operating activities Cash collected from customers Cash paid to vendors Cash paid for other expenses Net cash from operating activities Cash from investing activities Purchase ofequipment Net cash from investing activities Cash from financing activities Net increase (decrease) in cash Beginning cash balance Ending cash balance

150 (1,800) (50)


$(1,700)

tom'swGal

$(1,000)' (1,000) 0 $(2,700) 6'995 $ 3,995

;;$fifrffilr*

i; ;t;;,i fff $;bbdfi;ffii$;iffi; $4;0txt:ffi;1;

$i;"ffiii:'-

438

O F C A S H F L O WS CHAPTER 9 . PREPARI NG AND ANALYZI NGT H E S T A T E M E N T

EXHIBIT9.78 Statement of Cash Flows (lndirect) Tom's Wear,Inc. Statement of Cash Flows For the Month Ended March 31, 2006

t0m's weal

Cash from operating activities Net income + Depr ec iat ion e x p e n s e ............... - Increase in accounts receivable - Increase in inventory + Decrease inprepaid insurance payables in [ tPaJ o ur sD - u Decrease sLrc@c .. .. .. Net cash from operating activities Cash from investing activities Purchase ofequipment Net cash from investing activities Cash from frnancing activities Net increase (decrease) in cash Beginning cash balance Ending cash balance

$ 1,020 100 (1,850) (200) 50 r.c20)

$(1,700)
(1,000)a

(1,000) 0 $(2,700) 6,995 $ 3,995

A note was signedfor $3,000 waspurchased for $4,000. and cashpaid was $1,000. "Equipment income to net cash from operating activities in a supplemental schedule.That reconciliation looks exactly like the operating sectionof the statementof cashflows using the indirect method. The indirect presentationof the statementof cashflow is easierto preparefrom the income statementand the beginning and ending balancesheetsfor the period, but the presentation of the information is not easily understood.A company that usesthe indirect method disclosuresfor cashpaid for interestand cashpaid for taxessomewhere must make separate in the financial statements. This is required by GAAP. Keep in mind that the investing activities and the financing activities sectionsfor the two methods are identical; and the total net cash flow is the samefor both methods.

L.O.7 general Perform analysis of the statement flows of cash andcalculate freecash flow.

YourKnowledge: Applying Analysis Financial Statement


Look at the statementof cash flows for Auto Zone Inc., shown in Exhibit 9.8. First, notice The statementhas the three required parts: (1) cashflows the organizationof the statement. from operatingactivities, (2) cashflows from investingactivities, and (3) cashflows from financing activities. Second,notice the first section-cash provided by operatingactivitiesis preparedusing the indirect method. The statementstafts with the amount for net income and makes severaladjustmentsto that amount. Look at the adjustmentsand seeif you understandwhat information they provide. For example, depreciation and amortization are addedback to net income to work toward net cash from operating activities becausethe amounts for depreciation and amortization were subtractedin the original computation of net income but they were not cashexpenditures.That subtraction is undoneby adding the amountsbackto net income. There are many other adjustments that arebeyond the scopeofan introductory accounting course,but you should understandwhy theseadjustmentsarebeing made.They are "undoing" the noncashamountsthat were included in the calculation of net income. Investors are looking for a positive net cashflow from operating activities. In the long run, this is crucial for the continuing successof any business. The cash flows from investing activities section of the statementshows capital expenditures as the fust entry. Those are items such as property, plant, and equipment.Recall the discussionin Chapter4 about capital versusrevenueexpenditures-capitalizing a cost versus expensing a cost. These are costs that have been capitalizedby Auto Zone. Other entries in the cash flows from investins activities section include cash inflows and outflows

. APPL Y I N G ANALYSIS STATEMENT : INANCIAL Y O U R K N O WL E D G EF CHAPTERg

439

EXHIBIT9.8 AutoZone Statement of Cash Flows AutoZone's Statement of Cash Flows


This statementof cash flows has been preparedusing the indirect method.
YearEnded August28, August27, 2005 2004 (52 Weeks) (52 Weeks)

(in thousands)

Cash flows from operating activities: $ 571,019 $ 566,202 Net income Adiustments to reconcile net income to net cash provided by operating activities: 135,597 106,891 Depreciation and amortization of property and equipment . . 2t,527 Deferred rent liability a{iustment 2,343 4,230 Amortization of debt origination fees 24,339 31,828 Income tax benefit realized from exercise of options (42,094) (1,736) Gains from warranty negotiations Changesin operating assets and liabilities: (16,628) M,498 Deferred income taxes (42,485) 3,759 Accounts receivable (t24,566) (119,539) Merchandise inventories 109,341 43,612 Accounts payable and accrued expenses (67,343) l8 32,1 Income taxes payable (25,637) 29,186 Other, net 648,083 638,379 Net cash provided by operating activities Cash flows from investing activities: (283,478) (184,870) Capital expenditures (3,090) (11,441) Acquisitions 3,797 2,590 Proceeds from disposal of capital assets (282,771) (r93,72r) Net cash used in investing activities Cash flows from financing activities: (304,700) 254,400 Net change in commercial paper . 300,000 500,000 Proceeds from issuance of debt (431,995) RePaS''rnent of debt 33,552 64,547 Net proceeds from sale of common stock (426,852) (848,102) Purchaseof treasurystock ... 32,L66 Settlement of interest rate hedge instruments . . (34e) (e2e) Other (367,354) (460,908) Net cash used in financing activities (2,042) (16,250) Net increase (decrease) in cash and cash equivalents 76,852 93,102 Cash and cash equivalents at begirming of year Cash and cash equivalents at end of year Supplemental cash flow information: Interestpaid, net ofinterest cost capitalized . . . . Income taxes paid
gee Notes to Consoli,tl,qted, FiMrci,al Statemmts,

q___48!_$

76,852

$ 98,937 $ 77,871 $ 339,245 $ 237,010

related to the purchaseand sale of long-term assetsnot related to the normal operationsof AutoZone. (When AutoZone buys the items that it resells in the normal courseof business, the cash flows are included in the frrst section-cash provided from operating activities.) The cashflows from investing activities section of the statementof cashflows gives information about the company's plans for the future. Investmentsin property, plant, and equipmentmay indicate an expansionor, at the very least,a concernabout keeping the company's infrastructure up to date. Over time, a company's failure to invest in the infrastructure may indicate a problem. The cash flows from financing activities section of the statementof cash flows shows the cash flows related to the way the company is financed. Some of the items should be

440

CHAPTER 9 o PREPARI NG AND ANALYZI N GT H E S T A T E M E N T O F C A S HF L O WS

Freecashflow is equal to net cashfrom operatingactivities min usdivide nd s a nd m inus capitalexpenditures.

recognizable-proceeds from issuance of debt and proceeds from the sale of common stock. All of the items in this section relate to AutoZone's financing. This information, when combined with the information on the balance sheet, gives the financial statement user a complete picture of the way the company is financing the business. We should consider two more characteristicsof the statement.First, following the calculation of the net increase or decreasein cash for the year, the reconciliation from the year's beginning cashbalanceto the year's ending cashbalanceis shown. Second,there is supplementaryinformation disclosedconcerningthe cashpaid for interestand the cashpaid for taxes during the year. This is required by GAAP. When analyzing the statementof cashflows, managersand analystsoften calculatean amount called free cash flow. Free cashflow is defined as net cashfrom operatingactivities minus dividends and capital expenditures. This gives a measureof a firm's ability to engage in long-term investmentopportunities.It is sometimesseenas a measureof a company'sfrnancial flexibility. AutoZone's free cash flow is quite adequate:$648 million - $283 million = $365 million. Looking over the capital expenditures for the past 2 yeus, you can see that $365 million should be enough for new investmentopportunities.

Your Turn 9-5


$kpwp'mffiw*ww.p,ry

DRP Company reported net cash from operating activities of $45,600. Suppose the firm purchased worth of new long-term assets for cash $25,000 anddid not payanydividends duringthe year. Thefirm'saverage current liabilities for the yearwere $40,000. Whatwas the firm'sfreecash flow duringthe year?

m, )w:cwww# w,%T ffii,y,Jw) il-,l'dffiu si ne ss


The CashConversion Cycle
Youhave " butthere heard theoldadage that"cash rsking, is a broader position wayof thinking abouta firmscash thansimply looking at itscash balance. Asyoulearned in thesecond chapter of thisbook, liquidity refers to anasset's proximity to cash. According to Richard Loth("The Working Capital Position," Investopedia.com, August 4, 2006), it isactually liquiditythat isking,Hesays that A liquiditysqueeze is worse than a profit squeeze. A key management functionis to makesurethat a company's receivable and inpositions ventory are managed efficiently. This means ensuring an adequate levelof product availability and providingappropriate credit terms, whileat the same timemaking sure that working capitalassets don't tie up undue amounts of cash.Thisis a balancing act for managers, but an important one.lt isimportant because with highliquidity, a company cantake purchases, advantage of price discounts on cash reduce short-term borrowings, benefit from a top commercial creditratingand take advantageof market opportunities. position A firms liquidity can be measured by its cash conversion cycle. Thatis the length of time,in days, it for a firmto convert takes itsresource inputs intocash. This measurement isthesumof 1 and2 minus 3: 1. Theaverage number of days inventory isoutstanding,calculated fromthe inventory turnover ratio; 2. Theaverage number of days accounts receivable are outstanding, calculated from the accounts receivableturnover ratio; and 3. Theaverage number payable of days accounts are outstanding, calculated from the calculation of acpayable counts turnover. Next time you are analyzing a firm'sfinancial statements, lookup someinformation on the cash conversion cycle. lt could help you uncoverimportant information about how efficiently a firm is usingits working capital.

. B U S IN E S RS IS KC . ON TR OL, A N D E TH IC S 41 9R C H A P TE The statementof cashflows is a crucial pafi of the hnancial reporting for any company. Often creditors and investorswill look at this statementflrst when they are analyzing the financial condition of a firm. For the firm, however,the importance of the statementof cash flows is tied to the cashbudget and how the actual sourcesand usesofcash compareto the budgetedamounts.This analysis is an important function of managerialaccounting. The statementof cash flows provides important information for managers,creditors, and investors. In corporate annual reports, the statement of cash flows is presentedwith the other three basic financial statements-the income statement,the balance sheet, and the statementof changesin shareholders'equity-to provide information neededto evaluate a company's performance and to provide a basis for predicting a company's future potential.

andEthics Business Risk, Control,


In Chapter 6, you learned about the controls a company should have to minimize the with the risks associatedwith cash. Now we will talk about investors'risks associated that have been at the heart statementof cashflows. The misleading financial statements of such failures as Enron and WorldCom have been the income statement and the balance sheet.Managerscan rarely falsify cash inflows and outflows, so few people think of this statementas a place where the ethics of a firm's managementcould be tested. However, managerscan manipulate the classification of the cash flows. BecauseanaIysts are often looking for positive net cash flows from operating activities, especially in establishedcompanies,a firm's managersmay feel some pressureto make sure that this part of the statementof cash flows is positive. There is an opportunity to engagein the same type of manipulation as WorldCom did when it classified expensesthat beon the balancesheet.Someonecould as long-term assets longed on the income statement misclassify cash outflows from operating activities as investing cash outflows. This are the costsof doOperating expenses changesthe whole nature of such expenditures. ing business,so investorswant to see a low number. Investing cash outflows are often interpretedas a positive signal for future growth of the firm, so investorswant to see a high number. careThere is a greatdeal of information in the statementof cashflows, and it deserves As with the inforful considerationwhen you are analyzing a firm's financial statements. mation provided by the other financial statements,the statementof cash flows provides reliable information only when the firm's managementis ethical.

t,"&.8
Usethe statementof cash flows and the related controlsto evaluatethe risk of i nvesti ng i n a fi rm.

lt BeManipulated? Cash from Operating Activities-Can


thatcannot be manip- I asthe onestatement Thestatement flowsisoftencited of cash itscash from a firmcanincrease there areways ulated. Afterall,cash iscash. However, securitization of aclt is called a boost. if it needs operating activities on shortnotice the its receivables, classifying against borrows counts receivable.lt iswhena company In but it maybe misleading. by GAAP, inflowasan operating activity. lt isallowed cash to thefrnanthe notes flow.Besure to read cash manyways, it ismorelikea financing be asobvious as something that should whenyouareanalyzing cialstatements, even I cash
R "QuickCa s hv iaRec eiv ables Deals CanLea v e a B l u P r irc ytF uirs e c,a "b l yMicha ea l p o p o r tI,h e [ So urce:

,/
-

-- -- '

:::i ::: : :: : ::':i-'il --:

442

CHAPTER 9 o PREPARI NG AND ANALYZI N GT H E S T A T E M E N T o F c A s H F L o WS

Chapter Points Summary


The statementof cash flows explains the changein cash from the beginning of the accounting period to the end of the accountingperiod-the amount on one balancesheet and the amount on the subsequent balance sheet. Cash flows can be categorizedas cash from operating activities, cash from investing activities, and cashfrom financing activities. The statementof cashflows has a section for eachof thesecategories. There are two methods-direct and indirect-for preparing and presenting the statement of cash flows. The direct method simply provides all operating cash inflows and outflows in a straightforward manner.The indirect method startswith net income and adjusts it for all noncashitems-depreciation expenseand gains or losseson the sale of long-term assetsare typical noncashitems. It also adjustsfor changesin the current (excluding cash) and the current liabilities. Thesetwo methodsdescribethe cash assets from the operating activities section of the statement.The other two sections-cash from investing activities and cash from financing activities-are the same on both types of statementsof cash flows. Freecashflow is the amountof cashleft after cashspenton investments in long-term assetsand cashpaid for dividendsare subffactedfrom net cashfrom operatingactivities.It measures how much casha firm has availablefor long-term investmentopportunities. Before you invest in a firm, look at its statementof cash flows. A growing or established firm should be generatingpositive net cash flows from operating activities. Investing cash flows may provide insights into the firm's plans for the future. Be sure to look at the firm's cash situation over severalyears and also comparethe firm's sources and usesof cashto thoseof the competitors.

Chapter Summary Problems


SupposeAttic Treasures,a retail store, provided you with the following comparative balance sheetsand the related income statement.(Notice the most recent year is in the right column.) Assumethe firm did not purchaseany property,plant, and equipment(PP&E) during the year.

At

J anuar y 30,2008

J anuar y 29,2009

Assets Cash .. Accounts receivable Merchandise inventory Pr epaidr en t . . . Property, plant, and equipment (PP&E) Accumulated depreciation

$ 23,000 12,000 25,200 6,000 79,500 (24,000)

$ 39,200 23.450 28,100 5,500 70,000 (29,000)

Totar assets
Liabilities and Shareholders' Equity Ac c ount s p a y a b l e. . . . . Income taxes payable Long-terrn notes payable Common stock and additional paid-in capital Retained earnings Total liabilities and shareholders' equity

$-tztroo

stsz.zso

$ 12,300 $ 26,200 i0,000 8,r00 39,700 25,800 18,500 20,000 4r,200 57,r50 $121,700 $137,250

Attic Treasures IncomeStatement For the year endedJanuary29,2009


sales . Costofg oo ds s old. . . Gross margin Sellin ge xp en s es . . . . . General expense* Incomefromoperations..... Interest expense Income before income taxes . Income tax expense Net income
* includes rent expense of $2,000 md depreciation experoe of $6,000

$234,900 178,850 56P50 $24,000 8,500 32,500 23'550 f,200 22,350 3,400 $ 1q950

Instructions
Preparea statementof cash flows. Your instructor will tell you whether to use the indirect method or the direct method (or both). Solutions for each are provided.

Solution Direct Method


To preparethe cash from operating activities section using the direct method, go down the income statementand convert the accrual amounts to cash amounts by referring to the related current assetor current liability account. 1. Convert sales to cash collectedfrom customers. Sales: $234,900. (AR) from $12,000to $23,450 : $11,450. Increase in accounts receivable The increasein AR is the amount of salesAttic Treasuresdid NOT collect in cash, so is $234,900- $l1,450 = 9223,450. the cashcollectedfrom customers First, convert This takestwo steps. 2. Convertcost of goodssoldto cashpaid to vendors. cost ofgoods sold to total purchases. Costof goodssold = $178,850. Increase in inventoryfrom $25,200to $28,100: $2,900of additionalpurchases. The increasein inventory is added to the cost of goods sold to get total purchases= to cashpaid to vendors. $ 178,850+ $2,900: $18 1,750.Then,converttotal purchases : $181,750. Total purchases purchases Increasein accountspayableof $12,300to $26,200 : $13,900represent that did not get paid for, so cashpaid to vendors= $181,750- $13,900 : $167'850. Becausethere are no curto cash paid for selling expenses. 3. Convert selling expenses (such as accruedselling exrent assetsor current liabilities related to selling expenses penses),Attic Treasuresmust have paid cash for this entire amount. So cash paid for : $24,000. selling expenses 4. Convert general expenses to cashpaid for general expenses. : and $6,000depreciaGeneralexpenses $8,500.This includes$2,000rent expense follows: general as expenses down the tion expense.So we could break Rent expense $2,000 Depreciation expenses $6,000 Other expenses $ 500 to First, rent expenseis related prepaid rent on the balance sheet. Prepaid rent decreasedfrom $6,000 to $5,500. This meansthe company used rent it had already (last

44

CHAPTER 9 o PREPARI NG AND ANALYZI N GT H E S T A T E M E N T O F C A S H F L O WS

year) paid for, so the decrease in prepaid rent reducesthe rent expenseby $500 to get cashpaid for rent : $2,000 - $500 : $1,500. Depreciation expenseis a noncashexpense,so there is no cashflow associated with it. Other expensesof $500 must have been all cash becausethere are no associatedcurrent assetsor current liabilities on the balance sheet.So the total cashoaid for seneral e x p e n s e:s $1.500+ 5500: $2,000. Change interest expense to cashpaidfor interest. Interestexpense: $1,200. This must have been all cashbecausethere were no current assetsor current liabilities associated with it. Cashpaid for interest: $1,200. 6. Change income tax expenseto cashpaid for taxes'. Income tax expense: $3,400. Decrease in incometaxespayablefrom $10,000to $8,100 : $1,900,which represents additional taxesthe company paid beyond the income tax expenseon the income statement. Cashpaid for income taxes : $3,400 + $1,900 : $5,300. .You have now convertedall the income statementitems to cash inflows and outflows and are ready to preparethe first part of the statementof cash flows. Cashfrom operating activities Cashcollectedfrom customers Cashpaid to vendors C a s hp a i d fo r sel l i ngexpenses Cashpaid for generalexpenses Cashoaid for interest Cashpaid for incometaxes Net cashprovided by operating activities

$223,4s0 (167,8s0) (24,ooo) (2,000) (1,200) (s,300) $ 23,100

Next, calculatecashfrom investingactivities.An analysisof long-term assets shows that property,plant, and equipmentdecreased by $9,500.A decrease is caused by disposing of assets. Because the income statement showedno gain or loss from disposal of long-term assets,the assetsmust have been sold for book value. The property, plant, and equipmentaccountdecreased by $9,500 (the cost of the PPE sold) and the accumulated depreciation accountincreased by $5,000.Recall from the income statement that depreciation for the year was $6,000.If accumulated expense depreciation only increasedby $5,000, then $1,000 must have been subtracted. That meansthe PPE sold had a book value of $8,500 ($9,500 - $1,000).Because there was no gain or loss on the disposal,the companymust have receivedproceedsequal to the book value.So the cashinflow-proceeds-from disposalof PPE was an investingcashinflow of $8,500. 8. To calculate the cash flows from financing activities, analyze what happenedin the long-term liability accountsand the shareholders'equity accounts. Long-term notes payabledecreased from $39,700to $25,800.That must have been a cashoutflow of $13,900.Common stockand additionalpaid-in capitalincreased by $1,500.That must have been a cash inflow from the issue of stock of $1,500. Lastly, seeif the company paid any dividends during the year. Retained earnings increased from 941,200 to $57,150: $15,950.How doesthat compareto net income?Net income was $18,950 but retainedearningsonly increased by $15,950,so $3,000 must have been declared as dividends.The absence of dividends payable indicatesthat the dividends were paid. You are now ready to put the whole statementtogether using the direct method.

C H A P T E9 R . K E Y T E R M SF O RC H A P T E R 9

445

Attic Treasures Flows-DirectMethod Statement of Cash 29,2OO9 Forthe yearendedJanuary


Cashfrom operating activities Cashcollectedfrom customers Cashpaid to vendors Cas hpaid f or s e l l i n ge x p e n s e s Cashpaid for generalexpenses Cashpaid for interest Cashpaid for incometaxes Net cashprovided by operating activities Cashfrom investingactivities Cashproceeds from saleof property,plant and equipment Cas h f r om f inan c i n ga c ti v i ti e s Cas hpaid on lo a n p ri n c i p a l Cashproceeds from stock issue Cas hpaid f or di v i d e n d s Net cashusedfor financing activities Net inc r eas e in c a s hd u ri n g th e y e a r Cas hbalanc e, b e g i n n i n go f th e y e a r E ndingc as hbal a n c e

5223,4s0 (167,8s0) (24,ooo) (2,000) (1,200) (s,300) 23,100 8,s00 (13,900) 1,500 (3,000) (1s,400) 16,200 23,000 $ :g,zoo

lndirectMethod
To preparethe statementusing the indirect method, start with net income. Adjust it for any noncashexpenses and the changein every current asset(excluding cash) and every current Iiability. The other two sections-cash from investing activities and cash from financing activities-are the sameas for the direct method.

Attic Treasures of CashFlows-lndirectMethod Statement 29,2009 Forthe yearendedJanuary


Cashfrom operating activities N et inc om e Add depreciationexpense Deduct increase in accounts receivable Deduct increase in inventory Add decrease in prepaid rent payable Add increase in accounts Deductdecrease in incometaxes payable Net cashprovided by operating activities Cashfrom investingactivities Cashproceeds from saleof property,plant and equipment Cas h f r om f inanc i n ga c ti v i ti e s C as hpaid on lo a n p ri n c i p a l Cashproceeds from stock issue C as hoaid f or di v i d e n d s Net cashusedfor financing activities Net inc r eas e in ca s hd u ri n g th e y e a r C as hbalanc e, b e g i n n i n go f th e y e a r E ndingc as hbal a n c e

$ 18,9s0 6,000 (11,4s0) (2,900) s00 13,900 (1,900)

8,500 (13,900) 1,500 (3,000) (1s,400) 16,200 23,000 $ 3e,2oo

KeyTerms for Chapter 9


Direct method (p. 429) Free cash flow (p. 440) Indirect method @.429)

446

CHAPTER O F C A S H F L o Ws 9 o PREPARI NG AND ANALYZI N GT H E S T A T E M E N T

TURN Answers to YOUR Questions


Chapter 9 Your Turn 9-1
The differenceis in the cashflows from operatingactivities.The direct methodidentifieseach cashflow, whereasthe indirect method startswith net income and adjustsit to a cashamount. The net cashflow from operatingactivities is the sameno matter which method is used.The other two sections-cash from investing activities and cash from financing activities-are identical with both methods.

Your Turn9-2 : $60,000. - $15,000) + ($25,000 $50,000


This is a cash flow from operating activities.

YourTurn 9-3 : $300. - ($350 - $2s0) $400


This is a cash flow from operating activities.

Your Turn9-4
Begin with net income and add back depreciation expense: $50,000 + $7,000 : $57,000. Then. subtractthe $2,000 increasein accountsreceivable.Saleson account were included in net income but should be deductedif the cashhas not been collected. Next, add the $500 increasein salariespayable. Some of the salariesexpense,which was deductedon the income statement,was not paid at the balance sheetdate.

: - s2,000 + $500 + $7,000 $50,000

$55,500 net cash from operating activities.

YourTurn 9-5
- Purchaseoflong-termassets - Dividends: Freecashflow: Netcashfromoperations

: $20,600. - $25,000 $4s,600 Questions


1. What is the purposeof the statement of cashflows? 2. Which two financial statementsare required to preparethe statementof cash flows? 3. Describe the three categoriesof cash flows that explain the total change in cash for the year. 4. Why is the statementof cash flows so important? 5. What are the two traditional approaches for preparing and presentingthe statementof cashflows? What is the difference between thesetwo approaches? 6. Which types of businesstransactionswould result in cash from operating activities? Give three examplesof transactionsthat would be classified as cash flows from operating activities. 7. Which types of businesstransactionswould result in cash flows from investing activities? Give three examplesof transactionsthat would be classified as cash flows from investing activities. 8. Which types of businesstransactionswould result in cash flows from frnancing activities? Give three examplesof transactionsthat would be classified as cash flows from financing activities. 9. How is depreciation expensetreated when using the direct method of preparing the statementof cash flows? When using the indirect method? 10. Which account(s)must be analyzedto determine the cash collected from customers? How is this cashflow classified? 11. Which account(s)must be analyzedto determinethe proceedsfrom the sale of a building? How is this cash flow classified? 12. Which account(s)must be analyzedto determinethe cashpaid to vendors?How is this cash flow classified? 13. Which account(s)must be analyzedto determine the cash paid for dividends?How is this cashflow classihed?

. MU LTIP LE -C H OIC C H A P TE 9R QUE E S TION S 447 14. How is interest collected or interest paid classihed on the statementof cash flows? 15. Define free cash flow and explain what this amount indicates about a frm. 16. How might a firm misusethe statementof cashflows to give investorsa better impression of the firm's operations? Multiple-Choice Questions Use the following information to answer Questions 1-3. Quality Productsengagedin the following cash transactionsduring May. Purchaseof inventory Cash proceedsfrom loan Cash paid for interest Cash collected from sales New stock issued Salariespaid to employees Purchaseof new delivery van

$ s,000 $ 7,000 $ 400 $26,500 $25,000 $ 4,600 $20.000

Note: Answers in parentheses indicate net cash outflows. 1. How much is net cashfrom financins activities? a. $ 7,000 b. $25,000 c . $31, 600 d. $32,000 2. How much is net cashfrom investinsactivities? a. $(20,000) b. $(25,000) c. $ 25,000 d. $ 32,000 3. How much is net cash from operating activities? a. $26,500 b. $ (3,s00) c . $16, 500 d. $16, 900 4. Cash from the sale of treasury stock a. Would not be included in the statementof cash flows b. Would be classified as a contra-equity cash flow c. Would be classified as an investing cash flow d. Would be classified as a financing cash flow 5. The cash proceedsfron the sale of a building will be a. The cost ofthe building b. The book value of the building c. The book value plus any gain or minus any loss d. Shown on the financing portion of the appropriatefinancial statement 6. If a firm has net investing cash inflows of $5,000, net financing cash inflows of in cashfor the year of $12,000,how much is net cashfrom $24,000,and a net increase operating activities? a. Net cashinflow of $17,000 b. Net cashinflow of $29,000 c. Net cashoutflow of $17,000 d. Net cashoutflow of $19,000 7. Depreciation for the year was $50,000 and net income was $139,500. If the company used cash for all transactionsexcept those related to long-term assets, how much was net cash from operating activities? a. $139, 500 b . $189, 500 c. $ 89,500 d. Cannot be determinedfrom the eiven information

Use the following information to answer the next three questions. The income statementand additional datafor FrancesCompany for the year endedDecember 31. 2006. follows Salesrevenue Costof goodssold Salaryexpense Depreciationexpense Insuranceexpense Interestexpense Income tax expense Net income $400,000 $165,000 $ 70,000 $ 55,000 $ 20,000 $ 10,000 $ 18,000 $ 62,000

by $6,000and accounts by $12,000.Inventoriesincreased decreased Accountsreceivable inpayableincreased by $8,000.Prepaidinsurance payabledecreased by $2,000.Salaries creasedby $4,000. Interest expenseand income tax expenseequal their cash amounts. FrancesCompany uses the direct method for its statementof cash flows. 8. How much cash did FrancesCompany collect from customersduring 2006? a. $400,000 b. $412,000 c. $406,000 d. $388,000 9. How much cashdid FrancesCompanypay its vendorsduring 2006? a . $ 1 7 3 ,0 0 0 b. $165,000 c. $167,000 d . $ 1 6 3 ,0 0 0 during the year? 10. How much cashdid FrancesCompanypay for insurance a. $20,000 b. $24,000 c. $16,000 d. $48,000

ShortExercises (LO1) Identify cashflows. SE9-1.


Given the following cash transactions,classify each as a cash flow from: (a) operating activities, (b) investingactivities,or (c) financing activities. a. Paymentto employeesfor work done b. Dividendspaid to shareholders c. Paymentfor new equipment d. Payment to supplier for inventory e. Interest payment to the bank related to a loan SE9-2. Identfu cashflows. (LO 1) classifyeachas a cashflow from: (a) operatingacGiven the following cashtransactions, tivities, (b) investing activities, or (c) financing activities. a. Principal payment to the bank for a loan to whom saleswere previouslymade on account b. Collectionfrom customers for cashsales c. Collection from customers d. Collection for sale of land that had been purchasedas a possible factory site e. Petty cash used to pay for doughnutsfor staff SE9-3. Calculate and identifi cashflows. (LO I , 3, 4) College Television Company had supplies on its balance sheet at December 31,2006, of $20,000.The income statementfor 2001 showedsuppliesexpenseof $50,000.The balance on acwere purchased sheetat December3I,2001 , showedsuppliesof $25,000.If no supplies how much cashdid CollegeTelevisionCompanyspendon supcount (all were cashpurchases), of cashflows? plies during 2001?How would that cashoutflow be classifiedon the statement

. 9S H OR T C H A P TE R E X E R C IS E S M9 SE9-4. Calculateandidentifi cashflows. (LO I,3,4) Col Corporation reported credit salesof $ 150,000 for 2006. Col's accountsreceivablefrom saleswere $25,000 at the beginning of 2006 and $38,000 at the end of 2006. What was the amount of cash collected from salesin2006? How would the cash from this transactionbe classified on the statementof cash flows? SE9-5. Calculate and identify cashflows. (LO 6) A building cost $55,000and had accumulated depreciation of $15.000when it was sold for a gain of $5,000. It was a cash sale.How would the cash from this transactionbe classified on the statementof cash flows? SE9-6. Calculate and identify cashflows. (LO 1, 3, 4) Salesfor 2008 were $50,000;cost of goods sold was $35,000.If accountsreceivableinpayabledecreased creased by $2,000, by $2,000,inventorydecreased by $1,300,accounts and other accruedliabilities decreased by $1,000, how much cash was paid to vendors and suppliers during the year? How would the cash from this transaction be classified on the statementof cash flows? SE9-7. Calculate and identifu cashflow. (LO I, 3, 4) During 2007,Cameron in credit sales. Companyhad $300,000in cashsalesand $3,500,000 The accounts receivable balances were $450,000and $530,000at December31, 2006 and 2007, respectively.What was the total cashcollected from all customersduring 2007? How would the cash from this transactionbe classified on the statementof cash flows? SE9-8. Evaluate adjustmentsto net income using the indirect method. (LO 5) The income statementfor Lilly's Company for the year endedJune 30, 2008, showedsales of $50,000.During the year,the balancein accounts receivable increased by $7,500.What adjustmentto net income would be shown in the operating section of the statementof cash flows preparedusing the indirect method related to this information? How much cash was collected from customersduring the fiscal year endedJune 30, 2008? SE9-9. Evaluate adjustmentsto net income using the indirect method. (LO 5) The income statementfor Sharp Inc. for the month of May showed insuranceexpenseof $250. The beginning and ending balancesheetsfor the month showedan increaseof $50 in prepaid insurance.There were no payablesrelated to insuranceon the balance sheet.What adjustmentto net income would be shown in the operating section of the statementof cash flows preparedusing the indirect method related to this information? How much cash was paid for insuranceduring the month? SE9-10. Evaluate adjustmentsto net income using the indirect method. (LO 5) During 2007,Mail Direct Inc. incurred salary expenseof $67,500, as shown on the income statement. payableof $10,450;and the The January1,2007, balancesheetshowedsalaries December31,2007, balancesheetshowedsalaries payableof $13,200. What adjustment to net income would be shown in the operating section of the statementof cashflows prepared using the indirect method related to this information? How much cashwas paid to employees (for salary) during20}T? SE9-11. Evaluate adjustmentsto net income using the indirect method. (LO 5) Havelen'sRoad Paving Company had depreciationexpenseof $43,000 on the income statement for the year. How would this expensebe shown on the statementof cash flows prepared using the indirect method?Why? SE9-12. Calculate and identifu cashtlows using the indirect method. (LO 5) Beta Company spent $40,000 for a new delivery truck during the year. Depreciation expenseof $2,000 related to the truck was shown on the income statement.How are the purchase of the truck and the related depreciation reflected on the statementof cash flows preparedusing the indirect method?

450

O F C A S H F L O WS AND ANALYZI N GT H E S T A T E M E N T CHAPTER 9 . PREPARI NG

SE9-13. Evaluate adjustmentsto net income under the indirect method. (LO 5) B&W Inc. reported net income of $1.2 million in 2006. Depreciationfor the year was $120,000, accounts receivable increased $728,000, and accounts payable decreased $420,000. Compute net cashprovided by operating activities using the indirect method. SE9-14. Evaluate adjustmentsto net income under the indirect method. (LO 1, 5) In 2001, Jewels Company had net income of $350,000. The depreciation on plant assets during 2007 was $73,000, and the company incurred a loss on the sale of plant assetsof $20,000. Compute net cashprovided by operating activities under the indirect method. SE9-15. Evaluate adjustmentsto net income under the indirect method. (LO 5) The comparativebalancesheetsfor JayCeeCompany showedthe following changesin current by by $50,000, prepaid expensesdecreased assetaccounts:accountsreceivabledecreased in the by $17,000.Thesewere all the changes inventory increased $23,000,and merchandise (exceptcash). Net incomefor theyearwas $275,500. andcunent liability accounts culrent assets Computenet cashprovidedby or usedby operatingactivitiesusing the indirect method. SE9-16. Calculateand identify cashflows. (LO 5) C&S Supply Inc. had $125,000 of retained earningsat the beginning of the year and a balanceof $150,000at the end of the year. Net income for the year was $80,000.What How would this decrease in retainedearnings? transactionoccurredto causethe decrease of cash flows? be shown on the statement SE9-17. Use a statementof cashflows for decision making. (LO 7, 8) of cashflows what item(s)on the statement in investingin a company, If you wereinterested you? Why? to be of most interest would SE9-18.Identifu risksand contols. (LO 8) If you were an investor,why would you look at the statementof cashflows? Which amounts would provide information about the risk to an investor? SE9-19. Identify risks and contols. (LO 8) of long-terminvestmentopporIf you believethereis a risk that a firm is not taking advantage of cashflows help you confirm or disconfirm this belief? tunities,how would the statement

Exercises-Set A (LOI) cashflows. E9-1A. Identify


For eachof the following items, tell whether it is a cashinflow or cashoutflow and the sectionof the statementof cashflows in which the item would appear.(Assumethe direct method is used.) Item a. Cashcollectedfrom customers from issue of stock b. Proceeds c. Interestpayment on loan on l oan l d . Pri n c i p arepayment e. Cashpaid for advertising from saleof treasurystock f. Proceeds g. Money borrowed from the local bank (salaries) h. Cashpaid to employees i . Pu rc h a s of e equi pmentfor cash j. Cashpaid to vendorsfor inventory k. Taxes oaid E9-2A. Identify cashflows. (LO 1, 4, 6) For each transaction,indicate the amount of the cash flow, indicate whether eachresults in an inflow or outflow of cash, and give the section of the statementin which each cashflow would appear.Assume the statementof cash flows is preparedusing the direct method. l nfl ow or Outflow Sectionof the Statement

.t:.a::: .:,,:. ::.:.,. .::lt .t,: "::::r''1ii::-l:' .:,,.i 1:r:til,i.l

CHAPTER 9 o EXERCISES 451

, ,t,i, I ,-'. t :,,,::r:':,r'r

..........:

Inflow A m ount or Outflow a. ls s ued 100s h a re s of $2 par common s t oc kf or $1 2 p e r s h a re b. Borrowed $7,000from a local bank to expandthe business c. Purchased for $400cash $500of supplies and t he bala n c e on account d. Hir eda c ar p e n te r to b u i l d s o m e bookcases for the office for $500cash e. E ar nedr ev e n u e o f $ 1 9 ,0 0 0re , ceiving c as ha n d th e b a l a n c e on account $9, 200 f . Hir eda s t ud e n tto d o s o mety p i n g and paid him $ 2 5 0c a s h g. Repaid$7, 0 0 0 o f th e b a n k l o a n a l o n g with $250 interest. h. P aiddiv iden d s of $600

Sectionof the Statement

E9-3A.Prepare cashfromoperating activities section of statement of cashflowsusingthe :"i-j*, (LO 4) direcrmethod. it'fW Usetheincomestatement for ClarkCorporation for pastyearandtheinformation from the -J lffi comparative balance sheets shownfor thebeginning andtheendof the yearto prepare the ffi";,:,ifrIf;i#, cash from operating activities section of thestatement of cash flowsusingthedirectmethod.
S ales Costof goods sold G r os s m ar gin Operatingexpenses Wages Rent Ut ilit ies lns ur anc e Net income Account Accountsreceivable Inventory P r epaid ins ur a n c e Accountspayable Wagespayable pay abl e Ut ilit ies

$100,000 3s,000 55,000


$ 2,s00 1,200 980 320

s,000 60,000 $ Endof the Year $ 12,000 18,500 400 10,400 600 -0i +iJ,i::..W

Beginning of the Year $ 10,000 21,000 575 9,000 850 150

=_j;W..statementof cashflows using the indirect method. Then, compareit with the statementyou Mprenhar.con/reiners preparedfor E9-3A. What are the similarities? What are the differences?Which statement do you find most informative?
E9-54. Calculate change in cash. (LO 1, 4, 6) Given the following information, calculatethe changein cashfor the year. Cash received from sale of equipment Cashpaid for salaries Depreciation expensefor the year Cashreceivedfrom issueof stock Cash collected from customers Cashreceivedfrom saleofland Cash paid for operating expenses Cash paid to vendor for inventory $ 20,000 8,250 12,450 150,000 87,900 14,500 2,000 32,480

E9-4A.Prepare cash activities section of statement of cash from operating flows usingthe indirectmethod. (LO 5) Usetheinformation from E9-3Ato prepare thecash from operating activities section of the

E9-6A. Calculate cashfrom operating activities. (LO 3, 4) Use the information given for Evans Company to calculate a. Cash paid for salaries b. Cash paid for income taxes c. Cash paid for inventory items d. Cash collected from customers from stock issue e. Cashproceeds for E vans C ompany S tatements F ro mth e F i nanci al B al ance S heet IncomeS tatement Amount for the Year revenue Sales Accountsreceivable e x p e nse Sa l a ry p a yabl e Sa l a ri e s Cost of goods sold Inventory Accountspayable Incometax expense lncometaxes payable C o mmo ns tockand addi ti onal p a i d -i nc api tal $ 85,600 $ 8,700 21,400 2,300 24,300 4,800 2,500 28,500 7,400 nl a 630,000 8,500 71 8, 000 8,000 3,000 2, 100 $ 10,000 B egi nni ng of the Year End of the Year

E9-7A,. Prepare the cashfrom operating activities section of the statementof cashflows and determine the method used. (LO 2, 4, 6) Use the information from E9-6A to calculatethe cashflow from operationsfor EvansCompany. Basedon the information provided, which method of preparing the statementof cash flows doesEvansuse? E9-8A. Calculate cashflows from investing andfinancing activities. (LO 1, 6) The following eventsoccurred at GadgetsInc. during 2006. January15 March 8 May 10 July 14 25 September October 30 December31 Issuedbondsfor $250,000 Purchasednew machinery for $80.000 cash Sold old machineryfor $30,000,resultingin a $10,000loss Paid interestof$20,000 on the bonds Bonowed $5,000from a local bank Purchaseda new computer for $3,000 cash Paid cashdividendsof $4,600

Compute Gadgets'net cashflow from (1) investing activities and from (2) financing activities for 2006. E9-9A. Calculate cashfrom operating activities using the direct method. (LO 1, 4) The following information applies to Computer Company. fncome Statement for the Year Ended December31,2007 $ 20,000 Sales (15,200) Costof goods sold Grossmargin Rent expense Net income 4,800 (1,000) $ :,aoo

1. Accounts receivablestartedthe year with a balanceof $1,000 and endedthe year with a balanceof $3.300.

. EXERCISES 453 CHAPTER9

2. The beginning balance in accountspayable (to vendors) was 92,000, and the ending balancewas zero. Inventory at the end of the year was the same as it was at the beginning of the year (i.e., there was no changein inventory). 3. The company started the year with $5,000 of prepaid rent and ended the year with $4,000 of prepaid rent. Determine the following cashflows. a. Cash collected from customersfor salesduring the year b. Cash paid to vendorsfor inventory during the year c. Cash paid for rent during the year E9-10A. Calculate cashfrom operating activities using the indirect method. (LO 5, 6) BrassCompanyreportednet income of $290,000for 2007. The companyalso reporteddepreciation expense of $70,000anda gain of 93,000on the saleof equipment. The comparative balancesheetshowsa decrease in accounts receivable of $8,000for the year,a $5,000decrease in payable,and a $1,700increase accounts in prepaidexpenses. Preparethe cashfrom operating activities sectionof the statement of cashflows for 2007 using the indirect method. E9-11A. Calculate cashfrom operating activities using the indirect method. (LO 5) The following information was taken from Tram Inc.'s balancesheetsat December3 1, 2005 and 2006. Preparethe net cash provided by operating activities section of the company's statement of cashflows for the year endedDecember31, 2006, using the indirect method.

2005
Currentassets Cas h Accountsreceivable Inventory Prepaidexpenses Total current assets Cur r entliabiliti e s Accruedexpenses payable Accountspayable T ot alc ur r entlia b i l i ti e s $ 1 0 3 ,0 0 0 90,000 150,000 47,000 $390,000 $ 17,000 60,000 $ 7 7 ,0 00

2005
$ 99,000 79,000 142,000 50,000 $370,000 $ 15,000 92,000

$107,000 Net income for 2006 was $ 185,000.Depreciationexpense was $25,000. E9-12A- Calculate cashfrom operating activities using the direct method. (LO 4) ComptonCompanycompletedits first yearof operations on December3I,2006. The firm's income statement for the year showedrevenues of $175,000and operatingexpenses of $84,000. Accountsreceivablewas $54,000at year-endand payablesrelatedto operatingexpense were Computenet cashfrom operatingactivitiesusing the direct method. $21,000at year-end. E9-13A. Calculate cashfrom operating activities using the direct method. (LO I, 4) During the fiscal year endedSeptember30,2006, NapsterCompany engagedin the following transactions.Using the relevant transactions,preparethe cashfrom operating activities section of the statementof cash flows using the direct method. a. Paid interestof $7,000 b. Collected$175,000on accounts receivable c. Made cashsalesof $128,000 d. Paid salaries of $52,000 e. Recordeddepreciationexpenseof $27,000 f. Paid income taxesof $32,000 g. Sold equipmentfor cashof $152,000 h. Purchased new equipmentfor cashof $41,000 i. Made payments to vendorsof $62,700 j. Paid dividendsof$20,000 k. Purchasedland for cash of $ 174,000 1. Paid operatingexpenses of $32,500

O F C A S HF L O WS AND ANALYZI N GT H E S T A T E M E N T CHAPTER 9 . PREPARI NG

E9-14A. Prepare the statementof cashflows using the indirect method. (LO 5, 6) Use the following information for Just Nuts Company to preparea statementof cash flows using the indirect method. Just Nuts Company Balance Sheet June30

2007
Assets Cash Accountsreceivable lnventories Land E q u i p me n t lated depreciation Accumu Total assets

2006 $120,soo 60,000 175,000 120,000 180,000 (45,000) o,soo $61

$193,000 64,000 120,000 95,000 250,000 (7s,000) $647,000

Equity and Shareholders' Liabilities Accountspayable $ 42,ooo 150,000 p a y abl e Bo n d s C o m m o ns t ockand addi ti onal p a i d -i nc api tal e a rni ngs R e ta i n e d and sharehol ders' T o ta l l i a b i l i ti es e q u i ty

$ so,ooo
220,000 180,000 160,500 o,soo $61

200,000 245,000 $647,000

Additional information: a. Net income for the fiscal year endedJune 30, 2007, was $95,000. b. The company declaredand paid cash dividends. c. The company redeemedbonds payable amounting to $60,000 for cash of

$60,000. for $20,000 cash. common stock issued d. Thecompany


E9-15A. Prepare the statementof cashflows using the direct method. (LO 4, 6) Using the information from E9-14A, preparea statementof cash flows for Just Nuts Company using the direct method. E9-16A. Analyze a statementof cashflows. (LO 7) The following information has been taken from the most recent statementof cashflows of ExpansionCompany: Net cashused by operating activities Net cashprovided by investing activities Net cashprovided by financing activities

$ (e32,000) $ 1,180,500 $ 2.107.000

a. What information do these subtotalsfrom the statementof cash flows tell you about Expansion CompanY? b. What additional information would you want to seebefore you analyzeExpansion positive operatingcashflows in the future? Company'sability to generate c. Did Expansion have a positive net income for the period? What information would you like to seeto help you predict next year's net income? E9-17A. Computefree cashflow. (LO 7) Use the Pier 1 Imports Inc. consolidatedstatementof cashflows to compute the company's free cash flow for the 3 years shown. What does the trend in free cash flow tell you about Pier 1?

Pier l Imports, Inc. Consolidated Statements of Cash Flows


( ln thousands)

Year Ended 2005

(As restated, SeeNote 2)

(As restated, SeeNote 2)

Cash flow from operating activities: Net income (Ioss) $(39,804) Adiustments to reconcile to net cash (used in) provided by operating activities: Depreciation and amortization 78,781 Loss (gain) on disposal of fixed assets 1,781 Loss on impairment of fixed assets . 6,024 Write-down of assetsheld for sale 7,44r Deferred compensation 11,402 Lease termination expense 4,t76 Deferred income taxes (14,496) Sale of receivables in exchange for beneficial interest in securitized receivables (74,550) Tax benefits from options exercised by employees 760 Other (524) Change in cash from: Inventories 882 Other accounts receivable, prepaid expenses and other current assets (22,778) Income tax receivable (18,011) Accounts payable and accrued expenses 7,369 Income taxes payable (6,966) Other noncurrent assets (2,558) Other noncurrent liabilities (3,226) Net cash (used in) provided by operating activities (64,297) Cash flow from investing activities: Capital expenditures (50,979) Proceeds from disposition of properties . , . . . . . . . 1,401 Proceeds from sale of restricted investments 3,226 Purchase of restricted investments (3,500) Collections of principal on beneficial interest in securitized receivables Net cash provided by (used in) investing activities Cash flow from financing activities: Cas hd ivid en ds ..... (34,667) Purchases of treasury stock (4,047) Proceeds from stock options exercised, stock purchase plan and other, net 7,64r Issuance of long-term debt 165,000 Notes payable borrowings 86,500 Repalnnent of notes payable (86,500) Debt issuance costs (6,739) Purchase of call option (9,145) Net cash provided by (used in) financing activities 118,043 Change in cash and cash equivalents 64,r34 Cash and cash equivalents at beginning period (including cash held for sale of $3,359,$6,148 and $6,506,respectively) 189,081 Cash and cash equivalents at end ofperiod (including cash held for sate of $7,100,$3,359 and $6,148,respectively) $253,215 Supplemental cash flow information: Interest paid $ 8,136 Income taxes paid

$ 60,457 75,624 315 741 7,7L0


t 1^a

$ 118,001 64,606 (316) 455 6,573 3,259 184 (83,931) 4,997 4,894 (40,520) (16,927) 34,410 184 (2,027) 93,745 (12r,190) 34,450 (8,752) 78,788 (16,704)

2,035 (91,071) 3,668 (222) (6,860) (11,302) 2L,572 (14,116) 336 51,130 (99,239) 3,852 (10,807)

(34,762) (58,210)
Lar+ ( o

(26,780) (76,009) 15,709 (6,390) (584) (94,054) (17,013) 242,rL4

(16e) (80,668) (36,020) 225,101

$ 189,081 $_2%,n]_ $ 868 $ 1,791

$ 2r,342

$ 45,655

$ 63,788

The accompanying notes are an integral part of these financial statements Source: www.pierl com/investorrelations/annualReports.asp; frscalyear2006AnnualReport

455

456

O F C A S HF L O WS AND ANALYZI N GT H E S T A T E M E N T CHAPTER 9 . PREPARI NG

E9-18A. Identifu risks and conffols. (LO 8) Using the Pier 1 statementof cash flows shown in E9-17A, determine whether or not the frrm appearsto be taking advantageof new investmentopportunities.Is the firm in a growth stageor a more matufe stageof its businesslife? What evidence supportsyour opinion?

B Exercises-Set (LOI ) cashflows. E9-1B. Identifi


For each of the following items, tell whether it is a cashinflow or cashoutflow and the section of the statementof cash flows in which the item would appear.(Assume the direct methodis used.) Item a . C a s hp a id to vendorfor suP P l i es of treasurystock b. Purchase on bonds c . Pri n c i p arepayment l payment bonds on d. Interest e . C a s hp a i d for sal ari es of common stock f. Cashfrom issuance pai d g. Cash d i vi dends h . C a s hp a i d for rent and uti l i ti es of computerfor cash i . Pu rc h a se j . C a s hp a id for companyvehi cl e k. Incometaxespaid E9-2B.Identifi cashflows. (LO 1, 4) For each transaction,indicate the amount of the cash flow, indicate whether eachresults in an inflow or outflow of cash,and give the section of the statementin which each cash flow would appear.Assume the statementof cash flows is preparedusing the direct method. Item of $0.10P ar 6 6 0 shares a. lssued c o m m o nstockfor $15 per share. b. Sold $2,500of inventory,received i n cashand remai ni ng $ 1 ,5 0 0 on account $ 1 ,0 0 0 a $2,500comPuterby c. Purchased p a y i n gcashof $1,000 and si gni ng a short-termnote for the o th e r $ 1,500 d . P a i d$ 6 0 0for routi ne mai d to clean office service e. Paidrent and utility exPenses totaling $2,250 f. H i re da r unnerto carry between correspondences o ffi c e sa nd pai d her $175 g. Repaid short-term the $1,500 n o te a l o ng w i th $100i nterest stock of treasury h . Pu rc h a sed $t,sOO E9-3B. Prepare cashfrom operating activities using the direct method. (LO 4) Use the income statementfor Kristen Harrison's CosmeticsInc. for the past year and the information from the comparativebalancesheetsshown for the beginning and the end of the year to prepa.re the operatingsectionof the statementof cashflows using the direct method. lnflow or Outflow Sectionof the Statement lnflow or Outflow Sectionof the Statement

. EXERCISES 457 CHAPTER9

S ales Costof goods sold G r os s m ar gin Operatingexpenses Wages Rent Ut ilit ies I ns ur anc e Net income Account Accountsreceivable Inventory P r epaid ins ur an c e Accountspayable Wagespayable pay able Ut ilit ies

$ 1s0,000 55,000 95,000 $ 3,7s0 1,600 850 175

6,375

$ 88,62s Beginning of the Year 12,000 $ 18,200 600 8,000 725 0


End of the Year

$ 1o,ooo
19,700 200 7,400 850 -275-

E9-48. Prepare cashfrom operating activities using the indirect method. (LO 5) Use the information from E9-3B to preparethe cashfrom operating activities sectionof the statementof cashflows using the indirect method. Then, compareit with the statementyou preparedfor E9-3B. What are the similarities? What are the differences?Which statement do you find most informative? E9-58. Calculatechangein cash.(LO I, 5) Given the following information, calculate the changein cash for the year. Cash received from sale of company van Cash paid for utilities and rent Cash paid for interest expenseduring the year Cash paid for purchaseoftreasury stock Cash collected from customers Cash received from issuanceof bonds Cash paid for salaries Cash paid to do a major repair of equipment to prolong its useful life for five more years E9-68. a. b. c. d. Calculate cashfrom operating activities. (LO 2, 5) Cash paid for utilities Cash paid for interest Cash paid for inventory items Cash collected from customers B al ance S heet lncomeStatement Amount for the Year Sales revenue Accountsreceivable Utilitiesexpense pay abl e Ut ilit ies Costof goods sold Inventory Accountspayable Interestexpense Interestpayable

$ 15,000 5,150 10,650 25,000 68,250 114,500 12,000 32,480

F r omt he F inan c i aS l ta te m e n ts fo r MF C o m p a n y

Beginning of the Year $ 6,500

E nd of the Year

$ ztq,zso
$ t,zoo 2,700 6,000 2,000 2,300 18,300 1,500 25,600 7,800 1,500 5,750 2,400

458

O F C A S H F L O WS AND ANALYZI N GT H E S T A T E M E N T 9 . PREPARI NG CHAPTER

Eg-78. Prepare cashfrom operating activities section of statementof cashflows and determine the method used. (LO 2, 4) Use the information from E9-6B to calculatethe cashflow from operating activities for MF Company.Based on the information provided, which method of preparing the statementof cash flows does MF use? E9-88. Calculate cash flows from investing and financing activities. (Lo 1, 6) The following eventsoccurred at Garden & Home Store Inc. during 2009. January25 February 8 April 15 JuJy24 September20 December15 December31 lssuedcommon stock for $175,000 Purchaseda delivery truck for $65,000 cash Sold old delivery truck for $28,500,resulting in a $3,500 gain Borrowed $7,500from a local bank Purchasednew machinery for $18,000 cash Paid interestof $150 on the loan Paid cashdividendsof $1'750

Compute Garden & Home Store Inc.'s net cash flow from (1) investing activities and from (2) financing activities for 2009. E9-98. Calculate cashfrom operating activities using the direct method. (LO 1, 4) The following information applies to Electronics Plus Inc.: lncome Statementfor the Year EndedJune 30, 2010 S al es Costof goods sold margi n Gross Rent expense N et i ncome

$ 3s,ooo
(20,600) 14,400 (1,400)

$l-3'q99_

the year with a balanceof $1,500and endedthe year with started 1. Accountsreceivable a balanceof $500. 2. Thebeginning balancein accountspayable(to vendors)was $1,650,and the ending balancewas $550. Inventory at the end of the year was the sameas it was at the beginning of the year (i.e., there was no changein inventory). 3. The company started the year with $3,000 of prepaid rent and ended the year with $1,600of prepaidrent. Determine the following cash flows' a. Cash collected from customersfor salesduring the year b. Cash paid to vendors for inventory during the year c. Cash paid for rent during the year E9-108. Calculate cashfrom operating activities using the indirect method. (LO 5) St. Augustine Steel Inc. reported net income of $320,000 for 2008' The company also reported depreciationexpenseof $65,000 and a loss of $5,000 on the sale of equipment' The comparativebalance sheetshows a decreasein accountsreceivableof $6,500 for the year, Prepare in prepaidexpenses. payable,and a $1,450decrease in accounts a $3,500increase the using for 2008 cash flows of statement of the section activities operating the cashfrom indirect method. E9-11B. Calculate cashfrom operating activities using the indirect method. (LO 5) The following information was taken from Fix-It Company's balance sheetsat June 30, 2O0i and.2008.Preparethe net cash provided by operating activities section ofthe company's statementof cash flows for the year ended June 30, 2008' using the indirect method.

o EXERCISES 459 CHAPTER9

2008
Currentassets Cash Accountsreceivable Inventory Prepaidexpenses Total current assets Cur r entliabili ti e s

2007 $ 9s,000 89,000 188,000 45,000 $417,000 $ 22,000 63,000 8s,000 $

$105,000 80,000 210,000 53,000 $448,000 $ 18,000 85,000 $103,000

payable Accrued expenses


Accountspayable Total current Iiabilities

Net incomefor the yearendedJune30, 2008was $215,000. Depreciation expense was$30,500. E9-I28. Calculate cashfrom operating activities using the direct method. (LO 4) Capital AppliancesInc. completedits fust year of operationson June30,2007. The firm's income statement for the year showedrevenues of $ 180,000and operatingexpenses of $62,000. Accountsreceivablewas $30,000at year-endand payablesrelatedto operatingexpense were $18,500at year-end.Computenet cashfrom operatingactivities using the direct method. E9-13B. Calculate cashfrom operating activities using the direct method. (LO I, 4) During the fiscal year ended March 3I,2008, Radio Technology Inc. engagedin the following transactions.Using the relevant transactions, preparethe cashfrom operating activities section of the statementof cash flows using the direct method. a. Paid $130,000on accounts payablerelatedto operatingexpenses b. Collected$185,000on accounts receivable c. Made cashsalesof $315,000 d. Paid salaries of $40,000 e. Recordedamortizationexpense of $15,000 f. Declareda2-for-l stocksplit g. Paid intereston loan in the amountof $21,500 h. Repaidprincipal ofloan for $275,000 i. Sold equipmentfor $295,000 j. Paid dividendsof $15,000 k. Purchased a new building for cashof $215,000 I. Paid operatingexpenses of $65,500 E9-148. Prepare the statementof cashflows using the indirect method. (LO 2, 5) Use the following information for LAW Office Products and Supplies Inc. to prepare a statementof cash flows for the year ended December 3 1, 2007, using the indirect method. LAW Office Products and SuppliesInc. Balance Sheet

At December 31, 2007 2006


Assets Cash Accountsreceivable Inventories Land E quipm ent Accumu lated depreciation Total assets

$ ss,ooo
78,000 180,000 135,000 350,000 (so,ooo)

$ zs,soo
54,000 169,000 105,000 260,000 (60,000)

$ 708,000

$ ssr,soo

O F C A S HF L O WS AND ANALYZI NGT H E S T A T E M E N T 9 . PREPARI NG CHAPTER

Equity and Shareholders' Liabilities Accountspayable B o n d sp a y a bl e Commonstock and additional paid-incapital e a rni ngs R e ta i n e d equity and shareholders' Total liabilities

$ 3s,000 185,000
225'0OO 263,000 $708.000

$ +o,ooo
215,000 175,000 131,500 $s61,s00

Additional information: a. Net income for the fiscal year endedDecember31, 2007, was $145'000' b. The company declaredand paid cash dividends. c. The company redeemedbonds payable amounting to $30,000 for cash of $30,000. d. The companyissuedcommon stock for $50,000cash. E9-15B. Prepare the stdtementof cashflows using the direct method. (LO 4) Using the information from E9-148, prepare a statementof cash flows for LAW Office Products and Supplies Inc. using the direct method. of cashflows-(LO 7, 8) E9-168. Analyzea statement taken from the most recent statementof cash flows of Inwas The following information ComPanY' novative Electronics Net cash provided by operating activities Net cash used by investing activities Net cashprovided by financing activities

$ 845,000 $ (530,000) $1,675,000

a. What information do these subtotalsfrom the statementof cash flows tell you about Innovative Electronics Company? b. what additional information would you want to seebefore you analyze Innovative Electronics company's ability to generatepositive operating cash flows in the future? c. Did Innovative Electronics have a positive net income for the period? What information would you like to seeto help you predict next year's net income? E9-178. Computefree cashflow' (LO 7) Use the Best Buy consolidatedstatementof cashflows to compute the company's free cash flow for 2005 and 2006. What doesthe free cash flow tell you about Best Buy?

Best Buy Company, Inc. Consolidated Statements of Cash Ffows


( g in m iltions)

For the Fiscal Years Ended

February 25 2006

February26, 2005

February28, 2004

Operating Activities Net eamings (Gain) loss from and disposal of discontinued operations. net oftax Earnings from continuing operations A{iustments to reconcile from continuing operations to total cash provided by operating activities from continuing operations: Depreciation Asset impairment changes Stock-based compensation Deferred income taxes Excess tax benefits from stock-based compensation Other, net Changesin operating assets and liabilities, net of acquired assetsand liabilities: Receivables Merchandise inventories Other assets Accounts payable Otherliabilities .... Accrued income taxes . Total cash provided by operating activities from continuing operations Investing Activities Additions to property and equipment, net of $75, $117 and $26 non-cash capital expenditures in fiscal 2006,2005 and 2004,respectively Purchases of available-for-salesecurities ......... Sales of available-for-salesecurities Change in restricted assets

$ 1,140

984 (50) 934

705 95 800

1,140

456 4 t32 (151) (33) (3) (110) (457) (l 1) 385 165 178 1,695

459 22

(1) (28) 24 (30) (240) (50) 347


z+D

385 22 8 (14) 8 (27) (507) (7) 272 250 r97 r,397

301 1,991

Other,net
Total cash used in investing activities from continuing operations Financing Activities Repurchase of common stock . Issuance of common stock under employee stock purchase plan and for the exercise of stock options Dividends paid Long-term debt payments Net proceeds from issuance of long-term debt Excess tax benefits from stock-based comoensation

(648) (4,319) 4,L87 (20) 46 (754) (772) 292 (151)

(502) (8,517) 7,730 (140) 7 (1,422) (200) 256 (137) (371) (7)

(545) (2,989) 2,175 (18) 1 (1,376) (100) tL4 (130) (17)

(6e)
36
.l.t

Other,net
Total cash used in financing activities from continuing operations Effect ofExchange Rate Changes on Cash Cash Flows from Discontinued Operations (Revised - See Note 2) Operating cash flows Investing cash flows N etCashUsed inDisc ont inuedO per at ions ....... Increase (Decrease) in Cash and Cash Equivalents Cash and Cash Equivalents at Beginning of Year Cash and Cash Equivalents at End ofYear Supplemental Disclosure of Cash FIow Information Income tax paid Interesl paid .. See Notes to Consolidated Financial Statements

(10) (641) 27

40

(45e)
o

(87)
I

(52) 3n 354 109 245 (128) 373

q__qql
fi 547 16

q__qq!
$ 24r 35

$_-45_
$ 306 22 461

452

O F C A S HF L O WS AND ANALYZI N GT H E S T A T E M E N T CHAPTER 9 . PREPARI NG

E9-188. Identfu risks and contols. (LO 8) Use the Best Buy consolidatedstatementsof cashflows presentedin E9-17B to determine whether or not the firm appearsto be taking advantageof new investmentopportunities.Is the hrm in a growth stageor a more mature stageof its businesslife? What evidence supports your opinion? Problems-Set A P9-1A. Prepare the statementof cashflows (direct or indirect method). (LO 2, 3, 4, 5, 6, 7) The income statementfor the year ending December3I,2O0l , and the balancesheetsat DeServiceCompanyarepresentedhere. 31, 2007,for Samsula cember31, 2006,andDecember Samsula Service Company lncome Statement For the Year EndedDec.31, 2007 (a m o u n ts i n thousands, exceptearningsper share) Service revenue Expenses: Wa g e sa n d sal ari es Advertising Rent D e p re c iati on M i s c e l l aneous Total expenses lncome before taxes lncometaxes Net income per share E a rn i n gs Company Samsula Service Sheets ComparativeBalance December31,2007 (a mo u n ts in thousands)

$ 92,000 $ 50,000 10,000 4,800 3,500 5,200 83,600

$ a,+oo
2,940 $ s,460

$ o.s s

2007
Assets: Currentassets: Cash Accountsreceivable Supplies Prepaidadvertising Total current assets plant, and equipment Property, Eq u i p m ent Accumulated Less: d e p reci ati on Total property, plant, a n d e q ui pment Total assets

2006

$ 6,910 12,000 200 800


$ 19,910

$ 3,500 14,000 370 660 $ 18,s30

$ 44,000 21,600 22,400 g 42,310

$ 4o,ooo
18,000 22,000 $ 40,s30

C H A P T E9 R o PROBLEMS

463

Liabilit ies and Sto c k h o l d e rs E ' q u i ty : Cur r entliab i l i ti e s : payable Wagesand salaries payable Taxes T ot alc ur r e n tl i a b i l i ti e s Stockholders' equity: Commonstock Ret ained ea rn i n g s

$ 2,700 1,900

$ 3,300 1,780

$ +,soo
$ 30,000 7,710
37,710

$ s,oao
$ 30,000 5,450
35,450

T ot alliabilit ie s a n d s to c k h o l d e rs e'q u i ty

$ qz,zto

$ 40,s30

Required
a. Preparea statementof cash flows for the year ending December 31, 2007, using (a) the direct method and (b) the indirect method. b. Why is the statementof cash flows important to the company and to parties external to the company? c. As a user, which format would you prefer-direct or indirect-and why? d. Evaluate the way in which the company spent its cash during the year. Do you think the company is in a sound cash position? e. Calculate the firm's free cash flow for the 2 years shown. P9-24, Calculate cashfrom operating activities-indirect method. (LO 5) The information shown is from the comparativebalance sheetsof M&S Record Company at December 31,2007 and 2006.

(inthousands) Current assets: Cash Accounts receivable Inventory Prepaid rent Totalcurrent assets Current liabilities: payable Accounts payable Salaries Totalcurrent liabilities

At December 31

2007 $3,000 2,325 2,150 320 $t,tgs

2006 52,490 1,700 1,380 270 $s,840

$1,8e0 $1,oso 2,500 3,800 $4,390 $4,850

Netincome wasincluded for 200'7 was$356,000. Depreciation expense of $135,000 in the operating expenses for theyear. Required Usetheindirectmethod to prepare section of thestatement of cash thecashfrom operations flows for M&S RecordCompany . for theyearended December 31,2001

464

O F C A S H F L O WS AND ANALYZI N GT H E S T A T E M E N T CHAPTER 9 . PREPARI NG

P9-3A. Calculate cashfrom operating activities using the indirect method. (LO 5) The information shown comes from the balance sheetsof TCB Company at June 30, 2008 and2}07. TCBCompany Balance Sheets(Adapted) June 30, 2008,and June 30, 2007 (i n th o u s a n ds) Currentassets: Cash Accountsreceivable In v e n to ry P re p a i d i nsurance Total current assets C u rre n tl i a bi l i ti es: Accountspayable Wa g e sp ayabl e T o ta lcurrentIi abi l i ti es 10 $2,1 1,254 730 127 $2,6s0 977 856 114

2008

2007

$q,zzt $q,sgt
$1,0s4 $1,330 2,100 1,750 s4 53,080 $3,1

Net income for the year endedJune 30, 2008, was $86,900.Included in the operatingexexpense penses of $102,000. for the year was depreciation

Required
Prepare the cashfrom operating activities section of TCB Company's statementof cash flows for the year endedJune 30, 2008. Use the indirect method. P9-4A. Calculate cashfrom operating activities using the indirect method. (LO 5) Rollins Land Corporation had the following information available for 2005. Accountsreceivable P re p a i d i n s urance Inventory

January 1 $178,000 38,000 65,000

D ecember 31

$tst,ooo 16,000 71,000

Rollins Land Corporation reported net income of $295,000 for the year. Depreciation exwas $26,500. pense, includedon the income statement,

Required
Assume this is all the information relevant to the statementof cash flows. Use the indirect method to prepare lhe cashflows from operating activities section of Rollins Corporation's statement of cashflows for the year endedDecember31, 2005. P9-5A. Calculateinvestingandfinancing cashflows. (LO 6) To prepareits statementof cashflows for the year endedDecember 31, 2008, Myers Company gatheredthe following information. Loss on sale of machinery Proceedsfrom sale of machinery from bond issue(facevalue $100,000) Proceeds Amortization of bond discount Dividends declared Dividendspaid Purchaseof treasury stock

$ 8,000 50,000 80,000 1,000 25,000 15,000 30,000

Required
a. Preparerhe cashfrom irwesting section of the statementof cash flows. b. Preparethe cashfrom financing section of the statementof cash flows.

C H A P T E9 R r PROBLEMS

465

P9-6A. Calculate iwesting andfinancing cashflows. (LO 6) To prepareits statementof cashflows for the year endedDecember 31,2005, Martin Company gatheredthe following information. Gain on sale of equipment Proceedsfrom sale of equipment Purchaseof equipment Dividends declared Dividends paid Proceedsfrom sale of treasury stock Repaymentof loan principal Payment of interest on loan Required a. Preparethe cashfrom investing section of the statementof cash flows. b. Preparethe cashfrom financing sectionof the statement of cashflows. P9-7A. Calculateinvestingandfinancing cashflows. (LO 6) To prepareits statementof cashflows for the year endedDecember3 1, 2008, Murray Company gatheredthe following information. Dividends paid Purchaseof treasury stock Proceedsfrom bank loan Gain on sale of equipment Proceedsfrom sale of equipment Proceedsfrom sale of common stock

$ 4,000 10,000 80,000 5,000 2,000 90,000 21,000 2t0

$ 16,200 40,000 180,000 9,000 25,000 250,000

Required
a. Preparethe cashfrom investing section of the statementof cash flows. b. Preparethe cashfrom financing section of the statementof cash flows. P9-84. Analyzea statement of cashflows. (LO 5,6,7) Use the statementof cashflows for the Matlock Company to answerthe required questions. Matlock Company Statement of Cash Flows For the Year Ended December31,2007 ( in t hous ands ) Cashflows from operating activities: Net inc om e Depreciation expense Decrease in accounts receivable Increase in inventory Increase in prepaid rent payable Increase in accounts Net cashprovided by operating activities Cashflows from investingactivities: P ur c has o e f e q u i p me n t Proceeds from saleof old equipment Net cashusedby investingactivities Cashflows from financingactivities: Repayment of long-term mortgage Proceeds from saleof common stock Paymentof cashdividends

soo $1,

$ zto
320 (70) (1 0) 150

600 00 $2,1

$(1,000) 200 (800)

$(1,3s0) s00 (2oo)

466

O F C A S HF L O WS CHAPTER AND ANALYZI N GT H E S T A T E M E N T 9 . PREPARI NG

Net cashusedby financing activities in cashduring 2007 Net increase C a s hb a l a n ce, January1,2007 Cashbalance,December31,2007

(1,0s0)
250 346 596

Required
a. b. c. d. e. How did Matlock Company use the majority of its cash during 2007? What information does this give you about Matlock Company? What was Matlock Company's major sourceof cash dwing2007? Is this an appropriatesource ofcash for the long run? Explain. Calculate Matlock's free cash flow for 2007.

Problems-Set B P9-1B. Prepare the statementof cashflows (direct or indirect method). (LO 2, 3, 4, 5, 6, 7) Given here are the income statementfor Oviedo Oil Company for the year ending Decemat December31,2006, and December31,2001. ber 31, 2007, andthe balancesheets Ovi edoOi l C ompany Income Statement For the Year EndedDec.31, 2007 revenue Sales Costof goods sold m a rg in G ro s s Other expenses: Wa g e sa nd sal ari es Depreciation Mi s c e l l aneous Total other expenses lncome before taxes lncometaxes Net income Ovi edoOi l C ompany ComparativeBalance Sheets December 31,2007 ($ i n th o u s ands) Assets: Currentassets: Cash Accountsreceivable lnventory Total current assets plant, Property, a n d e q ui pment E q u i p ment Less: Accumulated d e p re ci ati on Total property,plant, a n d e q ui pment Total assets

$ 150,000 63,000 87,000

$ 32,ooo
4,500 12,400 48,900 $ 38,100 8,200 29,900 $

2007

2006

-02,900 60,000 $ 52,900

$ 6,400 2,700 42,000 $ s1,100

$ 82,300 (20,1 00) 62,200 $ 12s,100

$ 39,000 (1s,600) 23,400 $ 74,s00

Liabilit ies and s h a re h o l d e rs e'q u i ty Cur r entliab i l i ti e s : Accountspayable pay a b l e S alar ies payable Taxes T ot alc ur r e n tl i a b i l i ti e s Notespayable T ot al liabili ti e s S har ehold e rs e'q u i ty : Commonstock Ret ained ea rn i n g s T ot als har e h o l d e rs e'q u i ty T ot al liabili ti e s and s hare h o l d e rs e'q u i ty Required a. Preparea statementof cash flows for the year ending December 31, 2007, using (1) the direct method and (2) the indirect method. b. Why is the statementof cash flows important to the company and to parties external to the company? c. As a user, which format-direct or indirect-would you prefer and why? d. Evaluate the way in which the company spent its cash during the year. Do you think the company is in a sound cash position? e. Compute the firm's free cash flow. P9-28, Calculate cashfrom operating activities using the indirect method. (LO 5) The information shown is from the comparativebalance sheetsof Matt's Music Company at December31, 2008 and2O0l. ( in t hous ands) Currentassets: Cash Accountsreceivable Inventory P r epaid in s u ra n c e Total current assets Cur r entliabili ti e s : Accountspayable pa y a b l e S alar ies TotaI current Iiabilities At December 31 2008 2007 $ 0,+OO 1 ,5 0 0 1,900 g $ ,A O O

30,000 $ 39,800 $40,000 45,300 85,300 00 $12s,1

$ s,7oo 1,300 2,100 t oo $9, 10,000 $19,100 $40,000 15,400


55,400

$74,s00

$:,soo
2,725 1,050 520 $7,7es $2,890 1,500 $+,:go

$z,ogo
2,980 1,300 470 $6,840 $1,6s0 3,200 $4,8s0

Net income for 2008was$211,000. wasincluded Depreciation expense of $80,000 in the operating expenses for theyear. Required Usetheindirectmethod to prepare thecashfrom operations section of thestatement of cash flows for Matt's Music Company December for theyearended 31,2008. (LO 5) P9-38. Calculate cashfromoperating activitiesusingthe indirectmethod. The informationshowncomes from the balance sheets of WalkerCorporation at September 30, 2008and2007. SW Jffi Ef*",',:,i,i*fr:f,#"

,r, ::,

l'

1 l :.t..,.

:t ' r , r',.. 4 6 a

G c HA pr E R 9 . p R E p AR tN A N D AN AL y z tN G TH ES TA TE ME N oF T cA sH Fl ow s Walker Corporation Balance Sheets(Adapted) September30, 2008,and September30, 2007 (in thousands) Currentassets: Cash Accountsreceivable Inventory Prepaidinsurance Total current assets C u rre n tl i a bi l i ti es: Accountspayable W a g e spayabl e T o ta lcurrentl i abi l i ti es $z,t tO 1,254 700 157 $4,221 $t,0so 1,977 656 314 $4,597 2008 2007

$2,000 1,154 $f,t s+

$2,330 750 $3,080

Net income for the year endedSeptember 30, 2008, was $146,000.Includedin the operating expenses for the year was depreciation expense of $1 12,000.

Required
Prepare the cashfrom operating activities section of Walker Corporation's statement of cash flows for the year ended September30, 2008. Use the indirect method. P9-48. Calculate cashfrom operating activities using the indirect method. (LO 5) Ace Corporation had the following information available for 2008. January1 Accountsreceivable Prepaidinsurance Inventory $80,000 48,000 76,000 D ecember 31 $76,000 25,000 50,000

Ace Corporation reported net income of $130,000 for the year. Depreciation expense,includedon the income statement. was $20.800.

Required
Assume this is all the information relevant to the statementof cash flows. Use the indirect method to prepare the cash flows from operating activities section of Ace Corporation's statementof cash flows for the year endedDecember 3 1, 2008. P9-58. Calculate investing andfinancing cashflows. (LO 6) To prepareits statementof cashflows for the year endedDecember3 1, 2007, Wright Company gatheredthe following information. Proceeds from bond issue(facevalue $100,000) Amortization of bond premium Dividendsdeclared Dividendspaid Purchase oftreasury stock Loss on saleof machinery Proceedsfrom sale of machinery $120,000 1,000 15,000 12,000 50,000 18,000 30,000

Required
a. Preparethe cashfrom investing section of the statementof cash flows b. Preparethe cashfrom financing section of the statementof cash flows. P9-68. Calculateinvestingandfinancing cashflows. (LO 6) To prepare its statementof cash flows for the year ended December 31, 2008, Bowden Company gatheredthe following information.

.l:..t:.
lll. r::'ill:

cHAprER 9 e pRoBLEMS 469 Dividends declared Dividends paid Proceedsfrom sale oftreasury stock Repaymentof loan principal Payment of interest on loan Gain on sale of equipment Proceedsfrom sale of equipment Purchaseof equipment

.':.1,.t,,

$1s,000 i2,000 70,000 32,000 320 3,500 11,000 75,000

Required
a. Preparethe cashfrom investing section of the statementof cash flows. b. Preparethe cashfrom financing section of the statementof cash flows. P9-78. Calculate investingandfinancing cashflows. (LO 6) To prepareits statementof cash flows for the year endedDecember 3I,2001 , Tango Company gatheredthe following information. Proceedsfrom bank loan Gain on sale of equipment Proceedsfrom sale of equipment Proceedsfrom sale of common stock Dividends paid Purchaseof treasury stock

157,000 12,500 35,000 100,000 t2,400 85,000

Required
a. Preparethe cashfrom investing section of the statementof cash flows. b. Preparethe cashfromfinancing section of the statementof cash flows. P9-88. Analyze a statementof cashflows. (LO 5, 6, 7) Use the statementof cash flows for the SS&P Company to answer the required questions

Company S5&P Flows Statement of Cash Forthe YearEnded December 31,2007 (inthousands) Cash from operating activities: Netincome
Depreciation expense Decrease in accounts receivable Increase in inventory Increase in prepaid rent payable Decrease in accounts Net cashprovided by operating activities Cashfrom investingactivities: P ur c has o ef equipment Proceeds from saleof old equipment Net cashused by investingactivities Cas h f r om f ina n c i n ga c ti v i ti e s : Repayment of long-term mortgage Proceeds from saleof common stock P ay m ent o f c a s hd i v i d e n d s Net cashusedby financingactivities Net increase in cashduring 2007 Cas hbalanc eJ , a n u a ry1 ,2 0 0 7 Cas hbalanc e D , e c e mb e 3 r 1,2 0 0 7 $(7,500) 2,100 (1,200)

$ 2,s00

$ sto
720

(s0)
(20)

(1 so)

970

$ z,qto
$(3,000)
900

(2,100)

(6,600) $ (s,230)
10,580

$ s.3s0

47O

CHAPTER O F c A s H F L o Ws 9 I PREPARI NG AND ANALYZI N GT H E S T A T E M E N T

Required a. b. c. d. e. How did SS&P Company use the majority of its cash during2001? What information does this give you about SS&P Company? How did SS&P Company obtain the majority of its cash during2007'! Is this an appropriatesourceof cash in for the long run? Explain. CalculateSS&P's free cashflow for 2007.

Financial Analysis Statement


FSA9-1. Analyzea statement of cashflows (LO 7) Use Office Depot's financial statementson the book's website to answer the following questlons. a. What were the major sourcesand usesof cash during the most recent fiscal year? What does this indicate about Office Depot's cash position? b. What evidence,if any, is there that Office Depot is expanding? FSA9-2. Analyze a statementof cashflows. (LO 7, 8) The statementsof cash flow shown here are from Callaway Golf Company's 2005 annual report. Answer the following questions: a. Did the company use the direct or the indirect method of preparing the statement of cashflows? b. Did accounts receivable increase or decrease from December3L,2004, to December31, 2005?Explain. a noncash expense, c. Why is depreciation, includedon the statement of cash flows? d. On the most recent statementof cash flows, inventory is shown as a negative number (subtracted).However, the prior year's statementshows a positive number (added).Describe what happenedto the balancein the inventory account during eachof thoseyears. e. Did the balancein accountspayable and accruedexpenses increaseor decrease during the most recentyen? Explain. f. For every year of the 3-year period shown, Callaway Golf Company's net income has been significantly lower than its net cash from operating activities. How would you explain this to a friend who read somewherethat net income and net cash from operating activities should be quite close?Does this suggestaddedrisk for investors?

STATEMENA T NALYSIS C H A P T E9 R o FINANCIAL

471

Callaway Golf Company Consolidated Statements of Cash Flows


( ln thousands)

2005

YearEnded December31, 2004 2003

Cash flows from operating activities: Net income (Ioss) $ 13,284 Adjustments to reconcile net income (Ioss) to net cash provided by operating activities: Depreciation and amortization 38,260 4,031 Loss on disposal of long-Iived assets Tax benefit (reversal of benefit) 2,409 from exercise of stock options 6,527 Noncash compensation Net noncash foreign currency hedging loss Net loss from sale of marketable securities (3,906) Defe rred taxes ..... Changesin assets and liabilities, net of effects from acquisitions: t roA Accounts receivable, net .. . (65,595) Inventories, net 7,583 Other assets Accounts payable and accrued expenses 32,740 Accruedemployee 5,L2L compensationandbenefits....., r,224 Accrued warranty expense 26,676 lncome taxes receivable and payable (351) Deferred compensation Net cash provided by operating activities .. 70,298 Cash flows from investing activities: (34,259) Capital expenditures Proceeds from sale of capital assets 1,363 Acquisitions, net of cash acquired Proceeds from sale of marketable securities (32,896) Netcashusedininvestingactivities ....... Cash flows from financing activities: Issuance of Common Stock 14,8r2 (3e) Acquisition of Tleasury Stock (13,000) Proceeds from (pa5rmentson) Line of Credit, net (f9,557) Dividends paid, net Other financing activities : : : : : : : : : : : : : : : : : : : : : : : (17,828) Net cash (used in) provided by financing activities Effect of exchange rate changes on cash (1,750) andcashequivalents ..... 17,824 Net increase (decrease) in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year Supplemental disclosures (See Note 3 for acquisitions-related disclosures): Cash paid for interest and fees $ (2,096) Cash paid for income taxes $(24,837)

$(10,103) 51,r54 7,669 2,161

$ 45,523 44,496 24,163 (e82)


ID

r,74r
1,811 7,707 (r,048) l0,2gg r,554 (16,945) (5,895) (584)

2,619 98 (8,320) 12,698 4,997 (4,743) (2,561) (3,898) (838) 4,004

(40,7rr)
(273)

8,537

rr8,743

(25,986) (7,810) 431 r78 (s,204) (160,321)


-24 (34,759) (167,929) 20,311 (6,298) 13,000 (19,069) 7,944 L7,994 (4,755) (18,536) (13,414)

2,595 1,488 (15,683) (61,112) 47,340 L08,452 $ 31,657 $__47_p4o_ $ (1,384) $ (835) $(17,379) $ (30,925)

The accompanying notes are an integral par't of these financial statements.

CHAPTER O F C A S H F L O WS 9 . PREPARI NG AND ANALYZI N GT H E S T A T E M E N T

FSA9-3. Analyze a statementof cashflows. (LO 7, 8) The following is the statementof cash flows for Chico's FAS Inc. for the years endedJanuary 28,2006, January29,2005 and January 3I,2004.

Chico's FAS, Inc, and Subsidiaries Consolidated Statements of Cash Flows


( l n thous ands )

January 28, 2006

Fisca,IYear Ended January 29, Ja.nuary31, 2005 2004

Cash flows from operating activities Net income A{iustments to reconcile net income to net cash provided by operating activitiesDepreciation and amortization, cost of goods sold Depreciation and amortization, other Deferred tax @enefiQ expense Stock-based compensation expense Tax benefit of stock options exercised Defemed rent expense, net . . . Loss on impairment and disposal of property and equipment Decrease (increase) in assets,net of effects of acquisitionReceivables,net Inventories Prepaid expenses and other Increase (decrease) in liabilities, net of effects of acquisitionAccounts payable Accrued and other defemed liabilities

$ 193,981 $ 141,206 $ 100,230 4,651 M,20t (8,411) 1,615 2L,46L 3,673 753 (7,t47) (22,198) (5,955) 10,709 31,073 74,425 268,406 3,605 32,48L (2,986) 27,297 6,450 311 1,069 (18,280) (2,734) 8,929 26,272 82,4L4 223,620 1,970 21,130 1,336 15,126 1,874 3,746 (1,953) (4,658) (1,281) (3,175) 11,035 45,r50 145,380 (166,866) 153,447 (87,636) (52,300) (163,344) 15,231 (344) 14,887 6,923 9,753

Totala{iustments

..

Net cash provided by operating activities Cash flows from investing activities: (357,237) (404,2rt) Purchases of marketable securities Proceeds from sale of marketable securities 207,026 257,299 Acquisition of The White House, Inc., net of cash acquired . (10,418) Acquisition of equity investment . . . (1,307) Acquisition of franchise store (t47,635) (93,065) Purchases of property and equipment (308,264) (24t,284) Net cash used in investing activities Cash flows from financing activities: Proceeds from issuance of common stock . 28,467 22,684 (4,992) Repurchase of common stock . (1,278) Payments on capital leases . Net cash provided by financing activities 28,467 L6,4L4 (11,391) (r,250) Net (decrease) increase in cash and cash equivalents . . Cash and cash equivalents, beginning ofperiod L4,426 L5,676 Cash and cash equivalents, end ofperiod . . . . . Supplemental disclosures of cash flow information: Cashpaidforinterest . 360 107 ...... $ $ Cashpaidforincometaxes,net ..... $106,091 $ 56,4189 Non-cash investing and financing activities Com m ons t oc k is s u e d i n a c q u i s i t i o n ......... $ $

q___qpqq_ !_4fi_

q__Epzq_
I42 $ $ 47,855 $ 4,2 6 6

The accompanying notes are an integral part of these consolidated statements.

. IN TE R N E 9R E T X E R C IS C EA : R N IV AC LOR P . C H A P TE Answer the following questions: a. Does Chico's use the direct or the indirect method of preparing the statementof cashflows? b. Did receivablesincreaseor decreaseduring the most recent flscal year? c. Why is depreciation,a noncashexpense,included on the statementof cash flows? d. On the three years' statements, inventory is shown as a negativenumber (subtracted).Describe what happenedto the balancein the inventory account during eachofthose years. during the most recent e. Did the balancein accountspayable increaseor decrease year? Explain. f. Do you think Chico's is expanding?Find some numbers to support your answer. g. CalculateChico's free cashflow for all threeyears.What do thesevaluesindicate? h. Do you seeany particular risks indicated by Chico's cash flow patterns?

Critical Thinking Problems


Risk and Control
To be successful,a company must anticipate its cash flows. What evidencecan you find in the Staples' annual report in the back of the book that this company does adequatecash planning? Is there any information not available in the annual report that would help you make this evaluation?

Ethics
After 2 years of business,the Lucky Ladder Company decided to apply for a bank loan to finance a new store.Although the company had been very successful,it had never prepared a cashbudget. The owner of Lucky Ladder Company used the information from the first 2 years of businessto reconstruct cash forecasts,and he presentedthem with his financial statementsas though they had been prepared as part of the company's planning. Do you think this behavior was ethical? What would you do in similar circumstances? Why?

GroupAssignment
To preparethe classfor a debateabout the format of the statementof cashflows, assignthe direct method to half of the groups in the class and the indirect method to the other half of the groups. Have each group prepare arguments about the superiority of their assigned method of presentingthe operating section of the statementof cashflows. Think about both theoretical and practical aspectsofthe methods.

InternetExercise: Carnival Corp.


Carnival Corp. prides itself on being "The Most Popular Cruise Line in the World@"-a distinction achievedby offering a wide array of quality cruise vacations. IE 9-1. Go to www.carnival.com, selectAbout Us. a. SelectWorld's Leading Cruise Lines and list three of the sevencruise lines operatedby the Carnival Corp. Close the World's Leading Cruise Lines window. b. Select News, Virtual PressKit and then Carnival Cruise Lines'Fleet Information. Within the past 5 years,how many new ships has Carnival put into service? c. Are the payments for ships consideredcapital expendituresor revenue expenditures?On the statementof cash flows, which businessactivity category will report thesepayments?

474

O F C A S HF L O WS CHAPTER 9 . PREPARI NG AND ANALYZI N GT H E S T A T E M E N T

lE 9-2. Go to www.carnival.com, selectAbout Us and find Investor Relations.You will find a link to the annualreport (pdf file). Find the annualcashflow statement(page7 of the 2005 annual report) to answer the following questions. a. Does Carnival use the direct or the indirect method to preparethe statementof cash flows? How can you tell? Which activity section is affected by this choice of method? b. For the most recent year, list the amount of net cash inflow or outflow from each of the three major types of activities reported on the statementof cash flows. Which type of activity is providing the most cash?Is this consideredfavorable or unfavorable? c. For the most recent year, what amount is reported for net income and net cash from operating activities? Are these amounts the same?Explain why or why not. d. For the most recent year, did Carnival report cash inflows or outflows for capital expenditures? Is this consideredfavorable or unfavorable?Explain why. What do you think thesecapital expendituresare primarily for? What was the net amount of the capital expenditure?Which activity section reports this information? e. For the most recent year, what amount of cash dividends did Carnival pay out? For the most recent year did Carnival issue or retire any common stock?What was the net amount issued or retired? For the most recent year did Carnival issue or retire any long-term debt?What was the net amount issued or retired? Which activity section reports this information? f. Does this statementof cashflows indicate a strong or weak position with regard to cashand liquidity? Explain.