financial accounting 09.pdf

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r - - r r tPreporingnd nulyzingteStulementfCoshlowsHere'sWhereYou've eenYou eorned ow o compony ccountsorond reportsontributionsromowners,poymentf dividends,nd retoinedornrngs

Here'sWhereYou're oingYouwill eornwo woys o prepore nd presenthestotementf cosh lows. hi swillincreoseourunderstondingf thedifferenceetween oshbosis nd occruol osisoccou t i q.

Aewp"n{ryfi ee{twsWhen you are finished studying this chapter, you should be able to:1. Explain the importance of the statementof cash lows and he three classifications

of cash on the statementof cash lows.2. Bxplain the difference between the direct method and the indirect method ofpreparing he statementof cash lows.3" Convertaccrual amounts o cash amounts.4. Prepare he cash lows from operating activities sectionof the statementof cashflows using the direct method.5. Prepare he cash lows from operating activities section of the statementof cashflows using the indirect method.6. Prepare he cashflows rom investingactivities section and he cashflows romfi-nancing activities section of the statementof cash lows.7" Perform generalanalysis of the statementof cash lows and calculate free cash low.fi, Use the statementof cash lows and the related controls to evaluate he risk of in-

vesting n a firm.427


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428 CHAPTER . PREPARINGND ANALYZING HESTATEMENTF CASHFLoWs

L"(}"1Expla inhe importance fthe statementof cash lowsand the three classificationsof cashon the statementofcash lows.

Fraud s not restr ictedo publicly-held ompanies nd privately-owned companies. ven he publicsector ssubject o fraud. Eth-ical behavior s needed everywherel Here are just a few of theproblems ncoveredn an examination f the records f Hemp-steadSanitaryDistr ictNo. 1 in Nassau ounty n New York.Nonexistentime sheetsor sanitat ionworkers.Poorcontrolsovernearly$1 mil l ion n cash eceipts. phantomgarbage ruck hathad off icial lybeen"disposed f" but was nonethelesseen umblingdown the street. Unreasonable" i l ls or out-of-state onferences-includinga $576steakdinner for four. (Source: Tale of the Five-HattedAccountant,"byVivianS.Toy, he NewYorkTimes,September18,2005,p. 3, Sec1411.)

The mportancef the Statement f Cash lowsThe statementof cash lows-one of the four financial statements companymust prepareaspart of generally acceptedaccountingprinciples (GAAP)-shows all the cash he com-panyhas eceivedand all the cash he company hasdisbursedduring the accountingperiod.Each cash low relates o one of three businessactivities-operating, investing,or financ-ing activities. Exhibit 9.1 showsa summaryof the information presentedon the statementof cash lows.Thousandsof companiesgo bankrupt eachyearbecause hey fail to plan their cash lowseffectively.When the time comes o pay their bills, they do not have enoughcash on hand.Preparinga cash budget s a crucial activity for all companies. t is more complicated hanjust estimatingcash nflows andoutflowsfor the accountingperiod.The sourcesof cashandthe uses of cash must be estimated n detail-both the amounts of cash and when cash sneeded.Each month, projectedcash nflows and outflows must be budgetedby source anduse.With this level of detail, a company canplan ahead or any cashshortageby (1) secur-ing a line of credit from a local bank, (2) bonowing the money,or (3) altering the timing ofits receipts tighteningup credit policies)or disbursementspostponingpurchases).A cash budget s a detailedplan of a company'sestimatedcash receiptsand estimatedcash disbursements, ith very specif ic forecastsof the sources,uses,and the timing of thecash lows. The budgeted ash lows in the cashbudgetcan henbe comparedwith actualcashflows, and he comparison s thebasis or planning and evaluatingperformance.To comparethe actualcash lows for an accountingperiodwith theperiod'scashbudget,a companymustproducedetails about he actual sourcesof cashand actual usesof cash rom the company'srecords.Comparingactualcash lows with budgeted ash lows getsa company eady o pre-pare he nextperiod'sbudgeted ash lows. Eventhough he focus of financial reporting s fi-

'heuts &sALarge .S. ompaniesaveots f cashlCash spilingup at many argeU.S. irms.Accordingo lhe WallStreetournal("Capitalains:igCash oards,by anMcDonald,uly 1 2006, .C1), he174S&PIndustr ialsasectorhatexcludesinancialirms) adover 295bi l l ionn cashn hef i rstquarter f 2006 "That mount quals ore han7okof thecompanies'stock-market alue,he highesteveln nearlywo decades."


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CHAPTERg TW O METHODSOF PREPARINGND PRESENTINGHE STATEMENT F CASHFLOWS 429

EXHIBIT9.1Th e Statement of CashFlowsA firm's statementof cash lows will include every cash nflow andoutflow. The cash lows are divided into three categories:operating,investing, and financing.

nancialstatementsor shareholders nd nvestors,he nformation aboutcash lows is equallyuseful to managers f a company.Since Tom startedhis T-shirt business n January2006, we haveprepared he four ba-sic financial statementsor his businessevery month, ncluding the statementof cash lows.The way we haveprepared he statementof cash lows hasbeen o1. Identify every cash ransactionon our accountingequationworksheet,and then2. Classifyeachcashamountas one ofthree types:operating,nvesting,or financing.

When we use a separate olumn in the accountingequation worksheet or cash rans-actions,we simply take eachaddition of cash and each subtractionof cash; hen we clas-sify eachcash low as cash rom operatingactivities,cash rom investingactivities, or cashfrom financing activities. Becausea real company has a much more complex accountingsystem,needed o handle housandsor millions of transactions,examining each ransactionis not a feasible way for a company to prepare he statementof cash lows. In this chapter,we will discusshow the statement s actually prepared.

TwoMethods f PreparingndPresentingthe Statement f Cash lowsGAAP describes wo ways of preparing he statementof cash lows: the direct method andthe indirect method. These wo methodsare named or the way in which the operating sec-tion of the statement of cash flows-cash from operating activities-is prepared,eitherdirectly-by converting every number on the income statement o its cash amount-orindirectly-by startingwith net ncomeand adjusting t until you have he net cash rom op-erating activities. For the other two sections,nvesting and financing, there s only one wayto compute he cash lows: The transactionsare directly identified.Thus, in any discussion

The direct method showsevery cash nflow and outflowto prepare he statement ofcash lows.The indirect method startswith net incomeand makesadjustmentsor i tems hat arenot cash o prepare hestatementof cash lows.

-E-.{}.}Explain he di f ferencebetween the di rect methodand the indirect method ofprepar ing the statement ofcash lows.

Operating Investing Financing

Types oftransactions

Cash related to the day-to-dayactivities of mnning thebusiness-revenue and expensetrarsactrons

Cash elated o buying andselling assets hat the firm plansto use or longer han oneyearCash receipts and disbursementsrelated to loans (principal only);cash contributions from anddistributions to owners

Examples

Inflows Cashcollections romcustomers Cashproceeds rom the sale ofIandor buildingCashproceeds rom a newstock issue

Outflows Cashpaid to vendors orinventory Cashpaid for new land orbuilding Cashdividendspaid toshareholders

Cash flows aregenerally relatedto these balancesheet accounts

Current assetsandcurrent liabilities Long-termassetsLong-term iabilities andshareholder'sequity


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CHAPTER . PREPARINGND ANALYZING HESTATEMENT F CASHFLOWSEXHIBIT9.2Comparisonof the Directand IndirectMethods for the Statementof CashFlows

Statement of Cash Flows(cash ro m operating ctivit ies nly)

Direct MethodCash from operating activities:Cashcollected from customers . . . .Cashpaid for suppliesCash paid to vendors for inventory .Net cash from operating activities

Indirect MethodCash from operating activities:Net income- increase n accounts receivable- increase n supplies+ increase in accounts payable . .Net cash from operating activities

$500(30)(200)$270

$330(100)(10)50$270Both methods esult in the same otal cash rom operating activities.

about different methodsof preparinga statementof cash lows, the difference between hedirect methodand he indirect method appliesonly to cash rom operating activities.Before we discuss he two different methods n detail,we will look at a simple exampleof the difference between hesemethodsof preparing he statementof cash lows. We willstart with the fust month of business or a simple companywith the following transactions.1. Purchaseof inventory for $250-paid cash of $200 to vendor with the remaining $50on account(accountspayable)2. Salesof all inventory or $600-$500 for cashand$100on account accounts eceivable)3. Purchaseof supplies or cashof $3O-used $20 worth of them, with $10worth remain-ing for next month

Net income is calculatedas ollows.$2so $20 $330

Cost of goodssold Suppliesexpense Net incomeCash collected and disbursed s calculatednext.

$500 $200 $30 : 5270Cashsales Inventory purchases Suppliespurchase Net cash lowThis change rom accrual basisnumbers o cashbasis numberscan be done n the twoways shown n Exhibit 9.2-direct or indirect. The direct method examineseach tem onthe income statement,one by one. n contrast, he indirect method s more mechanical:Netincome is adjusted or all the changes n the current assets nd current iabilities, excludingcash and noncash tems from the income statement.You may want to study the transactionsand the exhibit again after you learn more about how to prepare he statements.Notice theonly cash lows in this example are cash lows from operating activities; and both methods

produce he sameamount of net cash rom operatingactivities.Both methodsof preparing he operatingsectionof the statementof cash lows requireinformation about he underlying fransactions o the cashcan be separatedrom the accrualaccounting numbers. For example, the amount of sales must be examined to get the actualcashcollected rom making those sales.Suppliesexpensemustbe examined o get the actualcashpaid for supplies.Doing this convertsaccrual-based mounts o cash-based mounts.

$600Sales

What is he major differencebetween he directand indirectmethodsof pre-senting he statementof cash lows? What are the similarities?Your Turn9-lHms#rWmsrstrri r"ir ij li ii ' ,i , ., : r' I


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CHAPTER . ACCRUAL CCOUNTING ERSUS ASH

Accrual ccounting ersus ashBasis ccountingAs you know, companies hat follow GAAP maintaintheir accounting ecordsusing the ac-crual basis. Preparing he statementof cash lows is actually converting the records of thebusiness o cashbasis.That is what you see n Exhibit9.2.There aremany reasonswhy ac-crual basis accountingand cashbasis accountingarenot generally the same.

For example,a company will record a saleand recognize he revenueon the incomestatementwhen the merchandises shippedor delivered.Does the companyalwaysreceivethe cash at that time? No. Thus, the amountof revenueearned rom sales or an accountingperiod may not be the sameas the amount of cashcollectedduring the period. At the endof the accountingperiod, when thecompany s preparing ts financial statements, ustomersmay still owe the company somemoney-there may be outstandingaccounts eceivable.That is one reason he cashcollected rom salesmight not equal he amountof the sales ora specific accountingperiod.

Also, the companymay have collectedcashduring the currentperiod from salesmadeduring theprior accountingperiod-accounts receivable rom theprior year may havebeencollectedin the current year.Thus, to calculate he cashcollectedfrom customers or thestatementof cash flows, we must consider and make an adjustment or the change n ac-counts receivable.

Supposea companybegat}O}7 with accounts eceivableof $500.These accounts e-ceivablewere recordedduring 2006, when the revenue rom the saleswas recognized.Allsalesare made on credit; and during 2007 t}recompanyhad salesof $3,000.At the end of2007 thebalance in accounts eceivablewas $600.How much cashwascollected rom cus-tomersduring 2007?Becauseaccounts eceivablestartedwith a balanceof $500 and endedwith a balanceof $600, the increase epresents ales hat havenot beencollected from thecustomers.Therefore, althoughsalesamounted o $3,000,only $2,900worth of thosesalesmust have beencollected n cash.

Another way to think about it is first to suppose hat customerspaid off their old ac-countsof $500. f total saleswere $3,000and f an endingaccounts eceivablebalancewas$600, then $2,400of the current salesmust havebeencollected.The beginning balanceof$500was collectedplus current salesof $2,400have beencollected-making the total cashcollected from customersduring the period equal to $2,900.This is the sort of reasoningthat must be applied to each tem on the income statement o prepare he statementof cashflows using the direct method.

The amount for every item on the income statements potentially different from thecashpaid or received or it. As we just discussed, he dollar amountof sales s potentiallydifferent from cash collected from customers.Cost of goods sold is potentially differentfrom cashpaid for inventory. nsuranceexpense s potentially different from the cashpaidto the insurancecompany-and so on, for all items on the income statement.The change n a current assetor a current liability will reflect the differencebetweenthe accrual-basedncome statementamountand the cashamount. Consider anexpenseonthe income statement.Supposesalary expense s shown on the year's income statementas $75.000.For the statement f cash lows, we want to showcashpaid to employeesasan operating cash outflow. What could make salary expensedifferent from cashpaid toemployees?First, we could havepaid someemployeescash hat we owedthem from last year.Thecashpayment would reduce the liability salariespayable. f we did pay some salariesweowed at the beginning of the year, hat cashpaid would be in addition to any currentyear'ssalary paid to employees.What else could make cashpaid to employeesdifferent fromsalary expense?We could have ncurred salaryexpense hat will not bepaid until next year.In other words, we recognizedsome salaryexpense hat did not get paid to the employees'We must have recorded t as salariespayable. n both cases, he differencebetweensalaryexpense andcashpaid to employeess reflected n the change n salariespayable rom thebeginning of the year to the end of the year.This is the sort of reasoning hat must be ap-plied to eachcurrent assetand each current iability (excluding cash)on the balance sheetto prepare he statementof cash lows.

BA5ISACCOUNTING 431

r,.{}.3Convertaccrual mounts ocashamounts.


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Your Turn 9-2'Wwgwtr'-',Wk.+',#.tr.ff

432 CHAPTER . PREPARINGND ANALYZING HESTATEMENT F CASHFLOWSSupposewe started he year with salariespayableof $690. Our salary expense or theyear,asshown on the ncome statement,s $75,000. f the balance n salaries ayable s $500at year-end,how much cashwas actuallypaidto employees? irst, we must havepaid off theamount we owed at the beginning of the year, $690. Then, because he ending balance nsalariespayable s $500,we must have paid only $74,500($75,000 - $500) ofthe currentyear'ssalaryexpense. hus, he total cashpaid o employeess $75,190 $690 + $74,500).Another way to interpretwhat happened s to say that we paid the full $75,000of this

year'sexpensen cashand we paid down our salariespayableby $190 ($690down to $500).That total s $75.190.

RoboCompany egan he yearwith $25,000n accountseceivable. uringthe year,Robo's ales otaled$50,000. t year-end,Robohad an accounts e-ceivable alance f $15,000. ow much ash id Robo ollectrom customersduring he year?How is that amountof cash lassifiedn the statement fcash lows?

I "$.4Prepare he cash lows fromope ating activities sectionof the statementof cashflows using he directmethod.

Preparinghe Statement f Cash lows:DirectMethodNow you are ready to learn the procedures or preparing a statementof cash lows. First,the cash from operating activities section of the statementof cash lows is preparedusingone of the following two methods we havealreadydiscussed.1. Direct method: Each tem on the accrual-basedncome statements converted o cash.2. Indirect method:Net income is the startingpoint, and adjustmentsare madeby addingand subtracting amountsnecessary o convert net income into net cash rom operatingactivities.

After you havedetermined he cash lows from operatingactivities,you determine hecash lows from investing activities and cash lows from financing activities.You will learnabout them later in the chapter.The direct method of computing cashflows from operating activities begins with ananalysis of the income statement. tem by item, every amount on the statement s analyzedto determine how much cash was actually collected or disbursed elated o that item.The first i tem on the income statement s usually revenue.What makes evenueon theincome statementdifferent from cash collected from customers?Any cash collected forsales n previous periods-that is, accounts eceivable-must be countedas cash collectedeven though it is not included as revenue.Conversely,any sales or the period for whichcashhasnot beencollected must be excluded rom cashcollections.Both cashcollectedbutnot counted as revenueand cashnot collectedbut included in revenuecan be identified bylooking at the change n accounts eceivableduring the period.We will useTom'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 asExhibit 3.13), for the month andanalyzeeachamount to change t from accrual o cash.Saleson the income statement or March amounted o $2,000.What we need o knowfor the statementof cash flows is how much cash was collected from customers duringMarch. We need to seehow accounts eceivablechangedduring the month. On March 1,Tom's Wear had $150 worth of accounts eceivable,and on March 31 the firm had $2,000worth of accounts eceivable.By comparing he balancesheetat the beginningof the monthwith the balance sheet at the end of the month, both shown n Exhibit 9.4, we can see ac-counts receivable ncreasedby $1,850. The amount of the change n accounts eceivablecame rom the currentperiod's salesnot collected.

Analyze what happened o accounts eceivable. t startedwith $150. Then during themonth, credit salesof $2,000were made(saleson the income statement).The ending bal-ance n accounts eceivable s $2,000.Thus, the cash collected from customersmust have


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CHAPTER . PREPARINGHE STATEMENT F CASHFLOWS:DIRECTMETHODEXHIBIT .3

Tom's Wear, nc.Income StatementFor the Month Ended March 31, 2006

433

lncome Statementfor Tom'sWear, Inc.for the Month EndedMarch 31

Sales revenueExpensesCost ofgoods sold 800Depreciation expense 100Insurance expense 50Interestexpense .. 30Netincome ..- . .

$2,ooo

(e80)$1,020

tom's Gal

Tom's Wear, nc.Balance SheetAt March 1 and March 31. 2006

EXHIBIT9.4Comparative alanceSheet orTom'sWear, nc .

March 3l March I March 31 March ICash $ 3,995Accounts receivable 2,000Inventory 300Prepaid insurance 75Prepaidrent .. 0Equipment (net of $100accumulateddepreciation) 3,900

Accounts payableOtherpayables . . . . .Interestpayable .. . .Notes payableTota]I iabi l i t ies .. . . . .

$6,695ID U100\2 50

$o 0303,000$ 3,030

$ 800bU00$ 850

Totalassets . . .$10,270 $7,070

Common stock 5,000Retained earnings .. . 2,240Total liabilities andshareholder'sequity $10,270 $7,070

been$150($2,000- $1,850). f you go back and ook at the transactionsor Tom'sWearduring March (in Chapter 3), you will find $150 was exactly the amount of cash he com-pany collectedfrom customers.Continuing down the March income statement, he next item is cost of goodssold of

$800. This is the cost of the merchandisesold during the month. How does hat comparewith the amount of cashpaid to vendors during the month? Did Tom's Wear sell anythingit bought the previousmonth from the beginning inventory; or did the companybuy moregoods n March than it actually sold in March? We need to look at what happened o theamount of inventory during the month. The beginning inventory balance was $100. Theending inventory balance was $300. That meansTom's Wear bought enough nventory tosell $800 worth and to build up the inventory by an additional$200.Thus,purchases f in-ventory must have been$1,000.Did Tom'sWearpay cash or thesepurchases f inventory?To seehow the purchaseof $1,000worth of inventory compareswith the cashpaid tovendors,we look at the change n accountspayable(to vendors).The beginning balance naccountspayablewas $800,and he ending balancewas zero.That meansTom's Wear musthavepaid $1,000to vendors or the month's purchasesand the $800 owed from February.Thus, he total paid to vendorswas $1,800.The next expenseon the March 31 income statement s depreciationexpense.Depre-ciation expense s a noncashexpense.That means we do not have any cashoutflow when

5,000L,220

0

l0m'swGal


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EXHIBIT9.5Cash rom OperatingActiviti es-D i rect tVt-etna

Your Turn 9-3

CHAPTER . PREPARINGND ANALYZING HE STATEMENT F CASHFLOWS

Tom's Wear, nc.Parbial Statement of Cash FlowsFor the Month Ended March 31, 2006

Cash from operating activitiesCash collected from customers $ 150Cashpaidtovendors (1,800)Cashpaidforadvertising (50)Net increase (decrease) n cash from operating activities

we record depreciationexpense.The cashwe spend o buy equipment s consideredan in-vesting cash low, and the periodic depreciationdoes not involve cash.Depreciation s oneexpensewe can skip when we are calculating cash rom operating activities using the di-rect method.Insuranceexpense f $50 s shown on the March 31 ncome statement.How much cashwas actually paid for insurance?When a company paysfor insurance, he payment s gen-erally recorded asprepaid nsurance.Examining the change n prepaid nsurancewill helpus figure out how much cashwas paid for insuranceduring the month. Prepaid nsurancestarted with a balance of $125 and endedwith a balance of $75. Because he decrease nprepaid nsurance s exactly the sameas he insuranceexpense,Tom's Wear must not havepaid for any insurance his month. All the expensecame from insurance hat was paid forin a previous period.The last expensewe need o consider s interest expense.On the income statement orMarch, we see nterest expenseof $30. Did Tom's Wearpay that in cash?On the balancesheet, he companybegan he month with no interestpayableandended he month with $30interestpayable. f it started he month without owing any nterestand ended he monthow-

ing $30, how much of the $30 interest expensedid the companypay for with cash?None.Tom's Wear must not havepaid any cash or interestbecause t owes he entire amount ofthe expenseat year-end.Tom'sWearpaid out onemore amountof cash elated o operating activitiesduring themonth. Can you find it? On the March I balancesheet, here s $50 that Tom's Wearowed;it is called otherpayables.By the end of March, that payablehas been educed o zero.Onlyone thing could havecaused hat reduction: a cashpayment to settle he obligation relatedto advertising.Thus,we will alsoput the cashoutflow of $50 on the statementof cash lows.To summarize,we have "translated" the accrual amounts ound on the income state-ment to cash amounts or the statementof cash lows. The cashcollected from customerswas$150.Tom's Wearpaid ts vendorscashof $1,800. t alsopaid $50 of otherpayables.Net cash low from operatingactivities was$(1,700).The operating sectionof the statementof cash lows using the direct method s shown n Exhibit 9.5.Remember,Exhibit 9.5 showsonly the cash low from operating activities.To explainthe entire change n cash rom March 1 to March 31, the investingand inancing cash lowsmust be included.

FlexCompany egan heyear2005with $350 f prepaidnsurance.or2006,the company'sncome tatement howed nsurancexpense f $400.f FlexCompany nded heyearwith $250 f prepaidnsurance,ow much ashwaspaid or insuranceuring2006?On he statement f cash lows,how wouldthat cash eclassified?

$(1,700)

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CHAPTER . PREPARINGHE STATEMENT F CASHFLOWS: NDIRECT ETHOD 435

Preparinghe Statement f Cash lows:lndirectMethodEven though the Financial Accounting StandardsBoard (FASB) suggestedhat companiesuse he direct method of preparing he statementof cash lows, more than907oof compa-nies use he indirect method.That is becausemost accountantshink it is easier o prepare'the statementof cashflows using the indirect method. Also, the requirement hat a com-panyusing the direct methodprovide a reconciliation of net income to net cash rom oper-ating activities meansmore work for the companyusing the direct method.Preparing he statementof cashflows using the indirect method-applied just to theoperating section of the statementof cash lows-starts with net income.Following net in-come, any amountson the income statement hat are noncashmust be added or subtractedto leave only cash amounts.Typical noncash tems are depreciationand amortization ex-pensesand any gains or losseson the sale of assets.Remember hat a gain or loss on thesale of a long-term asset s not cash; t is the differencebetween he book value of the assetand heproceeds rom the sale. We will include the proceeds rom the sale n the cash rominvesting activities section of the statementof cash lows.)

We will start with net incomefor Tom's Wear or March. Exhibits 9.3 and 9.4 showthenumberswe need o prepare he statementof cash lows using the indirect method.

The net income for March was $1,020.The first adjustmentwe make is to add backany noncashexpenses uch as depreciation.For Tom's Wear, we must add back to net in-come the $100 depreciationexpense.When we calculatedthe net income of $1,020, wesubtracted$100 that was not a cash outflow. Thus, we must add it back to net income tochangenet income to a cash number.Then, ust as you did when you prepared he statementof cash lows using the directmethod,you will evaluateevery amounton the ncome statement or its relationship o cashflows. Recall that in the direct method, we use changes n accounts eceivable o convertsales evenue nto cash collectedfrom customers,and we usechanges n inventory and ac-counts payable to convert cost of goods sold to cash paid to vendors. For the indirectmethod, f we adjust net income for every changen eachcurrentasset-with the exceptionof cash-and every change n eachcurrent iability, we will makeeveryadjustmentwe needto convert net income into net cash rom operatingactivities.

We will continuepreparing he statementof cash lows using the indirect method withTom's Wear for March. We start with net income of $1,020 and add back any noncashex-penses. epreciation f $100 s addedback.Then,usingExhibit 9.4,we examineeachcur-rent assetaccount and eachcurrent iability account or changesduring the month.

Accounts eceivablencreased y $1,850.That ncreaseepresents ales or which wedid not collect any cashyet. Thus, we need o subtract his increase n accounts eceivablefrom net income to convert net income into a cashnumber.

The next change n a currentassets the ncreasen inventoryof $200.This $200 ep-resentspurchasesmade hat have not yet been reportedas part of cost of goodssold onthe ncomestatement ecausehe temshavenot beensold.Still, Tom'sWear did pay cashfor them (we will assumecash was paid and make any adjustmentwhen we examine ac-countspayable),so the amount needs o be deducted rom net income becauset was acash outflow.Prepaid nsurancedecreased rom $125 to $75. This decrease f $50 was deductedasinsuranceexpenseon the income statement,but it was not a cashoutflow this period. Thisamount must be addedback to net income because t was not a cashoutflow

The last changes n current assetsald current liabilities are the changes n payables.Tom's Wear started he month with $800 of accountspayable and $50 of other payables.Tom's Wear ended he month with a zero amount of eachof these.That means$850 wasthe cashoutflow related o these wo amounts.The othercurrent iability is interestpayable.It started the month with no interest payable but ended the month with $30 of interestpayable.That is $30 Tom's Wear did not pay out. So the total change n current liabilitiesis a net decreaseof $820.This $820 amount was not included on the income statement-not deducted n the calculation of net income. Because he amountwas a cash outflow, we

L"#.5Prepare he cash lows fromope at ing activities sectionof the statementof cashflows using he indirectmethod.


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436 CHAPTER . PREPARINGND ANALYZING HE STATEMENTF CASHFLoWs

Cash rom OperatingActivities-IndirectMethodTom's Wear, Inc.Partial Statement of Cash FlowsFor the Month Ended March 31, 2006

Net income $ 1.020+ Depreciation expense 100- Increase n accounts receivable . . (1,8b0)- Increase n inventory (200)+ Decrease n prepaid insurance 50- Decrease npayables (820)*Net cash from operating actMties $(1,700)*Thisis comprised f the decreasen accounts ayable f $800,he decreasen otherpayablesor $50,and he ncreasen interestpayableor $30.

need o deduct an additional $820 rom net ncometo finish convertingnet ncome nto cashfrom operating activities.Look at the operating section of the statementof cash lows for Tom's Wear or Marchin Exhibit 9.6. The statementstartswith net income and makesall the adjustmentswe dis-cussed.Compare he cash rom operatingactivities section of this statementof cash lowspreparedusing the indirect method with the samesectionusing the direct methodshown nExhibit 9.5. The net cash low from operatingactivities is the sameno matterhow we pre-pare t-when we prepare he statementby examining every cash ransaction,as we did inChapter3; when we prepare t using thedirect method,aswe did earlier n this chapter;andwhen we prepare t using the indirect method,as we just did.Which way is easier o understand?The presentationproducedby the direct method-thepresentation hown n Exhibit 9.5-gives detailsaboutcash hat areeasier o understandhanthe details provided by the indirect method. Still, over 90Voof companies oday use the indi-rectmethod.A change n thispracticecould be a real benefit o usersof financial statements.

Your Turn 9-4 Suppose company adnet ncome f $50,000or the year.Depreciationx-pense,he onlynoncashtemon the income tatement, as$7,000. heonlycurrentassethat changed u ring he yearwas accountseceivable, hichbegan he yearat $6,500 nd ended he yearat $8,500. heonlycurrent ia-bility hat changed assalaries ayable, hichbegan he yearat $2,500 ndended he yearat $3,000. ssumehis s all the relevantnformation. alcu-latenet cash romoperating ctivities sing he indirectmethod.Wwmpm"ww-mw

EXHIBIT9.5

[,.(J.6Prepare he cash lows frominvesti g activities sectionand the cash lows fromf na nci g activities sectionof the statementof cashf ows.

Cashrom nvesting ndFinancingctivitiesIn addition to cash rom operating activities, thereare two other sectionsof the statementof cash lows: cash rom investing activities and cash rom financing activities.No matterwhich method you use to prepare he statementof cashflows, direct or indirect, the cashfrom investingactivities and cash rom financing activities sectionsareprepared he sameway-by reviewing noncurrent balancesheet accounts.The primary amountson the bal-ance sheet o review are property, plant, and equipment; notes payable; bonds payable;common stock; and retainedearnings.For Tom's Wear during March, start in the noncurrent assetssection of the balancesheet.The balancesheetat March 31 showsequipmentwith a cost of $4,000.The carryingvalue s $3,900and he accumulateddepreciation s $100, for a total costof $4,000.The as-set representing his equipmentwas not on the March I balance sheet,so Tom's Wear musthavepurchased$4,000worth of equipmentduring March. The purchaseof equipment s aninvesting cash low.

l0m'swGal


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CHAPTER. SUMMARY FDIRECTND NDIRECTETHODSWhen we see hat a companypurchaseda noncurrentasset,we must investigatehowthe company paid for the asset. n this case,we find that Tom's Wear paid cash of $1,000

and signed a note for $3,000.We include only the $1,000cash outflow in the statementofcash flows, but we must add a note disclosing the amount of the equipmentpurchase i-nancedby the note payable.All investing and financing activities must be disclosed,evenif there was no cash nvolved.

Next we review the liabilify sectionof thebalancesheet or changesn non-operatingi-abilities. Notice that on the balancesheetat March 1,Tom's Wear showsno notespayable.On thebalancesheetatMarch 31, notespayableshowsabalanceof $3,000.ThatmeansTom'sWear borrowed$3,000duringMarch. Again, when we discoversucha change,we mustfindout the details ofthe transactionbefore we can decidehow the transactionaffects he state-ment of cash lows. Generally,borrowingmoneyusinga note would result n a financing cashinflow. However, n this case, he note was given n exchange or equipment.Notice that theloan is disclosed,even hough the amount s not included on the statementof cashflows.Whenevera companyengagesn a financing or investingactivity, t mustbe disclosedon thestatementof cash lows, even hough the companyneveractually receivedor paid out anycash.The cash s consideredmplicit in the ransaction.t is as f Tom'sWear eceived hecashfrom the loan and immediately turned around andpurchased he equipment with it.

Other transactionswe should ook for when preparing he financing section of thestatementof cash lows include any principal paymentson loans and any new capitalcontributions-such as stock issued. We should also look for any dividends paid to thestockholders.For Tom's Wear for March 2001, noneof these ransactions ook place.

When we put the information about investing activities and financing activities with thecashfrom operating activities we have alreadyprepared, we haveall the information we needto complete he statement f cash lows. Look at the two statementsn Exhibit 9.7. We useddifferent methods o prepare he statements,but they aresimilar in form and amounts.

Check it out. The balance sheets n Exhibit 9.4 show that cashwent from $6,695 onMarch 1 to $3,995on March 31. The difference s a $2,700decreasen cash.Explainingthat change n the cash balance s the purposeof the statementof cash lows.

Summary f Direct nd ndirectMethodsThereare wo ways,both ways acceptableusing GAAR to prepareandpresent he statementofcash lows: the direct methodand the indirect method.The direct method providesmore detailabout cash rom operatingactivities. It shows he individual operatingcash lows. When a com-panyuses he direct method, GAAP requires hat the companyalsoshowa reconciliation of net

437

Tom's Wear, nc.Statementof CashFlowsFor the Month EndedMarch 31,2006

EXHIBIT9.74Statement of CashFlows (Direct)

tom'swGalash from operating activitiesCash collected from customersCashpaid to vendorsCashpaid for other expenses$ 150(1,800)(50)

Net cash from operating activities $(1,700)Cash from investing activitiesPurchase ofequipment $(1,000)'Net cash from investing activities (1,000)Cash from financing activities 0Net increase (decrease) n cash $(2,700)Beginning cash balance 6'995Ending cashbalance $ 3,995

;;$fifrffilr* $4;0txt:ffi;1;; ;t;;,i fff $;bbdfi;ffii$;iffi; $i;"ffiii:'-


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438 CHAPTER . PREPARINGND ANALYZING HE STATEMENT F CASHFLOWSEXHIBIT9.78Statement of CashFlows(lndirect)

Tom'sWear, nc.Statement of Cash FlowsFor the Month Ended March 31, 2006

t0m's eal Cash from operating activitiesNet income $ 1,020+Depreciat ionexpense .. . . . . . . . . . . . . . 100- Increase in accounts receivable (1,850)- Increase in inventory (200)+ Decrease nprepaid insurance 50- usLrc@c [tPaJoursD .. .. ..Net cash from operating activitiesDecrease n

payables r.c20)Cash from investing activitiesPurchase ofequipment (1,000)aNet cash from investing activitiesCash from frnancing activitiesNet increase (decrease) n cashBeginning cash balance

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

$ 3,995

L.O.7Perform eneral nalysisfthe statement f cashlowsandcalculatereecashflow.

Ending cash balance"Equipmentwaspurchasedor $4,000. notewas signed or $3,000 nd cashpaidwas$1,000.

income to net cash from operating activities in a supplemental schedule.That reconciliationlooks exactly like the operating sectionof thestatementof cash lows using the ndirect method.The indirect presentationof the statementof cash low is easier o prepare rom the in-

come statementand he beginning and endingbalancesheets or the period, but the presen-tation of the information is not easily understood.A company hat uses he indirect methodmust make separate isclosures or cashpaid for interestand cashpaid for taxessomewherein the financial statements. his is required by GAAP. Keep n mind that the investing ac-tivities and the financing activities sections or the two methods are dentical; and the totalnet cash low is the same or both methods.Applying ourKnowledge:Financial tatement nalysisLook at the statementof cash lows for Auto Zone Inc., shown n Exhibit 9.8. First, noticethe organizationof the statement. he statementhas he threerequired parts: (1) cash lowsfrom operatingactivities,(2) cash lows from investingactivities, and(3) cash lows from fi-nancing activities. Second,notice the first section-cash providedby operatingactivities-is preparedusing the indirect method.

The statementstafts with the amount for net income and makes severaladjustments o thatamount. Look at the adjustmentsand see f you understandwhat information they provide. Forexample, depreciation and amortization are addedback to net income to work toward net cashfrom operating activities because he amounts for depreciation and amortization were sub-tracted n the original computationof net ncome but theywerenot cashexpenditures.That sub-traction is undoneby adding he amountsbackto net ncome. There are many other adjustmentsthat are beyond the scopeofan introductory accounting course,but you should understandwhytheseadjustmentsarebeing made.They are"undoing" the noncashamounts hat were ncludedin the calculation of net income. Investors are ooking for apositive net cash low from operat-ing activities. In the long run, this is crucial for the continuing successof any business.

The cash lows from investing activities section of the statementshowscapital expen-dituresas he fust entry. Those are tems such asproperty, plant, and equipment.Recall thediscussion n Chapter4 about capital versus evenueexpenditures-capitalizing a cost ver-sus expensing a cost. Theseare costs hat have been capitalizedby Auto Zone. Other en-tries in the cash lows from investins activities section nclude cash nflows and outflows


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CHAPTERg APPLYING OURKNOWLEDGE: INANCIAL TATEMENTNALYSIS 439EXHIBIT9.8

AutoZoneStatementof CashFlows AutoZone's Statementof CashFlowsThis statementof cash lows hasbeenpreparedusing the indirectmethod.

(inthousands)Cash flows from operating activities:Net incomeAdiustments to reconcile net income to net cashprovided by operating activities:Depreciation and amortization of property and equipment . .Deferred rent liability a{iustmentAmortization of debt origination feesIncome tax benefit realized from exerciseof optionsGains from warranty negotiationsChanges n operating assetsand liabilities:Deferred income taxes

Accounts receivableMerchandise inventoriesAccounts payable and accrued expensesIncome taxes payableOther, netNet cashprovided by operating activitiesCash flows from investing activities:Capital expendituresAcquisitionsProceeds from disposal of capital assetsNet cash used in investing activitiesCash flows from financing activities:Net change n commercial paper .Proceeds rom issuance of debtRePaS''rnent f debtNet proceeds from sale of common stockPurchaseof treasurystock .. .Settlement of interest rate hedge instruments . .OtherNet cash used in financing activitiesNet increase (decrease) n cash and cash equivalentsCash and cash equivalents at begirming of yearCash and cash equivalents at end of yearSupplemental cash flow information:Interestpaid, net ofinterest cost capitalized . . . .Income taxes paidgee Notes to Consoli,tl,qted, FiMrci,al Statemmts,

YearEndedAugust27, August28,2005 2004(52Weeks) (52Weeks)

$ 571,019 $ 566,202

135,597 106,8912t,5272,34331,828(1,736)(16,628)(42,485)(t24,566)109,341(67,343)29,186648,083

(283,478)(3,090)3,797(282,771)(304,700)300,000

64,547(426,852)(34e)(367,354)(2,042)76,852

q___48!_$ 98,937$ 339,245

4,23024,339(42,094)M,4983,759(119,539)43,61232,18(25,637)638,379

(184,870)(11,441)2,590(r93,72r)254,400500,000(431,995)33,552(848,102)32,L66(e2e)(460,908)(16,250)93,102

$ 76,852

$ 77,871$ 237,010

related o the purchaseand sale of long-term assets ot related o the normal operationsofAutoZone. (WhenAutoZone buys the items that it resells n the normal courseof business,the cash lows are ncluded in the frrst section-cash provided from operating activities.)

The cash lows from investing activities sectionof the statementof cash lows gives n-formation about the company's plans for the future. Investments n property, plant, andequipmentmay indicate an expansionor, at the very least,a concernaboutkeeping hecom-pany's infrastructure up to date. Over time, a company's failure to invest n the infrastruc-ture may indicate a problem.The cash lows from financing activities sectionof the statementof cash lows showsthe cash flows related to the way the company is financed. Some of the items should be


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440 CHAPTER o PREPARINGND ANALYZING HESTATEMENT F CASHFLOWSrecognizable-proceeds from issuanceof debt and proceedsfrom the sale of commonstock. All of the items in this section relate to AutoZone's financing. This information,when combined with the information on the balancesheet,gives the financial statementuser a completepicture of the way the company s financing the business.We should consider wo more characteristicsof the statement.First, following the cal-culation of the net increaseor decrease n cash for the year, the reconciliation from theyear'sbeginning cashbalance o the year's ending cashbalance s shown.Second, here ssupplementarynformation disclosedconcerning he cashpaid for interestand hecashpaidfor taxes during the year.This is requiredby GAAP.When analyzing he statementof cash lows, managersand analystsoften calculateanamountcalled free cash flow. Free cash low is defined as net cash rom operatingactivitiesminus dividends and capital expenditures. his givesa measureof a firm's ability to engagein long-term nvestmentopportunities. t is sometimesseenas a measureof a company's r-nancial flexibility. AutoZone's free cash low is quite adequate:$648 million - $283 mil-lion = $365million. Looking over the capitalexpenditures or the past2 yeus, you can seethat $365 million should be enough or new investmentopportunities.

Freecash low is equal o netcash rom operatingactivit iesminusdiv idends nd minuscapitalexpenditures.

Your Turn 9-5$kpwp'm-fiw*ww.p,ry

DRP ompanyeported et cashromoperating ctivities f $45,600.upposethe irm purchased25,000 orth of new ong-term ssetsor cash nddid notpayanydividends uring heyear. he irm'saverage urrentiabilitiesor theyearwere$40,000. ha twas he irm's reecashlow during he year?

m,w:cwww#,%Tfii,y,Jw)l-,l'dffiune s sTheCashConversion ycleYou ave eardheoldadagehat cashs ing, but hereisa broader ayof thinking bouta firmscash ositionthan implyookingt tscash alance.syou earnednthesecondhapterf hisbook,iquidityeferso anasset'sproximityo cash. ccordingo Richardoth "TheWork-ingCapital osition,"nvestopedia.com,ugust , 2006),it isactuallyiquiditythatsking,Hesayshat

A liquidity queezes worse han a profitsqueeze. key managementunction s tomake ure hat a company'seceivablend n-ventory ositionsremanaged fficiently.hi smeans nsuring n adequateevel f productavailabilitynd providing ppropriate reditterms, hileat hesameimemaking ure hatworking capitalassets on't tie up undueamounts f cash.This s a balancing ct formanagers,utan mportantne. t is mportantbecauseith high iquidity,companyan akeadvantagef price iscountsn cash urchases,

reduce hort-termorrowings,enefit romatop commercialredit atingand akeadvan-tageof market pportunities.A firms liquidity osition anbe measuredy tscashconversionycle. hat s he ength f time, n days,ttakesor a firm o convertts esourcenputsnt ocash.Thismeasurements hesum f 1and2 minus :1 Theaverageumber f daysnventorysoutstand-ing,calculatedrom he nventoryurnoveratio;2. The verageumber f days ccountseceivablereoutstanding,alculatedrom he accountseceiv-able urnoveratio; nd3. Theaverage umber f days ccountsayablereoutstanding,alculatedrom he calculationf ac -counts ayableurnover.Next ime you are analyzing firm's inancial tate-ments,ookup some nformationn thecash onver-sion cycle. t could help you uncover mportantinformation bouthow efficiently firm is using tsworking apital.


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CHAPTER. BUSINESSISK. ONTROL,NDETHICS 41The statementof cash lows is a crucialpafi of thehnancial reporting for any company.

Often creditors and nvestorswill look at this statement lrst when they are analyzing he fi-nancial condition of a firm. For the firm, however, he importanceof the statementof cashflows is tied to the cashbudget and how the actual sourcesand usesofcash compare o thebudgetedamounts.This analysis s an important function of managerialaccounting.

The statementof cash lows provides important information for managers,creditors,and investors. In corporate annual reports, the statementof cash flows is presentedwiththe other three basic financial statements-the income statement, he balance sheet, andthe statementof changes n shareholders'equity-to provide information needed o eval-uate a company's performance and to provide a basis for predicting a company's futurepotential.

Businessisk,Control, ndEthicsIn Chapter 6, you learnedabout the controls a company should have to minimize therisks associatedwith cash. Now we will talk about nvestors'risks associatedwith thestatement f cash lows. The misleading inancial statementshat havebeen at the heartof such failures as Enron and WorldCom have been the income statement and the bal-ance sheet.Managerscan rarely falsify cash nflows and outflows, so few people hinkof this statementas a place where the ethics of a firm's management ould be tested.However,managerscan manipulate he classificationof the cash flows. Becauseana-Iysts are often looking for positive net cash lows from operatingactivities, especiallyin established ompanies,a firm's managersmay feel somepressure o make sure hatthis part of the statementof cash lows is positive.There s an opportunity to engage nthe same ype of manipulation as WorldCom did when it classifiedexpenses hat be-longed on the ncome statement s ong-termassets n the balancesheet.Someone ouldmisclassify cash outflows from operating activities as investing cash outflows. Thischanges he whole natureof such expenditures.Operatingexpenses re he costsof do-ing business,so investorswant to seea low number. nvestingcashoutflows are ofteninterpretedas a positive signal for future growth of the firm, so investorswant to seeahigh number.There s a greatdeal of information in the statementof cash lows, and t deserves are-ful considerationwhen you are analyzinga firm's financial statements.As with the infor-mation provided by the other financial statements, he statementof cash flows providesreliable information only when the firm's managements ethical.

t,"&.8Use he statementof cashflows and the relatedcontrols o evaluate he riskof invest ingn a f i rm.

CashromOperating ctivities-Cant BeManipulated? ,/ :The tatementf cashlows soften ited s heonestatementha tcannot emanip- I - - - - - 'ulated. fterall, ashscash. owever,here reways firmcan ncreasetscashromoperatingctivitiesn shortnoticef it needs boost.t iscalled ecuritizationf ac-countseceivable.ltswhena companyorrows gainstts eceivables,lassifyinghecashnflow sanoperatingctivity.t isallowed yGAAP,ut t maybe misleading.nmanyways,t ismore ikea financingashlow.Be ure o read henoteso the rnan-cial tatements,venwhenyouareanalyzingomethingha tshould e asobvious scash[Source:QuickCashviaReceivablesDealsCanLeaveaBlurryFiscalicture,"byMichaelapoport ,he

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


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442 CHAPTER o PREPARINGND ANALYZING HE STATEMENTF cAsH FLoWS

Chapter ummary ointsThe statementof cash lows explains he change n cash rom the beginning of the ac-counting period to the end of the accountingperiod-the amounton one balancesheetand the amount on the subsequent alancesheet.Cashflows can be categorizedas cash from operating activities, cashfrom investingactivities, and cash rom financing activities.The statementof cash lows hasa sectionfor eachof these ategories.There are two methods-direct and indirect-for preparing and presenting he state-ment of cash lows. The direct method simply provides all operatingcash nflows andoutflows in a straightforward manner.The indirect method startswith net income andadjusts t for all noncash tems-depreciation expenseand gains or losseson the saleof long-term assetsare typical noncash tems. It also adjusts or changes n the currentassets excluding cash) and he current iabilities. These wo methodsdescribe he cashfrom the operating activities section of the statement.The other two sections-cashfrom investing activities and cash from financing activities-are the same on bothtypes of statements f cash lows.Freecash low is the amountof cash eft aftercashspenton investmentsn long-termas-setsand cashpaid for dividendsaresubffactedrom net cash rom operatingactivities. tmeasures ow much casha firm hasavailable or long-term nvestmentopportunities.Before you invest in a firm, look at its statementof cash flows. A growing or estab-lished firm should be generatingpositive net cash lows from operatingactivities. In-vesting cash lows may provide insights into the firm's plansfor the future. Be sure olook at the firm's cash situation over severalyearsand also compare he firm's sourcesand usesof cash o thoseof the competitors.

Chapter ummary roblemsSupposeAttic Treasures,a retail store, provided you with the following comparativebal-ancesheetsand the related ncome statement. Notice the most recent year is in the rightcolumn.) Assume he firm did not purchaseany property,plant, and equipment PP&E) dur-ing the year.

AssetsCash .. $ 23,000 $ 39,200Accounts receivable 12,000 23.450Merchandise inventory 25,200 28,100Prepaidrent. . . 6,000 5,500Property, plant, and equipment (PP&E) 79,500 70,000Accumulated depreciation (24,000) (29,000)Totar ssets $-tztroo stsz.zso

January JanuaryAt 30,2008 29,2009

Liabilities and Shareholders' EquityAccountspayable .. . .Income taxes payableLong-terrn notes payableCommon stock and additional paid-in capitalRetained earningsTotal liabilities and shareholders' equity

$ 12,300i0,00039,70018,5004r,200$121,700

$ 26,2008,r0025,80020,00057,r50$137,250


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Attic TreasuresIncomeStatementFor theyearendedJanuary29,2009sales . $234,900Costofgoodssold.. . 178,850Gross margin 56P50Sel l ingexpenses.. . . . $24,000General expense* 8,500 32,500Incomefromoperat ions.. . . . 23'550Interest expense f,200Income before income taxes . 22,350Income tax expense 3,400Net income $ 1q950* includes rent expense of $2,000 md depreciation experoe of $6,000

InstructionsPreparea statementof cash lows. Your instructorwill tell you whether to use the indirectmethodor the direct method (or both). Solutionsfor each areprovided.SolutionDirectMethodTo prepare he cash rom operatingactivitiessection using the direct method,go down theincome statementand convert the accrualamounts o cash amountsby referring to the re-lated current assetor current iability account.

1. Convertsales o cash collectedfrom customers.Sales $234,900.Increasen accounts eceivable AR) from $12,000 o $23,450 $11,450.The increase n AR is the amountof salesAttic Treasures id NOT collect in cash, sothe cashcollected rom customerss $234,900 $l1,450 = 9223,450.2. Convertcostof goodssoldto cashpaid to vendors. his takes wo steps. irst, convertcost ofgoods sold o total purchases.Costof goods old= $178,850.Increasen inventory rom $25,200 o $28,100 $2,900of additionalpurchases.The increase n inventory is added o the cost of goods sold to get total purchases=$178,850+ $2,900 $181,750.Then,convert otalpurchaseso cashpaid o vendors.Totalpurchases $181,750.Increase n accounts ayableof $12,300 o $26,200 $13,900 epresent urchasesthatdid not get paid for, so cashpaid to vendors= $181,750 $13,900 $167'850.

3. Convert selling expenseso cashpaid for selling expenses.Because here areno cur-rent assets r current iabilities related to selling expenses suchas accruedselling ex-penses),Attic Treasuresmust havepaid cash or this entire amount. So cashpaid forsellingexpenses $24,000.4. Convertgeneral expenseso cashpaid for general expenses.Generalexpenses $8,500.This includes$2,000 ent expense nd $6,000deprecia-tion expense.So we could break down the generalexpenses s ollows:Rent expense $2,000Depreciation expenses $6,000Other expenses $ 500First, rent expense s related to prepaid rent on the balance sheet.Prepaid rent de-creased rom $6,000 o $5,500.This means he companyusedrent it had already(last


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44 CHAPTER o PREPARINGND ANALYZING HE STATEMENT FCASHFLOWS

6.

year) paid for, so the decreasen prepaidrent reduces he rent expenseby $500 to getcashpaid for rent : $2,000- $500 : $1,500.Depreciation expense s a noncashexpense, o there s no cash low associatedwith it.Other expensesof $500 must havebeen all cashbecause here are no associated ur-rent assetsor current iabilities on the balancesheet.So the total cashoaid for seneralexpenses $1.500 5500: $2,000.Change nterest expense o cashpaidfor interest.Interestexpense $1,200.This must have beenall cashbecausehere were no current assets r current iabilitiesassociated ith it. Cashpaid for interest $1,200.Change ncome tax expense o cashpaid for taxes'.Income ax expense $3,400.Decreasen income axespayable rom $10,000 o $8,100 $1,900,which representsadditional taxes he companypaid beyond he income tax expenseon the ncome state-ment. Cashpaid for income axes $3,400+ $1,900 $5,300..You have now convertedall the income statement tems to cash nflows and outflowsand areready to prepare he first part of the statementof cash lows.Cash rom oper atingactivit iesCash ollected rom customersCashpaid o vendorsCash aid or sel l ing xpensesCashpaid or generalexpensesCashoaid or interestCashpaid for income axesNet cashprovidedby operatingactivit ies

$223,4s0(1 7,8s0)(24,ooo)(2,000)(1,200)(s,300)$ 23,100

Next, calculate ash rom investingactivities.An analysisof long-termassets howsthatproperty,plant,and equipmentdecreased y $9,500.A decreases caused y dis-posingof assets. ecause he ncomestatement howedno gainor loss rom disposalof long-term assets, he assetsmust have been sold for book value.The property,plant,and equipmentaccountdecreased y $9,500 thecost of the PPE sold) and heaccumulated epreciation ccount ncreased y $5,000.Recall rom the ncomestate-ment hat depreciation xpenseor the yearwas $6,000. f accumulated epreciationonly increasedby $5,000, hen $1,000must have been subtracted. hat means hePPEsold had a book value of $8,500 $9,500- $1,000).Becauseherewas no gainor losson the disposal, he companymust have eceivedproceeds qual o the bookvalue.So he cash nflow-proceeds-from disposalof PPEwas an nvesting ash n-flow of $8,500.To calculate the cash flows from financing activities, analyzewhat happened n thelong-term iability accountsand the shareholders'equity ccounts. ong-termnotespayabledecreasedrom $39,700 o $25,800.That must havebeen a cashoutflow of$13,900.Commonstockandadditionalpaid-incapital ncreased y $1,500.Thatmusthave been a cash nflow from the issue of stock of $1,500.Lastly, see f the companypaid any dividends during the year. Retained earnings increasedfrom 941,200 to$57,150 $15,950.How does hatcompare o net ncome?Net incomewas $18,950but retainedearningsonly increased y $15,950,so $3,000must havebeendeclaredas dividends.The absence f dividends payable ndicates hat the dividendswerepaid.You are now ready to put the whole statement ogetherusing the direct method.

8.


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CHAPTER . KEYTERMSFO RCHAPTER 445

Attic TreasuresStatement f Cash lows-DirectMethodFor he yearended anuary 9,2OO9Cash rom operatingactivitiesCash ollected rom customersCashpaid o vendorsCash aid or sel l ing xpensesCashpaid or generalexpensesCashpaid or interestCashpaid or income axesNet cashprovidedby operatingactivitiesCash rom investing ctivitiesCashproceedsrom saleof property,plant and equipmentCash rom financi ng ct iv i t iesCash aidon loanprincipalCashproceedsrom stock ssueCash aid or d iv idendsNet cashused or financingactivitiesNet ncreasen cash uring he yearCash alance, eginning f the yearEnding ashbalance

5223,4s0(1 7,8s0)(24,ooo)(2,000)(1,200)(s,300)23,100

8,s00(1 ,900)1,500(3,000)(1s,400)16,20023,000$ :g,zoo

lndirectMethodTo prepare he statementusing the indirect method, start with net income.Adjust it for anynoncashexpenses nd the change n everycurrent asset excluding cash) and every currentIiability. The other two sections-cash from investing activities and cash from financingactivities-are the sameas or the direct method.

AtticTreasuresStatement f CashFlows-lndirectMethodFor heyearended anuary 9,2009Cash ro m operatingactivitiesNet ncomeAdd depreciation xpenseDeduct ncreasen accounts eceivableDeduct ncreasen inventoryAdd decreasen prepaid en tAdd increasen accounts ayableDeductdecreasen income axespayableNet cashprovidedby operatingactivitiesCash rom investing ctivitiesCashproceedsrom saleof property,plant and equipmentCash rom financi ng ct iv i t ies

Cash aidon loanprincipalCashproceedsrom stock ssueCash aid or dividendsNet cashused or financingactivitiesNet ncreasen cash uring he yearCash alance, eginning f the yearEnding ashbalance

8,500

$ 18,9s06,000(11,4s0)(2,900)s0013,900(1,900)

(1 ,900)1,500(3,000)(1 ,400)16,20023,000$ 3e,2oo

KeyTermsor ChapterDirect method (p. 429) Free cash low (p. 440) [email protected])


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446 CHAPTER o PREPARINGND ANALYZING HESTATEMENT F CASHFLoWs

Answerso YOUR URN uestionsChapterYour Turn 9-1The difference s in the cash lows from operatingactivities.The direct method dentifieseachcash low, whereas he ndirect method startswith net ncomeand adjusts t to a cashamount.The net cash low from operatingactivities s the sameno matterwhich method s used.Theother two sections-cash from investing activities and cash from financing activities-areidentical with both methods.Your Turn9-2$50,000 ($25,000$15,000)$60,000.This is a cash low from operating activities.YourTurn 9-3$400 ($350 $2s0) $300.This is a cash low from operating activities.Your Turn9-4Begin with net ncomeand add backdepreciation xpense: 50,000+ $7,000 $57,000.Then. subtract he $2,000 ncrease n accounts eceivable.Saleson account were includedin net income but should be deducted f the cashhas not been collected.Next, add he $500increase n salariespayable.Someof the salariesexpense,which was deductedon the in-come statement,was not paid at the balancesheetdate.$50,000 $7,000 s2,000 $500

$55,500net cash rom operating activities.YourTurn 9-5Freecashflow: Netcashfromoperations Purchaseoflong-termassetsDividends:$4s,600 $25,000 $20,600.Questions

1. What s thepurposeof the statement f cash lows?2. Which two financial statements re requiredto prepare he statementof cash lows?3. Describe the three categoriesof cash flows that explain the total change n cash forthe year.4. Why is the statementof cash lows so important?5. What are the two traditional approaches or preparingand presenting he statementofcash lows? What is the difference between hese wo approaches?6. Which types of business ransactionswould result in cash from operating activities?

Give three examplesof transactions hat would be classifiedas cash lows from oper-ating activities.

7. Which types of business ransactionswould result in cash lows from investingactiv-ities? Give three examplesof transactions hat would be classifiedas cash lows frominvesting activities.8. Which types of business ransactionswould result in cash lows from frnancing activ-ities? Give three examplesof transactions hat would be classifiedas cash lows fromfinancing activities.9. How is depreciation expense reatedwhen using the direct method of preparing the

statementof cash lows? When using the indirect method?10. Which account(s)must be analyzed o determine he cash collected from customers?How is this cash low classified?11. Which account(s)mustbe analyzed o determine heproceeds rom the saleof a build-ing? How is this cash low classified?12. Which account(s)must be analyzed o determine he cashpaid to vendors?How is thiscash low classified?13. Which account(s)must be analyzed o determine he cashpaid for dividends?How is

this cash low classihed?


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CHAPTER. MULTIPLE-CHOICEUESTIONS 44714. How is interestcollected or interestpaid classihed on the statementof cash lows?15. Define free cash low and explain what this amount ndicates about a frm.16. How might a firm misuse he statementof cash lows to give investorsa better mpres-sion of the firm's operations?Mult iple-ChoiceQuestionsUse the following information to answerQuestions1-3.Quality Productsengaged n the following cash transactionsduring May.

Purchaseof inventoryCashproceeds rom loanCashpaid for interestCash collectedfrom salesNew stock issuedSalariespaid to employeesPurchaseof new delivery van

$ s,000$ 7,000$ 400$26,500$25,000$ 4,600$20.000Note: Answers in parenthesesndicate net cash outflows.1. How much s net cash rom financins activities?

a. $ 7,000b. $25,000c. $31,600d. $32,0002. How much s net cash rom investinsactivities?a. $(20,000)b. $(25,000)c. $ 25,000d. $ 32,0003. How much is net cash rom operating activities?a. $26,500b. $ (3,s00)c. $16,500d. $16,9004. Cash rom the saleof treasurystocka. Would not be included in the statementof cash lowsb. Would be classified as a contra-equitycash lowc. Would be classified as an investing cash lowd. Would be classified as a financing cash low5. The cashproceeds ron the sale of a building will bea. The costofthe buildingb. The book value of the buildingc. The book value plus any gain or minus any lossd. Shown on the financing portion of the appropriate inancial statement6. If a firm has net investing cash inflows of $5,000, net financing cash inflows of$24,000,anda net ncreasen cash or theyearof $12,000, ow much s net cash romoperatingactivities?a. Net cash nflow of $17,000b. Net cash nflow of $29,000c. Net cashoutflow of $17,000d. Net cashoutflow of $19,0007. Depreciation or the year was $50,000and net income was $139,500. f the companyusedcash or all transactionsexcept hose related to long-term assets, ow much wasnet cash rom operating activities?a. $139,500b. $189,500c. $ 89,500d. Cannot be determined rom the eiven nformation


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Use the following information to answer he next threequestions.The income statementand additionaldata or FrancesCompany or the year endedDecem-ber 31.2006. ollows

Sales evenue $400,000Costof goods old $165,000Salaryexpense $ 70,000Depreciation xpense $ 55,000Insuranceexpense $ 20,000Interestexpense $ 10,000Income ax expense $ 18,000Net income $ 62,000

Accounts eceivable ecreased y $12,000. nventories ncreased y $6,000and accountspayabledecreased y $2,000.Salaries ayable ncreased y $8,000.Prepaid nsurance n-creased y $4,000. nterestexpenseand income tax expenseequal their cash amounts.FrancesCompanyuses he direct method for its statementof cash lows.8. How much cash did FrancesCompany collect from customersduring 2006?a. $400,000b. $412,000c. $406,000d. $388,0009. How muchcashdid FrancesCompanypay ts vendorsduring 2006?a. $173,000b. $165,000c. $167,000d. $163,00010. How much cashdid FrancesCompanypay for insurance uring theyear?

a. $20,000b. $24,000c. $16,000d. $48,000ShortExercisesSE9-1.dentifyashflows.LO1)Given the following cash ransactions,classify each as a cash low from: (a) operating ac-tivities,(b) investingactivities,or (c) financingactivities.a. Payment o employees or work done

b. Dividendspaid to shareholdersc. Payment or new equipmentd. Payment o supplier for inventorye. Interestpayment to the bank related o a loan

SE9-2. dentfu cashflows.(LO 1)Given the following cash ransactions, lassifyeachas a cash low from: (a) operatingac-tivities, (b) investing activities,or (c) financing activities.

a. Principal payment to the bank for a loanb. Collection rom customerso whom saleswerepreviouslymadeon accountc. Collection rom customersor cashsalesd. Collection for saleof land that had beenpurchasedas a possible actory sitee. Petty cash used o pay for doughnuts or staff

SE9-3. Calculateand identifi cash lows. (LO I , 3, 4)CollegeTelevisionCompany had supplies on its balancesheet at December 31,2006, of$20,000.The income statementor 2001 showedsuppliesexpenseof $50,000.The balancesheetat December3I,2001 , showedsuppliesof $25,000. f no supplieswerepurchased n ac-count all were cashpurchases), ow much cashdid CollegeTelevisionCompanyspendon sup-pliesduring 2001?How would thatcashoutflow be classifiedon the statement f cash lows?


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CHAPTER9SHORT XERCISESSE9-4.Calculateandidentifi cashflows.(LO I,3,4)Col Corporation reportedcredit salesof $150,000 for 2006.Col's accounts eceivable romsaleswere $25,000at the beginning of 2006 and$38,000at the end of 2006.What was theamount of cash collected from sales n2006? How would the cash rom this transactionbeclassifiedon the statementof cash lows?SE9-5. Calculateand identify cashflows. (LO 6)A buildingcost$55,000andhad accumulated epreciation f $15.000when t wassold ora gain of $5,000. t was a cash sale.How would the cash rom this transactionbe classifiedon the statementof cash lows?SE9-6. Calculateand identify cashflows. (LO 1, 3, 4)Sales or 2008 were $50,000;cost of goodssold was $35,000. f accounts eceivable n-creased y $2,000, nventorydecreasedy $1,300,accounts ayabledecreased y $2,000,and other accrued iabilities decreased y $1,000,how much cash waspaid to vendors andsuppliersduring the year?How would the cash from this transaction be classified on thestatementof cash lows?SE9-7. Calculate and identifu cashflow. (LO I, 3, 4)During 2007,CameronCompanyhad$300,000n cashsales nd$3,500,000n credit sales.The accounts eceivable alanceswere$450,000and$530,000at December31, 2006 and2007, respectively.What was the total cashcollected rom all customersduring 2007? Howwould the cash rom this transactionbe classified on the statementof cash lows?SE9-8. Evaluateadjustments o net income using the indirect method.(LO 5)The income statement or Lilly's Company or the yearendedJune30, 2008, showedsalesof $50,000.During theyear, he balancen accountseceivablencreased y $7,500.Whatadjustment o net income would be shown n the operating sectionof the statementof cashflows preparedusing the indirect method related o this information? How much cash wascollectedfrom customersduring the fiscal year endedJune 30, 2008?SE9-9.Evaluateadjustments o net income using the indirect method.(LO 5)The income statement or Sharp Inc. for the month of May showed nsuranceexpenseof$250.The beginning and ending balancesheets or the month showedan ncreaseof $50 inprepaid nsurance.There were no payables elated o insuranceon the balancesheet.Whatadjustment o net income would be shown n the operating section of the statementof cashflows preparedusing the indirect method related o this information?How much cash waspaid for insuranceduring the month?SE9-10. Evaluateadjustments o net income using the indirect method.(LO 5)During 2007,Mail Direct Inc. incurred salary expenseof $67,500,asshownon the incomestatement. he January1,2007 balance heet howed alaries ayableof $10,450;and heDecember 1,2007 balance heet howed alaries ayableof $13,200.What adjustmentonet ncomewould be shown n the operating section of the statementof cash lows preparedusing the indirect method related o this information? How much cashwas paid to employ-ees(for salary) during20}T?SE9-11. Evaluateadjustments o net income using the indirect method.(LO 5)Havelen'sRoad PavingCompany had depreciationexpense f $43,000on the ncome state-ment for the year.How would this expensebe shown on the statementof cash flows pre-paredusing 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.Depreciationex-penseof $2,000related o the truck was shownon the income statement.How are the pur-chaseof the truck and the related depreciation reflected on the statementof cash flowspreparedusing the indirect method?

M9


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45 0 CHAPTER . PREPARINGND ANALYZING HE STATEMENT F CASHFLOWSSE9-13.Evaluate adjustments o net income under the indirect method.(LO 5)B&W Inc. reportednet income of $1.2 million in 2006. Depreciation or the year was$120,000, accountsreceivable ncreased$728,000, and accountspayable decreased$420,000.Computenet cashprovided by operating activities using the indirect method.SE9-14.Evaluateadjustments o net income under the indirect method.(LO 1, 5)In 2001 JewelsCompany had net income of $350,000.The depreciation on plant assetsduring 2007 was $73,000,and the company incurred a loss on the sale of plant assetsof$20,000.Computenet cashprovided by operating activities underthe indirect method.SE9-15.Evaluate adjustments o net incomeunder the indirect method.(LO 5)The comparativebalance sheetsor JayCeeCompanyshowed he following changesn currentassetaccounts:accounts eceivabledecreased y $50,000,prepaid expensesdecreased y$23,000,and merchandisenventory ncreased y $17,000.Thesewere all the changesn theculrent assets ndcunent iability accountsexcept ash).Net ncome or theyearwas$275,500.Computenet cashprovidedby or usedby operatingactivitiesusing he ndirect method.SE9-16.Calculateand identifycashflows. LO 5)C&S Supply Inc. had $125,000of retainedearningsat the beginning of the year and abalanceof $150,000at the end of the year.Net income for the year was $80,000.Whattransaction ccurred o cause he decreasen retainedearnings?How would this decreasebe shown on the statement f cash lows?SE9-17. Usea statementof cash lows for decision making. (LO 7, 8)If you were nterestedn investingn a company,what tem(s)on he statement f cash lowswould be of most nterest o you? Why?SE9-18. dentifu risksand contols. (LO 8)If you were an nvestor,why would you look at the statementof cash lows? Which amountswould provide information about the risk to an investor?SE9-19. Identify risks and contols. (LO 8)If you believe here s a risk thata firm is not taking advantage f long-term nvestment ppor-tunities,how would the statement f cash lows help you confirm or disconfirm his belief?Exercises-SetE9-1A.dentifyashflows.LO )For eachof the following items, ell whether t is a cash nflow or cashoutflow and he sectionofthe statementof cash lows in which the item would appear. Assume he direct method s used.)

Itema. Cash ollected rom customersb. Proceedsrom issue f stockc. Interestpaymenton loand. Pr incipalepayment n loane. Cashpaid for advert isingf. Proceedsrom saleof treasury tockg. Money borrowed ro m the localbankh. Cashpaid o employeessalaries)i . Purchasef equipment or cashj. Cashpaid o vendors or inventoryk. Taxes aid

lnf lowor Outf low Section fthe Statement

E9-2A. Identify cash lows. (LO 1, 4, 6)For each ransaction, ndicate the amountof the cash low, indicate whether each esults nan nflow or outflow of cash, andgive the section of the statementn which each cash lowwould appear.Assumethe statementof cash lows is preparedusing the direct method.


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.t:.a:::::." : : : : r '. : , , . i 1

, ,t i,CHAPTER o EXERCISES 451 :, , , :. . . .Amounta. lssued 00shares f $2 parcommonstock or $12per shareb. Borrowed$7,000 ro m a localbankto expand he businessc. Purchased 500of supplies or $400cashand he balance n accountd. Hireda carpentero bui ld somebookcasesor the office or $500cashe. Earned evenue f $19,000,eceiving$9,200 ash nd he balance n accountf . Hireda student o do some ypingand paidhim $250 ashg. Repaid 7,000 f the bank oanalongwith $250 nterest.h. Paiddividends f $600

Inflow Section for Outf low the Statement

E9-3A.Prepare ashfromoperating ctivities ection f statement f cashflowsusing he :"i-j*,direcrmethod.LO4) it'fWUse he ncome tatementor ClarkCorporationor pastyearand he nformationrom he -J lfficomparativealance heets hownor thebeginning nd heendof theyear o preparehe ffi";,:,ifrIf;i#,cash romoperating ctivities ection f thestatementf cash lowsusing hedirectmethod.SalesCostof goodssoldGrossmarginOperatingexpenses

WagesRentUt i l i t ieslnsurance

Net incomeAccountAccounts eceivableInventoryPrepaidnsuranceAccountspayableWagespayableUt i l i t ies ayable

$100,0003s,00055,000$ 2,s001,200980320 s,000

$ 60,000Beginningf theYear End f theYear

$ 12,0001 ,50040010,400600-0 -

$ 10,00021,0005759,000850150E9-4A.Prepare ashrom operating ctivities ection f statement f cashlowsusing he i +iJ,-indirectmethod.LO5) i::..WUse he nformationrom E9-3A opreparehecash rom operating ctivities ection f the =_j;W..-tatementof cash lows using the indirect method. Then, compare t with the statement ou Mprenhar.con/reinersprepared or E9-3A. What are the similarities? What are the differences?Which statementdo you find most informative?E9-54. Calculate change n cash.(LO 1, 4, 6)Given the following information, calculate he change n cash or the year.

Cash eceived rom sale of equipment $ 20,000Cashpaid for salaries 8,250Depreciationexpense or the year 12,450Cash eceived rom issueof stock 150,000Cashcollectedfrom customers 87,900Cash eceived rom saleofland 14,500Cashpaid for operatingexpenses 2,000Cash paid to vendor for inventory 32,480


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E9-6A. Calculate cashfrom operating activities. (LO 3, 4)Use the information given for Evans Companyto calculatea. Cashpaid for salaries

b. Cashpaid for income taxesc. Cashpaid for inventory itemsd. Cashcollected from customerse. Cashproceedsrom stock ssueFrom he Financial tatementsor Evans ompany

Balance heetIncomeStatement Beginning EndAmount for the Year of the Year of the Year

Sales evenue $ 85,600Accounts eceivable $ 8,700 $ 10,000Salary xpense 21 400Salar ies ayable 2,300 2,100Costof goods sold 24,300Inventory 4,800 8,000Accounts ayable 2,500 3,000Income ax expense 28,500lncome axespayable 7,400 8,500Common tockand addit ionalpaid- in api tal nla 630,000 718,000

E9-7A,. Prepare the cash rom operating activities section of the statementof cash lowsand determine he method used. LO 2, 4, 6)Use the nformation from E9-6A to calculate he cash low from operations or EvansCom-pany.Basedon the information provided, which methodof preparing he statementof cashflows doesEvansuse?E9-8A. Calculate cashflowsfrom investing andfinancing activities. (LO 1, 6)The following eventsoccurredat Gadgets nc. during 2006.

January15 Issuedbonds or $250,000March 8 Purchasednew machinery for $80.000cashMay 10 Soldold machinery or $30,000, esulting n a $10,000 ossJuly 14 Paid nterestof$20,000 on the bondsSeptember 5 Bonowed $5,000 rom a local bankOctober 30 Purchaseda new computer or $3,000cashDecember31 Paid cashdividendsof $4,600

ComputeGadgets'net cash low from (1) investing activities and from (2) financing activ-ities for 2006.E9-9A. Calculate cashfrom operating activities using the direct method.(LO 1, 4)The following information applies o Computer Company.

fncomeStatement for the Year Ended December31,2007Sales $ 20,000Costof goodssold (15,200)Grossmargin 4,800Rentexpense (1,000)Ne t income $ :,aoo

1. Accounts receivablestarted he yearwith a balanceof $1,000and ended he year witha balanceof $3.300.


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CHAPTER9 EXERCISES 4532. The beginning balance n accountspayable (to vendors) was 92,000, and the endingbalancewas zero. nventory at the end of the yearwas the sameas t was at the begin-ning of the year (i.e., therewas no change n inventory).3. The company started he year with $5,000 of prepaid rent and ended the year with$4,000of prepaidrent.

Determinethe following cash lows.a. Cash collectedfrom customers or salesduring the yearb. Cashpaid to vendors or inventory during the yearc. Cashpaid for rent during the year

E9-10A. Calculate cashfrom operating activities using the indirect method.(LO 5, 6)BrassCompany eportednet ncomeof $290,000 or 2007 The companyalso eporteddepre-ciationexpense f $70,000andagainof 93,000on thesaleof equipment.The comparative al-ancesheet howsa decreasen accountseceivable f $8,000 or the year,a $5,000decreasenaccounts ayable,and a $1,700 ncreasen prepaidexpenses. repare he cash rom operatingactivitiessectionof the statement f cash lows for 2007 using he ndirect method.E9-11A. Calculate cashfrom operating activities using the indirect method.(LO 5)The following information was aken rom TramInc.'s balancesheetsat December31,2005and 2006. Prepare he net cashprovided by operating activities section of the company'sstatement f cash lows for the yearendedDecember31, 2006,using he ndirectmethod.

2005 2005Currentassets

Cash $103,000 $ 99,000Accounts eceivable 90,000 79,000Inventory 150,000 142,000Prepaidexpenses 47,000 50,000

Totalcurrentassets $390,000 $370,000Current iabi l i t iesAccruedexpenses ayable $ 17,000 $ 15,000Accounts ayable 60,000 92,000Totalcurrent iabi l i t ies $ 77,000 $107,000

Net income or 2006was$185,000.Depreciation xpensewas$25,000.E9-12A- Calculate cash rom operating activities using the direct method.(LO 4)ComptonCompanycompleted ts first yearof operations n December3I,2006. The firm's in-comestatementor theyearshowed evenues f $175,000and operatingexpenses f $84,000.Accounts eceivablewas $54,000at year-endandpayables elated o operatingexpensewere$21,000at year-end.Computenet cash rom operatingactivitiesusing he directmethod.E9-13A. Calculate cashfrom operating activities using the direct method.(LO I, 4)During the fiscal yearendedSeptember30,2006, NapsterCompanyengagedn the follow-ing transactions.Using the relevant ransactions,prepare he cash rom operatingactivitiessectionof the statementof cash lows using the direct method.a. Paid nterestof $7,000b. Collected$175,000on accountseceivablec. Made cashsalesof $128,000d. Paidsalaries f $52,000e. Recordeddepreciationexpenseof $27,000f. Paid ncome axesof $32,000g. Soldequipment or cashof $152,000h. Purchased ew equipment or cashof $41,000i. Made paymentso vendorsof $62,700j. Paiddividendsof$20,000k. Purchasedand for cashof $174,000

1. Paidoperatingexpenses f $32,500


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CHAPTER . PREPARINGND ANALYZING HE STATEMENT F CASHFLOWSE9-14A. Prepare the statementof cash lows using the indirect method.(LO 5, 6)Use the following information for Just Nuts Company o preparea statementof cash lowsusing the indirect method.

JustNuts CompanyBalanceSheetJune30

AssetsCashAccounts eceivablelnventoriesLandEquipmentAccumuated depreciationTotal assetsLiabil i t ies nd Shareholders' quityAccounts ayableBonds ayableCommon tockand addit ionalpaid- in api talRetained arningsTotal iabi l i t ies nd shareholders'equi ty

Additional information:a. Net income for the fiscal year endedJune 30, 2007 was $95,000.b. The companydeclaredand paid cash dividends.c. The companyredeemedbondspayableamounting to $60,000 or cash of$60,000.d. The ompanyssuedommontockor$20,000ash.

E9-15A. Prepare the statementof cashflows using the direct method.(LO 4, 6)Using the information from E9-14A, preparea statementof cash lows for JustNuts Com-pany using the direct method.E9-16A. Analyze a statementof cash lows. (LO 7)The following information has been aken from the most recent statementof cash lows ofExpansionCompany:

2007$193,00064,000120,00095,000

250,000(7s,000)$647,000

$ 42,ooo150,000200,000245,000

$647,000

2006$120,soo60,000

175,000120,000180,000(45,000)

$61 , oo

$ so,ooo220,0001 0,000160,500

$61 ,soo

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

Net cashused by operatingactivitiesNet cashprovided by investing activitiesNet cashprovided by financing activities

a. What information do these subtotals rom the statementof cash lows tell youaboutExpansion CompanY?

b. What additional nformation would you want to seebeforeyou analyzeExpansionCompany'sability to generate ositive operatingcash lows in the future?

c. Did Expansionhave a positive net income for the period?What informationwould you like to see o help you predict next year's net income?

E9-17A. Computefree cashflow. (LO 7)Use hePier 1 Imports Inc. consolidatedstatementof cash lows to compute he company'sfree cash low for the 3 yearsshown.What does he trend in free cash low tell you aboutPier 1?


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Pier l Imports, Inc.Consolidated Statements of CashFlows(l n housands)

Year Ended2005(As restated, (As restated,SeeNote 2) SeeNote 2)

$ 60,457 $ 118,001Cash flow from operating activities:Net income (Ioss) $(39,804)Adiustments to reconcile to net cash (used in)provided by operating activities:Depreciation and amortizationLoss (gain) on disposal of fixed assetsLoss on impairment of fixed assets .Write-down of assetsheld for saleDeferred compensationLease ermination expenseDeferred income taxesSale of receivables n exchange for beneficialinterest in securitized receivablesTax benefits from options exercised by employeesOtherChange n cash from:InventoriesOther accounts receivable,prepaid expensesand other current assetsIncome tax receivableAccounts payable and accrued expensesIncome taxes payableOther noncurrent assetsOther noncurrent liabilitiesNet cash (used in) provided by operating activitiesCash low from investing activities:Capital expendituresProceeds rom disposition of properties . , . . . . . . .Proceeds rom sale of restricted investmentsPurchaseof restricted investmentsCollections of principal on beneficial interestin securitized receivablesNet cash provided by (used in) investing activitiesCash flow from financing activities:Cashdiv idends .. . .Purchasesof treasury stockProceedsfrom stock options exercised,stock purchaseplan and other, net

(34,667)(4,047)7,64r165,00086,500(86,500)(6,739)

(9,145)118,04364,r34

189,081

$253,215$ 8,136$ 2r,342

Issuanceof long-term debtNotespayable borrowingsRepalnnentof notes payableDebt issuancecostsPurchaseof call optionNet cashprovided by (used in) financing activitiesChange in cash and cash equivalentsCashand cash equivalentsat beginning period(including cash held for sale of $3,359,$6,148and $6,506, espectively)Cashand cash equivalentsat end ofperiod(including cash held for sate of $7,100,$3,359and $6,148, espectively)Supplemental cash flow information:Interest paidIncome taxes paid

78,7811,7816,0247,44r11,4024,t76(14,496)(74,550)

760(524)882

(22,778)(18,011)7,369(6,966)(2,558)(3,226)(64,297)(50,979)

1,4013,226(3,500)

(91,071) (83,931)3,668 4,997(222) 4,894(6,860) (40,520)

(11,302) (16,927)2L,572 34,410(14,116) 184336 (2,027)

75,6243157417,7L0t 1^a2,035

Lar+ ( o

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

225,101

$ 189,081$ 868$ 45,655

64,606(316)4556,5733,259184

15,709

(6,390)(584)(94,054)(17,013)

242,rL4

$_2%,n]_$ 1,791$ 63,788

51,130 93,745(99,239) (12r,190)

3,852 34,450(10,807) (8,752)78,788(16,704)

(34,762) (26,780)(58,210) (76,009)

The accompanying notes are an integral part of these financial statementsSource: ww.pierlcom/investorrelations/annualReports.asp;rscal ear2006AnnualReport 455


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456 CHAPTER . PREPARINGND ANALYZING HE STATEMENT F CASHFLOWSE9-18A. Identifu risks and conffols. (LO 8)Using the Pier 1 statementof cashflows shown n E9-17A, determine whether or not thefrrm appearso be taking advantage f new investmentopportunities. s the firm in a growthstageor a more matufe stageof its business ife? What evidencesupportsyour opinion?Exercises-SetE9-1B.dentifi ashflows.LO )For eachof the following items, tell whether t is a cash nflow or cashoutflow and he sec-tion of the statementof cash flows in which the item would appear. Assume the directmethod s used.)

Itema. Cash aid o vendor or suPPl iesb. Purchase f treasury tockc. Pr incipalepayment n bondsd. Interestpaymenton bondse. Cash aid or salar iesf. Cash rom issuance f commonstockg. Cash ividends aidh. Cash aid or rent and ut i l i t iesi . Purchasef computer or cashj . Cash aid or company ehiclek. Income axespaid

lnflow Section for Outf low the Statement

E9-2B.Identifi cashflows. (LO 1, 4)For each ransaction, ndicate the amount of the cash low, indicate whether each esults nan inflow or outflow of cash,and give the section of the statementn which each cash lowwould appear.Assume he statementof cash lows is preparedusing the direct method.

lnflow Section fItem or Outf low the Statementa. lssued 60shares f $0.10Parcommonstock or $15per share.b. Sold$2,500 f inventory, eceived$1,500n cash nd remaining$1,000 n accountc. Purchased $2,500 omPuterbypaying ash f $1,000 nd signinga short-termnote for theother $1,500d. Paid$600 or rout inemaidserviceo cleanoff icee. Paid ent and uti l i ty exPensestotaling $2,250f. Hireda runner o carrycorrespondencesetweenoff ices nd paidher $175g. Repaidhe $1,500 hort- termnote alongwith $100 nteresth. Purchasedt,sOO f treasury tock

E9-3B. Prepare cashfrom operating activities using the direct method.(LO 4)Use the ncome statementor Kristen Harrison's Cosmetics nc. for thepast yearand he in-formation from the comparativebalancesheetsshown or the beginning andthe end of theyearto prepa.rehe operatingsectionof the statementof cash lows using the directmethod.


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CHAPTER9 EXERCISES 457

E9-48. Preparecash rom operating activities using the indirect method.(LO 5)Use the information from E9-3B to prepare he cash rom operating activities sectionof thestatementof cash lows using the indirect method. Then, compare t with the statement ouprepared or E9-3B. What are the similarities?What are the differences?Which statementdo you find most informative?E9-58. Calculatechange n cash. LO I, 5)Given the following information, calculate he change n cash or the year.

SalesCostof goodssoldGrossmarginOperatingexpenses

WagesRentUti l i t iesInsurance

Net incomeAccountAccounts eceivableInventoryPrepaid nsuranceAccountspayableWagespayableUti l i t ies ayable

Sales evenueAccounts eceivableUtil i t iesexpenseUti l i t ies ayableCostof goodssoldInventoryAccountspayableInterestexpenseInterestpayable

$ 1s0,00055,00095,000

$ 3,7s01,600850175 6,375

$ 88,62sBeginningf theYear

$ 12,00018,200600

8,000725

0

En dof the Year$1o,ooo19,700200

7,400850

-275-

$ 15,0005,15010,65025,00068,250114,50012,00032,480

Balance heet

Cash eceived rom sale of company vanCashpaid for utilities and rentCashpaid for interest expenseduring the yearCashpaid for purchaseoftreasury stockCash collected from customersCash received rom issuanc

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