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Chapter 16 “How Well Am I Doing?” Statement of Cash Flows Solutions to Questions 16-1 The purpose of a statement of cash flows is to highlight the major activities that have provided cash and that have used cash during a period and to show the resulting effect on the overall cash balance. 16-2 Cash equivalents are short-term, highly liquid investments such as treasury bills, commercial paper, and money market funds. They are included with cash because investments of this type are made solely for the purpose of generating a return on funds that are temporarily idle and they can be easily converted to cash. 16-3 (1) Operating activities: Transactions that enter into the determination of net income are generally classified as operating activities. (2) Investing activities: Transactions that are involved in the acquisition or disposition of noncurrent assets are generally classified as investing activities. (3) Financing activities: Transactions (other than the payment of interest) involving borrowing from creditors, and any transactions (except for stock dividends and stock splits) involving the owners of a company, are generally classified as financing activities. 16-4 Interest is included as an operating activity since it is part of net income. Financing activities are narrowly defined to include only the principal amount borrowed or repaid. 16-5 The gain is deducted from net income to avoid double counting, since the entire proceeds from the sale will appear as a cash inflow from investing activities. 16-6 Transactions involving accounts payable are not considered to be financing activities because such transactions relate to a company’s day-to-day operating activities rather than to its financing activities. 16-7 Examples of direct exchanges include issuing capital stock in exchange for property or equipment, converting long-term debt into common stock, and acquiring property and equipment through a long-term lease. The effects of such exchanges are provided in a separate, accompanying schedule to the statement of cash flows. 16-8 The repayment of $300,000 and the borrowing of $500,000 must both be shown “gross” on the statement of cash flows. That is, the company would show $500,000 of cash provided by financing activities and then show $300,000 of cash used by financing activities. 16-9 The direct method reconstructs the income statement on a cash basis by restating sales, expenses, and all other income statement items in terms of cash inflows and outflows. The indirect method determines the cash provided by operating activities by starting with net income and adjusting it to a cash basis. 16-10 Depreciation is not a source of cash. Adding back depreciation charges to net income to compute the amount of cash provided by operating activities creates the illusion that depreciation is a source of cash. A company could double or triple its depreciation charges, and there would be no effect on the amount of cash provided by operating activities. Charges to the accumulated depreciation account are added back to net income since they are equivalent to a decrease in an asset account. [See Exhibit 16-2.] 16-11 If the Accounts Receivable account increases during a period, the increase must be deducted from net income under the indirect method since this is an increase in a noncash asset. 16-12 If the Accounts Payable account decreases during a period, the decrease must be added to cost of goods sold under the direct method. In other words, the cost of goods sold is increased by the amount of the decrease in accounts payable. Since the cost of goods sold is increased, the net cash flow provided by operating activities is decreased. Note that this is how a change in a liability should be handled according to Exhibit 16-2. The effect of a decrease in a liability is a decrease in cash. 16-13 The $60,000 cash dividend will be a use of cash in the financing activities section of the statement. The stock dividend will not appear on the statement of cash flows, since a stock dividend involves no cash. 16-14 A sale of equipment for cash would be an investing activity. Any transaction involving the acquisition or disposition of noncurrent assets is classified as an investing activity. 16-15 Cost of goods sold $250,000 Decrease in inventory –15,000 Decrease in accounts payable +10,000 Cost of goods sold adjusted to a cash basis $245,000 Exercise 16-1 (15 minutes) Transaction Operating Investing Financing Source Use a. Short-term investment securities were purchased X X b. Equipment was purchased X X c. Accounts payable increased X X d. Deferred taxes decreased X X e. Long-term bonds were issued X X f. Common stock was sold X X g. A cash dividend was declared and paid X X h. Interest was paid to long-term creditors X X i. A long-term mortgage was entirely paid off X X j. Inventories decreased X X k. The company recorded net income of $1 million for the year X X l. Depreciation charges totaled $200,000 for the year X X m. Accounts receivable increased X X Exercise 16-2 (10 minutes) Item Amount Add Deduct Accounts Receivable $ 70,000 decrease X Accrued Interest Receivable 6,000 increase X Inventory 110,000 increase X Prepaid Expenses 3,000 decrease X Accounts Payable 40,000 decrease X Accrued Liabilities 9,000 increase X Deferred Income Taxes 15,000 increase X Sale of equipment 8,000 gain X Sale of long-term investments 12,000 loss X Exercise 16-3 (15 minutes) Net income $84,000 Adjustments to convert net income to a cash basis: Depreciation charges for the year 50,000 Increase in accounts receivable (60,000) Increase in inventory (77,000) Decrease in prepaid expenses 2,000 Increase in accounts payable 30,000 Decrease in accrued liabilities (4,000) Increase in deferred income taxes 6,000 Net cash provided by operating activities $31,000 Exercise 16-4 (15 minutes) Sales $1,000,000 Adjustments to a cash basis: Less increase in accounts receivable – 60,000 $940,000 Cost of goods sold 580,000 Adjustments to a cash basis: Plus increase in inventory + 77,000 Less increase in accounts payable – 30,000 627,000 Operating expenses 300,000 Adjustments to a cash basis: Less decrease in prepaid expenses – 2,000 Plus decrease in accrued liabilities + 4,000 Less depreciation charges – 50,000 252,000 Income taxes 36,000 Adjustments to a cash basis: Less increase in deferred income taxes – 6,000 30,000 Net cash provided by operating activities $ 31,000 Note that the $31,000 agrees with the cash provided by operating activities figure under the indirect method in the previous exercise. Exercise 16-5 (20 minutes) HOLLY COMPANY Statement of Cash Flows For the Year Ended December 31, 2002 Operating activities: Net income $20 Adjustments to convert net income to a cash basis: Depreciation charges for the year 10 Increase in accounts receivable (7) Increase in inventory (14) Increase in accounts payable 6 Net cash provided by operating activities 15 Investing activities: Additions to plant and equipment (30) Net cash used for investing activities (30) Financing activities: Increase in common stock 20 Cash dividends (8) Net cash provided by financing activities 12 Net decrease in cash (3) Cash, January 1, 2002 7 Cash, December 31, 2002 $ 4 Exercise 16-5 (continued) While not a requirement, a worksheet may be helpful. Change Source or Use?
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