measuring and evaluating cash flow - university of albertacsproat/homework/acctg...

CHAPTER FOUR 4Chapter Introduction: Measuring and Evaluating Cash Flow

Measuring and Evaluating Cash Flow

4.1

NEL

“Yes, I’ll see him,” Shelagh Frost sighed when the reception-ist asked if she were able to talk to Paul Northey. Shelaghwas an investment advisor, and Northey was one of herclients. He was not comfortable with risk, and whenever heshowed up unannounced wanting to see her, it was alwaysabout a problem in his investment portfolio, and he tendedto blame her for problems.

In stormed Northey. “I’m both angry and confused,Shelagh,” he said, not waiting to sit down. “You rememberlast year I bought shares of Guestz Ltd., which everyonesaid looked like a winner. You said it looked like a winner,”he said accusingly. “Well, the company has been reportinggood income each quarter and for the whole recent fiscalyear, but I just read in the paper that it is going to have seri-ous trouble paying its debts, and may even have to makearrangements with its creditors to stave off bankruptcy! Theshare price tanked on this news, before I could sell, so I’velost a bundle. What the blazes is going on?”

Shelagh started to speak, but Northey didn’t stop. “Ithought it might be just one of those things, one of thosechances you take. But another of my investments,Belhaeven Inc., which,” he smiled thinly, “I picked outmyself, no thanks to you, is doing quite well: it’s the samesize as Guestz and is making less profit, but is in no finan-cial difficulty at all, and its price is going up a little. Howcan Guestz be making an income but not have any cash topay its bills, while Belhaeven is making less income and hasno trouble with cash? How can making an income lead to trouble, and making less income lead to no trouble, andhow can two similar companies be so different that way?”

“Paul, believe me, I know how you feel,” said Shelagh.“I recommended Guestz to some other people too, andthey aren’t very happy either. I’ve spent some time withGuestz’s financial statements, trying to figure out what wentwrong with its cash in spite of a rosy income number. Here,look at the company’s cash flow statement with me: it showswhat was going wrong.”

For information on this topic, please visit the online tutorial atwww.gibbins6e.nelson.com

FinancialAcct-C04-v3 3/28/06 4:29 PM Page 229

Chapter 2 focused on the balance sheet, and Chapter 3

explained how the income statement measures performance.

In this chapter, we return to the comparison of accrual income

and cash income introduced in Chapter 1, which is set out in the

fourth statement in the set of financial statements, the cash

flow statement. We’ll also see a lot more about cash flow besides

that comparison. In this chapter, you’ll learn:

• Why the cash flow statement is important, why it is

arranged as it is, what story it tells about cash flow, and

how it completes and complements the story told by the

other statements;

• How to answer Paul’s question about why a good accrual

income can exist at the same time as a cash shortage (and,

sometimes, a poor income or even a loss going with a cash

surplus);

• How to use the cash flow information to supplement the

analysis and interpretation of the balance sheet and

income statement that began in Chapters 2 and 3, so that

you could tackle Shelagh’s task of explaining to Paul what

happened to Guestz Ltd.;

• How to assemble a basic cash flow statement and make

sure that it reconciles to the income statement and

balance sheet. This learning will help to consolidate your

understanding of those statements and to develop your

analytical skill, because the cash flow statement does not

come from a set of accounts in the general ledger or trial

balance, as those other statements do, but rather from an

analysis of those other statements.

The learning categories introduced in Chapter 1, the

“How” procedures, the “Why” concepts, and the “Uses” analy-

sis, are all important and integrated in the study of cash flow.

Learning Objectives

230 PART TWO PREPARING AND USING FINANCIAL ACCOUNTING’S REPORTS

The Purpose of Cash Flow AnalysisPerformance in generating additional wealth for the enterprise, as measured by theaccrual accounting-based income statement, is very important to managers, investors,tax authorities, and many others. But the world is complex, and there is more toperformance than generating accrual income. An additional important aspect ofperformance is managing the inflow and outflow of cash so that the enterprise hasenough cash to pay its bills, finance its growth, and keep its borrowing under control.We all have to worry about cash flow, about how much cash is available, and whereneeded additional cash will come from. Businesses are no different, spending mucheffort on their cash management.

No business enterprise can survive without cash. Nor can other organizations, suchas governments, as we have seen in recent years with governments struggling to raiseenough cash from taxes and other charges to meet their financial and social obligations.Employees, suppliers, and tax authorities must be paid, loans must be repaid, and assetsmust be kept up to date. To evaluate an enterprise’s performance, it is important forpresent and potential investors and creditors to have information about the enterprise’scash inflows and outflows and its resulting cash position.

Can the enterprise pay its debts and other financial obligations as they become due?This ability is commonly referred to as solvency. Does the enterprise have enough cashand short-term assets now to cover its immediate debts and obligations? This ability iscommonly called liquidity. Enterprises can get into difficulty by not managing cash prop-erly. Many new and established firms, like Guestz Ltd. in the previous section, have hadpositive net incomes, yet have still run out of cash. On the other hand, some enterprisesseem to have rather a lot of cash, raising questions about why they are so well off andwhat might be done with the cash. Keeping a large supply of cash lying around idle is noway to earn a return for owners: the cash should be put to work by making investments,

4.2

NEL

The cash flowstatement is astandard part of theset of financialstatements.

Managing cash flow is a central part ofmanaging anenterprise.

Having cash to meetobligations is essentialto business success.

Solvency: ability tomeet obligationswhen due.Liquidity: cash to coverimmediate needs.

FinancialAcct-C04-v3 3/28/06 4:29 PM 30

improving buildings and equipment, attracting new customers, or paying off interest-bearing debt.

In the example of Simone’s jewellery business in Section 1.10 of Chapter 1, it wasshown that accrual income is not the same as cash income, because some revenues andexpenses do not involve an inflow or outflow of cash in the present period. The exampleof uncollected revenue has already been mentioned. Amortization is another example:the cash flow happened when the asset was acquired, so the amortization expense doesnot involve any current cash flow. Here’s an example where accrual income doesn’tcorrespond to cash flow.

• Suppose a company like Guestz Ltd. makes a deal providing revenue of $1,000 oncredit, and the customer hasn’t paid yet.

• The company has expenses of $700 to generate this revenue, and the expenses haveto be paid soon.

• The accrual income for the deal is the revenue minus the expenses, or $300. Looksgood: a 30% return on revenue. Accrual income’s measure of performance is verypositive.

• But the deal provides the company no cash to pay its expenses; instead, it has $1,000of accounts receivable, which cannot be used to pay expenses unless the customerpays or some other way is found to get cash for the receivables.

• The deal may therefore force the company to borrow money from a bank or otherlender to provide it the needed cash. How much should it borrow? Or should itinstead hound the customer for payment? Should it beg its creditors for more timeto pay the $700 in expenses? How will it be able to afford a planned new machine tokeep its product quality competitive? All of these questions are about the manage-ment of cash, and they are not answered by the positive accrual income measure.

To help answer such questions, the fourth major financial statement has been devel-oped. The cash flow statement provides information about a firm’s generation and use ofcash and highly liquid short-term assets, and, therefore, assists in evaluating the firm’sfinancial viability.

Even if accrual income were replaced by the kind of cash income measure shown inSimone’s jewellery example in Section 1.10, this would not fully measure what hashappened to cash. Cash income refers to operating results, from transactions withcustomers, suppliers, and employees. Certain inflows of cash (such as those resultingfrom getting a bank loan or issuing shares) or outflows of cash (such as dividends or apurchase of land) are not part of the day-to-day process of generating revenue andincurring expenses, and so are not part of cash income. They reflect management deci-sions beyond generation of income in the current period.

The cash flow statement therefore has a two-fold purpose:

1. To produce a measure of performance based on day-to-day cash flow, cash gener-ated by ordinary business activities, instead of accrual accounting’s net incomemeasure.

This cash measure, which we have called cash income and which the cash flowstatement calls cash from operations, does not mean that accrual income is invalid; rather,it provides a different perspective on performance and so enhances the informationfor users.

2. To incorporate other nonoperating cash inflows and outflows, such as from invest-ing in new assets, selling off old ones, borrowing or repaying debts, obtaining newcapital from owners, or paying dividends to the owners.

By including nonoperating cash flows, the cash flow statement provides a completedescription of how the firm’s cash was managed during the period, to tell the fullstory of why the enterprise has more, or less, cash at the end of the period than atthe beginning.

CHAPTER 4 MEASURING AND EVALUATING CASH FLOW 231

NEL

Accrual income does not necessarilyprovide cash to be spent.

Even cash incomedoes not cover allinflows and outflowsof cash.

The cash flowstatement reports cash income, calling itcash from operations.

The cash flowstatement also reportsnonoperating cashflows from financingand investingactivities.


With this information, the user can evaluate management’s strategy for manag-ing cash and make a better judgment of the company’s liquidity, solvency, risk, andopportunities than could be made just from the balance sheet, income statement,and statement of retained earnings.

The Cash Flow StatementThe cash flow statement, like the other statements, has a standard format. It is useful toknow, because variations from that format may be a signal of special circumstances orproblems. Here is the format, with summary figures from CPR to illustrate the categories (we’ll look at CPR’s cash flow statement in more detail later in the chapter).

4.3


NEL

Things keep changing. The cash flow statement is arelatively recent addition to the set of financial state-ments, having become a standard part in only the last

few decades. During that time, it has undergone severalchanges in name, format, and content. You should be alert

for other titles left over from the past. Other terms and titlesyou may encounter are statement of changes in financial position, statement of source and application of cash, andfunds statement.

FYIFYI

Here are two questions you should be able to answer basedon what you have just read. If you can’t answer them, itwould be best to reread the material.

1. What does cash flow have to do with liquidity andsolvency?

2. What else is there to cash flow beyond the cash incomewe saw in Simone’s jewellery business in Chapter 1?

how’s your understanding?


Some important features of this format are:

1. The cash flow statement covers the same period as the income statement.2. Cash includes some equivalents: very liquid near-cash assets that can be turned into

cash without any risk of loss, such as demand bank deposits and certificates with amaturity of three months or less. CPR defined its cash as “cash and short-terminvestments.”

3. In some cases, cash may include temporary negative bank balances (overdrafts) ifthey are just a result of cash management activity and the bank balances regularlyvary from positive to negative. In 1999, CPR had a bank overdraft of $14.7 million,which it deducted from cash and short-term investments to produce a “net cash”amount, but has not shown an overdraft since.

4. If there is anything unusual about the enterprise’s definition of cash (and equiva-lents), or any other category of the statement, that should be explained in the notes tothe financial statements. You may even see a little reconciliation at the bottom of thecash flow statement. CPR had this in 1999 when it had the bank overdraft, showing how net cash was calculated. You can view this on CPR’s website (www.cpr.ca).

5. The cash flow statement follows some rules to ensure that its focus stays on cash. Forexample, if a dividend has been declared but not all paid, only the paid part isincluded in the cash flow statement’s financing activities section. Another exampleis that if there is an account payable for a noncurrent asset, the investing activitiesfigure shows only the amount paid so far. Any asset acquisitions, borrowing, or shareissues that are done without cash, such as acquiring land in return for shares, areexcluded from the cash flow statement.


NEL

4•1

EXHIBIT

Cash Flow Statement Standard Format(With Summary Figures for Canadian Pacific Railway

for 2004, in millions)

CPR 2004

Operating activities:Cash generated by operations from day-to-day cash receipts and payments related to the activities that generate income. $ 786.0

Investing activities:Cash used to invest in additional noncurrent assets, including investments in other companies, minus any cash proceeds obtained by disposing of such assets. (666.1)

Financing activities:Cash obtained from borrowing and from issuing share capital, minus borrowing repaid or shares redeemed. Any cash transactions in retained earnings (not included in net income) are included here, especially dividends and share issue costs. 98.4

Change in cash for the period:Net sum of the above three categories. $ 218.3

Cash (and equivalents) at the beginning of the period:Brought forward from last period’s cash flow statement and balance sheet. 134.7

Cash (and equivalents) at the end of the period:Equals what is shown on the balance sheet at the end of the period. $ 353.0

Same period asincome statement.

Cash and equivalentsare defined.

Negative cash (bankoverdraft) is possible.

The cash flowstatement also hasfootnotes.

Only actual cash flowsduring the period areincluded.


6. Any of the numbers in the cash flow statement can be positive or negative, accord-ing to what happened during the period. For example, a bad year can result in cashfrom operations being negative, in which case it might be described as cash used inoperations! As another example, a company undergoing significant restructuringcould have more cash coming in from selling off assets than cash going out to buymore, so its investing section could be a positive cash inflow instead of the usualcash outflow.

7. At the bottom of the cash flow statement or in the financial statement notes, theamount of interest paid in cash and cash flows arising from income tax should bedisclosed. CPR did this in its notes.

8. Deriving the cash flow from day-to-day operations is one of the main reasons forhaving the cash flow analysis. The cash from operations figure takes away accrualaccounting’s many adjustments, which are very important in measuring income butobscure the cash effects. To emphasize this, most cash flow statements begin withthe net income figure from the income statement and then explicitly remove theeffects of changes in accounts receivable, accounts payable, amortization, and otheraccruals. This is called the indirect method of deriving cash from operations, asdistinct from the direct method of just listing operating cash receipts and deductingoperating cash payments (also called disbursements). The direct and indirect methodsof calculating cash from operations both end up with the same figure for cash fromoperations, they just go about the calculation differently:

Cash flow analysis is a good way to cement your understanding of what the financialstatements contain and to sharpen your analytical skills. This chapter starts with the intu-itively simpler direct method of preparing the cash flow statement and then turns to theindirect method, both because it is the usual method and it allows some practice inreworking the financial statements for analysis. The chapter ends with some morecomplex and realistic examples.


NEL

Operating, investing,and financing cashflows can all be eitherpositive or negative.

Interest and tax cashpayments should bedisclosed.

Cash from operationsis derived indirectlyfrom accrual income.

Indirect Method Direct Method

Start with accrual net income

Start with operating cash receipts

Deduct operating cash payments

Cash generated from operations

Remove the effects on income of noncash expenses

(especially amortization) and revenues (especially gains on sale)

Remove the effects on income of uncollected revenues, unpaid expenses,

and other items in working capital

figure 4.1


Cash Flow Analysis Using Receipts andPayments

The direct method classifies information from the Cash ledger account and supportingdetailed cash receipts and payments records into the cash flow statement categoriesshown at the beginning of Section 4.3. It’s probably the way you’d expect cash flow analysis to be done, so let’s begin with it. An example will show you how this works.

The following information is summarized from Roebuck Industries Inc.’s cashrecords for this year:

Preparing the cash flow statement from this information is straightforward—just putthe figures above into the appropriate statement categories. Note that there is nomention of accrual income; in fact there is no way to tell what it is. Two principlesfollowed in categorizing the cash flow statement’s information are reflected in the statement that follows:

4.4


NEL


1. What are the summary categories of cash flow used in thecash flow statement?

2. Dubroy Inc. defines its cash and equivalents to include thefollowing (this year’s and last year’s figures shown in thatorder for each): Cash ($13,000; $4,000), Demand deposit

in MegaBank ($25,000; $50,000), and Occasional bankoverdraft ($7,000; $3,000).

What is the net total change in cash that the cashflow statement for this year will explain?

Cash and equivalents at the beginning = $4,000 + $50,000 – $3,000 = $51,000. At the end they = $13,000 + $25,000 – $7,000 = $31,000. So the change in cash is negative$20,000.


4•2

EXHIBIT

Cash on hand at the beginning of the year $ 813,430Cash receipts for the year:

Cash sales $ 73,320Collections from customers for credit sales 17,894,530Proceeds from sale of land 1,200,000Proceeds from issue of new bonded debt 5,300,000Proceeds from issue of new shares 840,000 25,307,850

26,121,280

Cash payments (disbursements) for the year:Expenses paid in cash 49,210Payments to suppliers and employees 14,992,860Income tax paid 765,500Paid to acquire new noncurrent assets 6,733,310Repayments on noncurrent debt 3,112,300Costs of new share issue 21,340Dividends paid 400,000 26,074,520

Cash on hand at the end of the year $ 46,760

The cash flowstatement’s categoriesseparate day-to-dayincome from othercash flows.


• Segregate operating cash flows (those related to day-to-day income-generating activi-ties) from the more intermittent nonoperating cash flows for investing and financing; and

• Identify cash flows related to the statement of retained earnings and put them intothe financing category (for example, share issue costs and dividends paid).

Here is the resulting statement.

This analysis shows that Roebuck’s cash went down almost to zero during the year,because the company spent more cash acquiring new assets than it raised through oper-ations and financing. Though by far the largest inflows and outflows of cash were fromday-to-day operations, the net contribution of operations to the company’s cash supplywas smaller than the net contribution through financing activities.

Some details are interesting. The company raised about a sixth of the cash neededfor the new assets by selling some land. The financing was primarily debt this year, notshares, so the company is further in debt than it was (we can see that the debt-equity ratiowill have gone up this year, though we don’t know by how much without having thebalance sheet). In paying for new assets and paying dividends, the company almostexhausted its cash. While this may have left it in a more risky position in regard to payingits bills, it is not necessarily an unwise thing to have done, because having a lot of cashsitting around earns the company little (maybe just a little bank interest), and the moneymay have been quite productively spent on new assets or paying off noncurrent debt.

These points illustrate two important features of cash flow analysis:

• It gives insight into the company’s strategy for managing its financial affairs, and atthe very least suggests a list of questions that could be followed up in more detail.


NEL

Positive numbers aresources of cash andnegative numbers areuses of cash.

4•3

EXHIBIT

Roebuck Industries Inc.Cash Flow Statement for This Year (Direct Method)

Operating activities:Operating cash receipts ($73,320 + $17,894,530) $17,967,850Operating cash payments

($49,210 + $14,992,860 + $765,500) (15,807,570)Cash obtained from operations $ 2,160,280

Investing activities:Acquisitions of new noncurrent assets $ (6,733,310)Proceeds from sale of land 1,200,000

Cash used for investing $ (5,533,310)

Financing activities:Proceeds from issue of new bonded debt $ 5,300,000Repayments on noncurrent debt (3,112,300)Proceeds from issue of new shares 840,000Costs of new share issue (21,340)Dividends paid (400,000)

Cash obtained from financing $ 2,606,360

Change in cash for the year $ (766,670)

Cash at the beginning of the year 813,430

Cash at the end of the year $ 46,760

The cash flowstatement’s analysis isquite informative.

The cash flow analysisindicates financialmanagementstrategies.


For example, did the company sell the land because it was short of cash, or was itoffered a price that was too good to pass up?

• For maximum usefulness, it should be combined with other information about thecompany, especially the information in the other financial statements. For example,what is the company’s debt load, and did the increase this year put it in a difficultposition? (The balance sheet can help with that question.) Or, what proportion ofincome is the company paying out as dividends? (The income and retained earningsstatements help with that question.)

Cash Flow Analysis Using Adjusted AccrualIncome and Balance Sheet Changes

The direct method illustrated in Section 4.4 just requires information from the cashrecords. But in fact the cash flow statement has traditionally been prepared, andpresented, in quite a different way, by analyzing changes in the balance sheet andcombining that analysis with information from the income and retained earnings state-ments. This is done for many reasons, including tradition and its ability to relate operat-ing cash flow to accrual income, but also because, in practice, digging out the details ofcash receipts and payments over a whole year can be a large task, especially if there areseveral or many cash and bank accounts, as is true for most medium to large-sizedcompanies. The indirect method is explained in this section because without understand-ing it, you will be mystified by the format of the cash from operations section of mostpublished cash flow statements. The analysis also will help polish your analytical skill andknow-ledge of the other statements, as well as your insight about what cash flow analysisdepicts.

The indirect method relies on a basic property of double-entry accounting. Sincecash is one of the accounts that make up a balanced balance sheet, any change in cashmust be exactly reflected in one or more other balance sheet accounts. So we can analyzecash changes by looking instead at changes in all the other accounts in the balance sheet: thosechanges will tell us what the company did with its cash. Here is the balance sheet equa-tion, to demonstrate that this must be true arithmetically (∆ stands for change from oneyear, 2004, to the next, 2005):

4.5


NEL


1. How can you best draw insights from the cash flow statement’s analysis?

2. Suppose on the last day of this year, Roebuck experiencedthe following three cash transactions in addition to thosealready included above. What would be the resultingfigures for operations, investing, financing, and change incash for the year? (1) A customer who had been very slow in paying came

in and paid an old account receivable of $50,000. (2) The company got additional bank loan financing of

$120,000.

(3) The company issued new shares valued at $75,000 in exchange for a small plot of land it wanted forexpansion of its factory.

The first item is an operating receipt, increasing cash from opera-tions by $50,000. The second is a financing inflow, increasingcash from financing by $120,000. The third doesn’t involve anycash and so wouldn’t be part of the cash flow statement.Results: Cash from operations up $50,000 to $2,210,280, cashfor investing unchanged at $(5,533,310), cash from financingup $120,000 to $2,726,360, change in cash improved$170,000 to $(596,670).


The indirect method isused in preparingmost companies’ cashflow statements.

Because of doubleentry, changes in cashmust be explained bychanges in all otheraccounts.


This year: Cash2005 + Noncash assets2005 = Liabilities2005 + Equity2005

Last year: Cash2004 + Noncash assets2004 = Liabilities2004 + Equity2004

Difference: ∆ Cash + ∆ Noncash assets = ∆ Liabilities + ∆ Equity

Rearranging:∆ Cash = ∆ Liabilities + ∆ Equity – ∆ Noncash assets

The indirect method uses this basic approach: construct the cash flow statement byplacing all balance sheet account changes in the appropriate categories of the cash flowstatement after adjusting for (eliminating) all noncash components of those accountchanges. This method can handle great complexity, and accountants have procedures toensure that no changes are forgotten in the analysis, but such complexities and proce-dures are beyond the scope of this book. The schedule below shows how the indirectmethod works for the categories of the cash flow statement. Brief additional explana-tions follow the schedule and then the Roebuck Industries example is redone using theindirect method. (In Section 4.7, after some practice doing the analysis, we will see howCanadian Pacific Railway did these calculations.)


NEL

The indirect methoddetermines changes inall noncash balancesheet accounts,eliminating those notinvolving cash.

4•4

EXHIBIT

Categorization of the Changes in Noncash Balance Sheet Accounts

Operating activities:Start with net income or if different, income from continuing

operations for this period (part of the retained earnings change)Adjustments to eliminate noncash components of income:

Remove revenues and expenses (usually nonoperating) that are entirely noncash: gains and losses, write-downs and write-offs of investments andnoncurrent assets in general

Remove revenues and expenses that relate to noncurrent past or future cash flows: amortization (asset cost paid in the past), and future costs to be paid(future income taxes, warranties, pension costs, etc.)

Remove the effects on accrual income of working capital account changes: accounts receivable, inventories, prepaid expenses, accounts payable, estimated accrued liabilities, etc., and investments whose trading is part ofoperations

Investing activities:Additions to plant and equipment and intangible and other assets, minus any

amounts not yet (or ever) paid in cash and so still showing as payableProceeds from disposal of plant and equipment and intangible and other assets

(account changes due to elimination of cost and accumulated amortization ofdisposed assets are ignored because they are not cash items)

Additions to and proceeds of disposal of mainly noncurrent investments

Financing activities:Changes in current and noncurrent debt financing, minus any parts not involving

cash (such as exchanges for shares or noncash assets)Changes in share capital, minus any parts not involving cash (such as exchanges

for debt or noncash assets)Changes in retained earnings other than net income for this period: dividends,

share issue costs, etc., minus any parts not paid in cash (e.g., stock dividendsor dividends payable)


Here are some comments to lead into an example of how the indirect methodworks.

1. Remember the changes equation above:

∆ Cash = ∆ Liabilities + ∆ Equity – ∆ Noncash assets.

From this equation, you can see thatchanges in liabilities and equity (+ signs)have the same sign as changes in cash,whereas changes in noncash assets (– sign)have the opposite sign. This should beintuitively sensible: borrowing money, forexample, increases the debt liability and the cash, and paying the debt back reducesboth. Issuing shares also increases cash, and dividends both reduce equity andreduce cash when they are paid. On the other hand, paying cash for a new assetincreases the asset but decreases cash, and reducing an asset (say by selling land orcollecting accounts receivable) increases cash. Increasing noncash assets impliesusing cash to do so, and decreasing noncash assets implies getting cash for them.

2. Though accrual income does not necessarilyincrease cash right now, on average earning incomewill increase cash. Again, the intuition should beclear. Earning income helps cash. If you find this abit subtle, think of the opposite: surely it would notmake sense to expect cash to go down whenincome goes up, or cash to go up when the company incurs a loss. Also, as income ispart of equity through retained earnings, its effect on cash is the same as otherequity items. Likewise, reducing equity (retained earnings) by declaring dividendsreduces cash when the dividends are paid.

3. Given the starting point of net income, theadjustments to it in the operating activitiespart of the categorization schedule abovejust remove from income all the things thatwere done to create accrual income insteadof cash income. These are the same sorts ofadjustments we saw in Section 1.10 whenreconciling Simone’s Jewellery accrual andcash incomes. Therefore, items thatincreased accrual income are deducted inthese adjustments, such as gains onnoncurrent asset disposals, increases in accounts receivable (uncollected revenue),and increases in inventory (unused goods). Conversely, items that decreased accrualincome are added in these adjustments, such as amortization expense, losses onnoncurrent asset disposals, asset write-downs and write-offs, and increases inaccounts payable and accrued estimated liabilities.

4. The treatment of gains and losses on noncurrent asset disposals is a bit subtle tounderstand, but understanding it is useful because it relates to how the stock marketreacts to financial information. If a company makes a gain on the sale of a noncur-rent asset, it does so because it received cash (or a promise of cash) exceeding thebook value of the asset, that is, exceeding the net value of the asset’s cost minus itsaccumulated amortization. A loss on sale happens if the cash is less than book value.Such an asset sale is recorded this way:


NEL

Changes in equity andin cash: up together,down together. Samefor liabilities. Oppositefor noncash assets.

Income and changesin cash: up together,down together.

L↑⇒Cash↑ L↓⇒Cash↓E↑⇒Cash↑ E↓⇒Cash↓

OthA↑⇒Cash↓ OthA↓⇒Cash↑

• Start with net income• Deduct noncash items that

increased the income (didn’tincrease cash)

• Add back noncash items thatdecreased the income (didn’tdecrease cash)

• The result is cash income(cash from operations)

Income⇒Cash↑ on average

Loss⇒Cash↓ on average

Div⇒Cash↓ when paid

The indirect cash fromoperations calculationstarts with net incomeand removes all theaccruals that cause itto differ from cashincome.


Dr Cash (the proceeds from the disposal)Cr Noncurrent asset cost (to remove the asset’s cost from the accounts)

Dr Accumulated amortization (to remove the asset’s acc. amort. from theaccounts)

Dr Loss on sale, or Cr Gain on sale (the difference between proceeds and book value)

Here’s the subtle part. The gain or losson disposal, which is in the incomestatement and so is part of accrual netincome, is not what we want on thecash flow statement, because it is notthe cash part, it is just the differencebetween the cash and the book value,as the journal entry above shows. Sothe gain or loss has to be removedfrom the net income and the cashproceeds inserted instead, but in theinvesting activities section because it isnot a result of day-to-day operations. Again helped income, so it must be deducted from net income in the operating activitiessection to remove it. A loss reduced income, so it must be added back to net income toremove it. (The removal of the asset cost and the accumulated amortization is ignoredin the cash flow analysis because neither is a cash item.)

If a noncurrent asset, such as a factory or an investment in another company, is writ-ten down or written off because it is felt to have less or no value, the entry above has no“proceeds” amount, because there is no cash. So the whole amount of the write-down orwrite-off, which is in income, must be added back to net income in the operating activi-ties section. This can drastically affect the difference between net income and cash fromoperations, because such write-downs and write-offs may be quite large (remember theBig Bath and goodwill write-downs from Chapter 3, for example). If such losses or write-downs are large, cash from operations might be quite positive even if accrual incomewas made low or negative by the write-down or write-off. Perhaps because of the lack ofcash effect, the stock market often seems to ignore large write-offs, write-downs, or losseson disposal, not penalizing companies that report them on their income statements.

The indirect method’s appeal may begin to become apparent to you from thesepoints. By identifying the changes in noncash accounts (assets, liabilities, and equity),the analysis identifies where the company’s cash came from and what the company didwith the cash. This can all be done without having to go through the cash account(s)and write down what each transaction seemed to be for.

An Indirect Method Example: Roebuck Industries AgainFinancial information about Roebuck Industries Inc., which we saw in the previoussection about the direct method, is below. The indirect method is based on balancesheet changes, as indicated in the changes version of the balance sheet equation shownabove, so we focus on

• balance sheet changes, including retained earnings (each change just equals thisyear’s account balance minus last year’s); and

• the income components (several are useful for the analysis, and net income is partof the retained earnings change).


NEL

Gains on disposal arededucted from netincome in operatingactivities.

Cash proceeds areincluded in investingactivities.

Noncurrent asset disposals and cash flow

Where there is a gain on disposal:The proceeds are a cash inflow.The gain is not cash and so must be

subtracted from income to get cashfrom operations.

Where there is a loss on disposal:The proceeds (if any) are a cash inflow.The loss is not cash and so must be added

back to income to get cash from operations.

Losses on disposal andwrite-downs areadded back to netincome in operatingactivities.


All the balance sheet changes must have some connection with cash flow—a purelynoncash transaction, such as issuing shares in return for land (Dr Land, Cr Share capi-tal) is ignored, so no such purely noncash changes are included in the balance sheetchanges below.


NEL

Roebuck Industries Inc.Balance Sheet Changes

(This Year Minus Last Year)

ASSETSCurrent assets:

Cash down $ (766,670)Accounts receivable up 2,875,870Inventory down (1,225,770)

Noncurrent assets:Asset cost up* 6,328,310Accum. amortization up (3,794,630)

TOTAL CHANGES $ 3,417,110

LIABILITIES AND EQUITYCurrent liabilities:

Accounts payable down $(1,359,410)Dividend payable up 100,000Equipment payable** up 220,000

Noncurrent liabilities:Bonded debt up 5,300,000Other debt down (3,112,300)

Equity:Share capital up 840,000Retained earnings up 1,428,820

TOTAL CHANGES $ 3,417,110

* Cost change = $6,953,310 new assets minus $625,000cost of land sold.

** Owing on new assets acquired.

Roebuck Industries Inc.Income Statement for the Year

Revenue $20,843,720Expenses:

COGS, etc. $14,390,490Amortization 3,794,630

$18,185,120

Operating income $ 2,658,600Gain on land sold* 575,000

Income before tax $ 3,233,600Income tax expense 1,283,440

Net income $ 1,950,160

* Gain = $1,200,000 proceeds minus $625,000 land cost.

Roebuck Industries Inc.Retained Earnings Changes for the Year

Add net income $1,950,160Deduct dividends

declared* (500,000)Deduct costs of

share issue (21,340)

NET CHANGE $1,428,820

* $100,000 owing at year-end.

4•5

EXHIBIT

Generating the cash flow statement from these changes basically is aprocess of putting the changes in the appropriate categories of the cashflow statement and eliminating any noncash items from income, asexplained earlier in this section. The result is a cash flow statement thathas exactly the same category totals as the example in Section 4.4, anddiffers from that statement only in the way cash from operations is derived.

Here is the cash flow statement, including various explanations tohelp you follow what is going on—these would not usually be shown on astatement because accountants assume the reader of the statement hassome understanding of how the statement is assembled. Also, in thisexample we have used only the changes in accounts, so the statement endswith the change in cash.


Take a few moments and go through the preceding set of balance sheet changes forRoebuck Industries. You’ll see that every change is somewhere on the cash flow statement:

• The change in cash is the cash flow statement’s “bottom line.”• Decreases in noncash assets and increases in liabilities and equity are all positive in

their effects on cash. The opposites, increases in noncash assets and decreases inliabilities and equity, are all negative in their effects.

• The change in retained earnings has three components: net income, share issuecosts, and dividends. They are all on the cash flow statement. Income is combinedwith several other changes to get cash from operations. Dividends are combinedwith the change in dividends payable to get dividends paid.

• The change in noncurrent assets cost is there too. The cost of new assets($6,953,310 according to the footnote) is reduced by the change in equipmentpayable ($220,000) to get the cash spent on new assets, $6,733,310.

• The cost of the old land removed is also represented, because that $625,000 cost isreplaced on the cash flow statement by two amounts: the positive $1,200,000 cashproceeds and the negative $575,000 gain deduction, which net to $625,000.

• The $3,794,630 change in accumulated amortization, which looks as though itincreases cash on the cash flow statement, does not really do that. It is there in oper-ating activities to cancel out the effect on income of having deducted the noncashamortization expense in calculating the net income.


NEL

4•6EX

HIBIT

Roebuck Industries Inc.Cash Flow Statement for This Year (Indirect Method)

Operating activities:Net income for the year $ 1,950,160Deduct noncash revenue to eliminate it: gain on land sale (575,000)Add back noncash expense to eliminate it: amortization 3,794,630Deduct increase in accounts receivable to eliminate its effect (2,875,870)Add back reduction in inventory to eliminate its effect 1,225,770Deduct decrease in accounts payable to eliminate its effect (1,359,410)

Cash obtained from operations $ 2,160,280

Investing activities:Acquisitions of new noncurrent assets ($6,953,310 – $220,000) $(6,733,310)Proceeds from sale of land 1,200,000

Cash used for investing $(5,533,310)

Financing activities:Proceeds from issue of new bonded debt $ 5,300,000Repayments on noncurrent debt (3,112,300)Proceeds from issue of new shares 840,000Costs of new share issue (21,340)Dividends paid ($500,000 – $100,000) (400,000)

Cash obtained from financing $ 2,606,360

Change in cash for the year $ (766,670)

�

�

Using the indirect method,items in the operating

section are not sourcesand uses of cash but

rather the removal ofnoncash revenues and

expenses from accrual netincome.

The investing andfinancing sections

are identical to thedirect method.

Positive numbers = sources of cash

Negative numbers = uses of cash

Every balance sheetchange isappropriatelyrepresented on thecash flow statement.


The indirect method statement is different from the direct version only in the oper-ations section. The operations section provides information not available from thedirect version:

• The difference between accrual accounting income and cash income (cash fromoperations): accrual income is only slightly lower here, but in many cases is quitedifferent. The direct method doesn’t provide accrual income and so doesn’t showthe difference.

• Components of that difference, such as the gain on the land sale and the amortiza-tion of noncurrent assets, neither of which is provided by the direct version.

• The effect of changes in working capital accounts. Roebuck has tied up $2,875,870of additional cash by letting the accounts receivable grow, and has used another$1,359,410 by paying off more accounts payable. On the other hand, there is$1,225,770 less cash tied up in inventory.

Demonstration Problem: Doing the Cash FlowStatement from Balance Sheet Changes

Here is a second demonstration of how to use balance sheet changes and net incomeadjustments to analyze cash flow, using the indirect method. Below are the balance sheetchanges for Simplistic Enterprises Ltd., and then the cash flow statement derived fromthem. The cash flow statement includes some comments to help you see what each cashflow item stands for.

4.6


NEL


1. What are the kinds of adjustments the indirect methodmakes to net income, and why are they done?

2. Suppose Roebuck Industries Inc. experienced the follow-ing transactions on the last day of this year, in addition tothose already included above. What would be the result-ing figures for operations, investing, financing, andchange in cash for the year? (1) The company bought more inventory on credit for

$60,000. (2) The company issued more shares for $130,000 cash. (3) The company paid off its equipment loan, causing a

temporary bank overdraft.

The first item reduces both the inventory decrease and theaccounts payable decrease by the same amount, having no neteffect on cash from operations, which is appropriate becausethere was no cash involved. The second item raises the proceedsfrom new shares by $130,000 and reduces the negative cashchange by the same amount. The third item eliminates theequipment loan change and so increases cash paid for newassets by $220,000 to $6,953,310. The second and third itemstogether cause a net reduction in cash of $90,000, changing thetotal cash change to negative $856,670. If we go back toRoebuck’s cash account information in Section 4.4, we can seethat cash on hand at the end of the year would now becomenegative ($46,760 – $90,000 = $(43,240)).




NEL

4•7EX

HIBIT

Simplistic Enterprises Ltd.Balance Sheets for 2006 and 2005,

with Changes Calculated

2006 2005 Change

AssetsCurrent assets:

Cash $150 $130 $20Accounts receivable 200 160 40

Noncurrent assets:Building cost 500 420 80Accumulated amortization* (180) (130) (50)

$670 $580 $90

Liabilities and EquityCurrent liabilities:

Temporary bank overdraft $ 10 $ 25 $(15)Accounts payable 110 65 45

Noncurrent liabilities:Mortgage debt 140 175 (35)Future income tax 100 90 10

Equity:Share capital issued 100 85 15Retained earnings** 210 140 70

$670 $580 $90

* The change in accumulated amortization is due to $50 in amortization expense deducted in determining 2006accrual income.

** According to the statement of retained earnings, the change in retained earnings is due to the 2006 net income of$95 having been added to the 2005 balance, minus dividends paid of $25.



NEL

4•8

EXHIBIT

Simplistic Enterprises Ltd.Cash Flow Statement

(with additional comments)for the Year 2006

Operations

Net income for the year (accrual net income as shown in the income statement and part of the change in retained earnings on the balance sheet) $ 95

Add back amortization expense (the change in accumulated amortization: this expense reduced accrual income but did not reduce cash income so adding it back helps to calculate cash income) 50

Add back future income tax expense (the change in the liability: as foramortization, this expense did not reduce cash income so adding it back also helps to calculate cash income) 10

Deduct the change in accounts receivable (the receivables are higher, so some of the 2006 income is from revenue that has not been collected, so cash income was lower because of the cash that has not yet come in) (40)

Add change in accounts payable (the higher payables mean that some of theexpenses deducted from 2006 income have not yet been paid, saving cash for now and meaning cash income was higher because of that) 45

Cash generated from operations (cash income) $160

Investing

Increased investment in the building (increasing a noncurrent asset would have taken cash, so this has a negative effect) $ (80)

Financing

Decrease in mortgage debt (reducing the mortgage would have taken cash) $ (35)

Increase in share capital (this would have brought cash) 15

Dividends paid during the year (part of the change in retained earnings) (25)

Net cash used in financing $ (45)

Net total change in cash for the year $ 35

Cash, beginning of the year 105

Cash, end of the year $140

Cash consists of:

Cash $150

Minus temporary bank overdraft (10)

Net cash $140


The cash flow statement is an insightful analysis. Just by rearranging the balancesheet changes between two dates (2005 and 2006), we have produced several pieces ofinformation:

• Simplistic increased its cash by $35 during the year: cash went up by $20 and thetemporary bank overdraft went down by $15. (Positive cash went up, negative cashwent down, so both increase cash.)

• This increase was entirely due to day-to-day operations because investing and financing activities both reduced cash.

• Cash from operations ($160) was nearly twice the accrual net income ($95) becausethe net income was reduced by noncash expenses for amortization and futureincome taxes. It is normal for cash from operations to exceed net income becauseof such expenses.

• Cash from operations would have been even higher had Simplistic collected moreof its accounts receivable. On the other hand, the company hung onto some cash bynot paying some accounts payable.

• The company spent $80 on its building during the year, which was more than the$50 amortization expense. This is evidence that the company is keeping its buildingup to date, not just letting its value decline through use.

• The company raised some cash by issuing shares ($15), but that was more thanoffset by the $35 needed to make payments on the mortgage principal during theyear and the $25 in dividends paid.

The cash flow analysis shows us why the company’s net income of $95 did not producean equal increase in cash. Many more things were going on involving cash.

Interpreting A Company’s Cash FlowStatement

In Chapters 2 and 3, we saw the comparative balance sheets, income statements, andstatements of retained earnings of Canadian Pacific Railway. Now let’s see what thecompany’s cash flow statement has to tell us. Following it is Note 10 on changes innoncash working capital accounts, but other notes are not included in this book.

4.7


NEL


1. What does the cash flow statement’s analysis showbeyond the performance portrayed in the income statement?

2. Horizon Inc. has the following results and balance sheetchanges from last year to this year. Calculate the threecategories of the cash flow statement and determine thetotal change in cash for the year.

Net income for the year, $23,950; Dividends declaredand paid, $9,250; Amortization expense, $16,900; Future

income tax expense, $2,200; Increase in accounts receivable, $1,205; Increase in accounts payable, $4,320;Increase in mortgage debt, $10,000; Increase in sharecapital, $15,000; Increase in cost of noncurrent assets,$57,260.

Cash from operations = $23,950 + $16,900 + $2,200 – $1,205+ $4,320 = $46,165. Cash used in investing = $57,260. Cash from financing = $10,000 + $15,000 – $9,250 = $15,750. Net total change in cash = $46,165 – $57,260 + $15,750 = $4,655 increase.




NEL

4•9

EXHIBIT

Canadian Pacific Railway LimitedStatement of consolidated cash flows

2004 2003 2002Year ended December 31 (Restated – (Restated –(in millions) see Note 2) see Note 2)

Operating activitiesNet income $ 413.0 $ 401.3 $ 487.5Add (deduct) items not affecting cash

Depreciation and amortization 407.1 372.3 340.2Future income taxes (Note 7) 131.5 31.8 95.0Environmental remediation charge (Note 3) 90.9 – –Restructuring and impairment charge (Note 4) (19.0) 215.1 –Foreign exchange gain on long-term debt (94.4) (209.5) (13.4)Amortization of deferred charges 24.7 20.3 19.3Other – – (0.8)

Restructuring payments (88.8) (107.0) (119.3)Other operating activities, net (Note 20) (112.2) (365.0) (45.0)Change in noncash working capital balances

related to operations (Note 10) 33.2 (53.6) –

Cash provided by operating activities 786.0 305.7 763.5

Investing activitiesAdditions to properties (Note 12) (673.8) (686.6) (558.5)Other investments (2.5) (21.9) 4.0Net proceeds from disposal of transportation

properties 10.2 8.2 3.5

Cash used in investing activities (666.1) (700.3) (551.0)

Financing activitiesDividends paid (81.7) (80.8) (80.8)Issuance of shares 2.5 2.0 2.0Issuance of long-term debt 193.7 699.8 –Repayment of long-term debt (16.1) (376.6) (405.7)

Cash provided by (used in) financing activities 98.4 244.4 (484.5)

Cash positionIncrease (decrease) in net cash 218.3 (150.2) (272.0)Net cash at beginning of year 134.7 284.9 556.9

Net cash at end of year $ 353.0 $ 134.7 $ 284.9

Net cash is defined as:Cash and short-term investments $ 353.0 $ 134.7 $ 284.9

(Notes to consolidated financial statements are not included.)


This is a consolidated statement, as were CPR’s other statements. Therefore, itdescribes the cash flows of the group of companies making up CPR. Like the incomestatement in Section 3.4, the cash flow statement covers three years, 2002–2004.

An immediately striking piece of information is that CPR’s change in cash has beensteadily rising, going from negative $272.0 million in 2002 to $218.3 million in 2004.The statement also reveals that the major source of cash for CPR has been operations ineach year and that the company has been heavily investing in additions to propertythroughout the period.

A. Operating Activities.

(1) Operations provide internal financing. Day-to-day operations (cash income) has been amajor source of cash for CPR over the last three years. While slightly less than newlong-term debt ($699.8 – $376.6 = $323.2) in 2003, cash from operations is greaterthan the total increase in cash in all three years, indicating that CPR is reliant oninternal financing, cash produced by the company’s business operations. Shortly, wewill compare this internal financing to external sources.


NEL

4•10EX

HIBIT

Canadian Pacific Railway Limited

10. Change in noncash working capital balances related to operations(in millions) 2004 2003 2002

(Use) source of cash:Accounts receivable $ (39.0) $ 45.2 $ 21.1Materials and supplies (35.5) 2.5 (6.6)Accounts payable and accrued liabilities 112.3 (76.3) (17.4)Income and other taxes payable (4.6) (25.0) 2.9

Change in noncash working capital $ 33.2 $ (53.6) $ –

CPR has anuncomplicateddefinition of cash.

For CPR, cash isuncomplicated, beingdefined as just thecash and short-terminvestments asset,which you can verifyby looking back at thebalance sheet inSection 2.9.

CPR’s change in cashand cash on handhave been rising.

CPR relies on internalfinancing.


(2) Noncash expenses. The impactof noncash expenses is signif-icant for CPR. In 2004 and2003, the three mainnoncash expenses exceedednet income, and were almostequal in 2002. This aloneshows why accrual income isnot a good approximation ofcash income. The schedulehere uses information from the cash flow statement: only the depreciation andamortization figure is also shown individually on the income statement in Section3.4; the others are part of other items in the income statement and so we learn theiramounts only from the cash flow statement, which is one of the cash flow state-ment’s contributions.

(3) Accrual expenses and cash flows differ in timing. Restructuring costs (mostly costs suchas severance pay for employees laid off in cost-saving arrangements, but also someenvironmental remediation costs) are an interesting case of the use of accrualaccounting. In 2003, a provision of $215.1 million for these costs was included as anexpense in calculating income. The journal entry would be Dr Restructuringexpense 215.1, Cr Restructuring liability 215.1. No cash was involved in recordingthe expense, so the $215.1 was added back to income in calculating cash from oper-ations in 2003. The actual cash payments made each year have not equaled theexpense shown on the income statement. The unpaid balance is included mainly inthe “deferred liability” noncurrent liability account.

(4) Noncash working capitalchanges related to opera-tions. CPR’s cash flowstatement shows onlysmall changes here: a$33.2 million increasein 2004, a slightlylarger decrease of$53.6 million in 2003,and no change in 2002. This indicates that the amounts in accounts receivable,inventories, and accounts payable are being carefully controlled by CPR. We willlook into this in more detail in Section 10.4.

If you go to the balance sheet and calculate the changes in the four accountsshown in Note 10, you will see that these are not quite the same as the changesshown in Note 10, and they don’t add up to the same as Note 10. You get $4.3 netchanges, not the $33.2 shown in Note 10, a difference of $28.9 million. CPR’s notesprovide some background on this but don’t make it clear what has happened. Thereason appears to arise from two items in the cash flow statement: “restructuringpayments” and “other operating activities, net.” Both of these items involve changesto some of the four accounts, and when those changes are removed, you get theremaining changes shown in Note 10. Such complications mean that the cash flowstatement contains information not obvious from the balance sheet and incomestatement, which are summarized from hundreds or thousands of accounts. Whenyou try to reconstruct a company’s cash flow statement, you often can’t get exactlythe same numbers because the company has used more detailed accounting informa-tion than in the summarized statements and hasn’t provided all those details. But youcan usually get close, as in this case! All this is a reminder that small net changes cancome from quite large positive and negative changes, so disclosure of the background


NEL

CPR has large noncash expenses.

CPR has had largerestructuring costs inmost years since 1999,not actually paid for inthe year incurred.

Noncash workingcapital changes hadlittle net effect onCPR’s operating cashflows.

Significant noncash expenses for CPR

2004 2003 2002

Deprec. & amort. $407.1 $372.3 $340.2Future income taxes 131.5 31.8 95.0Amort. of def. chgs 24.7 20.3 19.3

Sum $563.3 $424.4 $454.5

Net income $413.0 $401.3 $487.5

CPR’s noncash working capital changes 2003–2004

2004 B/S 2003 B/S Change

Accts rec’ble $434.7 $395.7 $(39.0)Inventories 134.1 106.4 (27.7)Accts payable 975.3 907.0 68.3Taxes payable 16.2 13.5 2.7

Total $ 4.3


information can be quite useful to understanding what happened during the year.The notes to the financial statements can be a bit hard to read sometimes, but they areusually helpful in understanding the numbers in the statements.

(5) Noncash working capital changes not related to operations. The calculation in Note 10 toremove some noncash working capital changes not related to operations is areminder that not all working capital accounts relate to operations. Two suchaccounts in particular are in CPR’s current liabilities, as shown in CPR’s balancesheet in Section 2.9: dividends payable ($21.0 million in 2004, and $20.2 million in2003) and current portion of long-term debt ($275.7 million in 2004, $13.9 millionin 2003). As we saw earlier in this chapter, such items are part of the Financing cashflow calculation, so CPR did not include their changes in determining cash fromoperations. There is one more noncash working capital account shown in Section 2.9,the change in which is not shown separately in the cash flow statement: CPR’scurrent asset for future income taxes. That account is included in the future incometax noncash expense already described above.

(6) Miscellaneous stuff in operations. In nearly every cash flow statement, there are a few“other” items that arise from various accounting calculations and don’t fit the usualcategories. In its 2002 cash flow figures, CPR includes $(0.8) million in its incomeadjustments as “Other” with no further explanation. Lower down in the Operationssection, $(112.2) million in 2004 and $(365.0) million in 2003 in “other operatingactivities” are shown. We can’t tell where the first item comes from but Note 20 (notincluded here) explains that “other operating activities” are cash payments in each ofthese years that exceed the expenses shown on the income statement relating topensions, other benefits, and post-employment restructuring benefits. This is asecond example of why you can never quite reproduce the cash flow statement fromthe other statements yourself: the company’s accountants have used more detailedinformation than is disclosed in preparing the statement. In addition to its way ofarranging balance sheet changes and income statement items to tell a new story, thecash flow statement also adds new information that we cannot get from the otherstatements.

B. Investing Activities.

(1) Overall investment spending. There was a lot of information in CPR’s Operations cashflow section! The Investing section is simpler. In 2004, CPR spent $673.8 million incash on new properties (land, track, trains, buildings, equipment) and got$10.2 million net proceeds from the disposal of transportation properties. Newspending was about the same as 2003, which was up almost 20% from 2002. While inprinciple we could deduce these amounts from noncurrent asset balance sheetchanges and related income statement information using the methods shownearlier in this chapter, in practice most companies’ noncurrent asset accounts aremuch too complex to permit this. We have to rely on the company and its auditorsto work it all out correctly.

(2) Internal financing of investments. Two things about CPR’s investments in propertiesare particularly worth noting. First, the total amount spent was less than cash fromoperations, so the company could have financed all its investing internally fromoperations, without external financing (borrowing or issuing more share capital).This was also true in 2002, but in 2003, CPR did not have enough cash from operations to finance the property additions internally.


NEL

Not all noncashworking capitalchanges relate tooperations.

There usually aremiscellaneous “other”items in the cash flowanalysis.

CPR spent more thanhalf a billion dollars onnew property in eachyear.

CPR could finance allits property additionsfrom operations in2002 to 2004.


(3) Renewal of noncurrent assets as they wear out. Second, the depreciation and amortiza-tion expense ($407.1 million in 2004: see the Operations section) was considerablyless than expenditures on new properties ($673.8 million in 2004). This indicatesthat CPR was renewing its properties as their economic value was used up (as esti-mated by the depreciation and amortization expense). An important purpose of thecash flow statement is to allow us to compare these two figures and so judge whetherthe company is keeping its noncurrent assets renewed.

C. Financing Activities.

(1) Capital rearrangements. The capital structure of CPR changed little during the period2002 to 2004. The small inflows of $2.5 million in 2004 and $2.0 million in 2003 arethe proceeds of issuing shares under stock option plans, 100,000 shares in 2003, and200,000 shares in 2004.

(2) Dividends. The cash flow statement indicates that CPR paid $81.7 million in dividendsin 2004. The retained earnings statement in Section 3.4 indicates $82.5 million individends were declared. The difference of $0.8 million ($82.5 – $81.7) is dividendsdeclared but unpaid during 2004. This tracks to the change in dividends payable ofthe same amount on the balance sheet in Section 2.9. Dividends payable rose to$21.0 million at the end of 2004 from $20.2 million at the end of 2003.

(3) Debt rearrangements. CPR repaid $16.1 million of its outstanding long-term debtduring 2004, slightly more than the current portion of long-term debt shown on thebalance sheet at the end of 2003. New long-term borrowings totalled $193.7 million,almost $100 million more than was needed to pay dividends and retire long-termdebt that came due during the year. Thus we can see that about half of the increasein cash was borrowed money, with the remainder coming from operations. CPR mayhave wanted to borrow now in preparation for repayment of the much larger amount($275.7 million) of long-term debt maturing in 2005.

The cash flow analysis has told us a lot, revealing several important things aboutCPR and its financial arrangements that were not so apparent from the balance sheetsand income statements. If we’d wanted to work at those statements, we could havederived some of the information (not all, as some was included in account balancechanges that we could not see readily from the other statements). But the cash flowstatement saves us the trouble, as long as we know how to read it. Focusing on 2004, wehave learned, among other things, the following:

• CPR’s cash showed a big increase from 2003.• CPR’s cash from operations was much larger than its accrual income in 2004.• CPR generated enough cash from operations to finance its new investments in 2004.• CPR spent more renewing its property than the estimated value consumed as the

property was used (depreciated and amortized).


NEL

CPR was renewing itsnoncurrent assets astheir economic valuewas consumed.

CPR’s cash flowstatement reports onthe 2004 externalfinancing.

CPR did not pay allthe dividends itdeclared in 2004.

CPR increased long-term debtslightly in 2004.

Cash flow analysisprovides insight intobusiness strategy aswell as plain cashmanagement.


• CPR borrowed during 2004 in order to increase cash holdings, possibly in preparationfor debt retirement in 2005.

Cash Flow and The ManagerManagers are responsible not only for earning income for the company, but also formanaging cash so that bills can be paid on time, excess borrowing and interest costs canbe avoided, and the company’s liquidity and solvency can be generally protected.Effectively employing available cash so that it does not remain idle, earning nothing, isalso important. Cash flow and income are generally positively correlated (good perform-ance tends to move them both up, and poor performance tends to move them bothdown), and over a long enough time (years), they are almost the same. But as we saw forCPR, in any given year they are likely not the same. Their relationship can be complex,as these two examples illustrate:

1. A few years ago, Quebec increased gasoline taxes to a higher rate than that inOntario. This caused immediate problems for Quebec gas stations near the Ontarioborder: driving a few kilometres to buy gas in Ontario made a big difference in theprice, unless a Quebec gas station owner decided to “swallow” the difference in tax.A CBC reporter interviewed a Quebec station owner and asked, “What are the impli-cations of this for your long-run profitability?” The owner said, “Unless I can getsome cash in the short run, there isn’t going to be a long run!”

2. A problem new businesses can have is to grow too fast. Often the product demandand the entrepreneurial enthusiasm are high: the business was founded in the hopethat people would want the product or service, and it is exciting to everyone whenthey do! The income statements of such businesses often show high profits (netincomes), but the cash flow statement and the balance sheet may tell a differentstory. In the enthusiasm of making sales and satisfying customers, inventory levelsoften get too high (making sure there is something for everyone on hand) andcollections from customers often lag (receivables get too high as the entrepreneurconcentrates on the pleasures of selling rather than the nuisance of collecting). Theaccrual income-based cash flow analysis deducts the increases in inventories andreceivables from accrual-basis net income, and may show that operating cash flowsare small or even negative. When this happens, you do not need a cash flow

4.8


NEL


1. CPR relied on internal financing in 2004. How can we tellthis?

2. Which figures on the cash flow statement would youcompare to get an indication of whether a companyappears to be renewing its noncurrent assets as they losetheir value through use?


Cash flow and incomeare related, but notthe same, especially inthe short run.

Long-run profitabilitymay depend on theshort-run cashsituation.

Sometimes newbusinesses withgrowing income havecash problems.


statement to know you are in trouble: your bank balance tells you that! But the cashflow statement reports the whole story to others, so that they can see what you haveaccomplished in obtaining and using cash in your operating, financing, and invest-ing activities. You then have to be prepared to explain such activities to users of thefinancial statements.

The cash flow statement provides a measure of managerial performance in managingcash, so smart managers must be aware of how their efforts are reflected in it, just asthey are aware of the income statement and balance sheet measures of performanceand position.

Revisiting Cash Basis Versus Accrual BasisAccounting

This section returns to ideas first encountered in the Simone’s Jewellery example inSection 1.10 and referred to since: the comparison of cash basis and accrual basisaccounting. It aims to consolidate your knowledge of cash flow analysis, and should alsohelp your understanding of how accrual accounting works by augmenting records of cashreceipts and disbursements. Income tax is ignored, to avoid cluttering up the example.

Information for Goblin Consulting Ltd. for this year is:

4.9


NEL

There has been increasing researchon the value of the cash flowstatement, mostly in connection

with public companies’ share pricechanges (buy-and-sell decisions byinvestors). Most research, so far, defines

cash flow simply as net income plus amortization (deprecia-tion) expense. Such research usually finds that share pricesdo respond a little to the added information.1 While most ofthe share price response is to the earnings (accrual netincome) figure, some response to the cash flow informationhas also been found.2

Stock market

prices do seem to

respond to cash

flow information

in addition to

income.

FYIFYI

FinancialAcct-C04-v3 3/28/06 4:30 PM 3

If we did a cash basis income statement for this year, we would get something like this:

Operating receipts ($1,600 + $75,200 + $1,000) $77,800Operating expenditures ($900 + $61,300 + $2,200) 64,400

Cash income for this year $13,400

There are also:

• Nonoperating receipts of $6,500 ($6,000 debt + $500 proceeds); and • Nonoperating expenditures of $17,000 ($3,000 debt payments + $14,000 new

equipment).

If we added and subtracted those from $13,400, we’d get the total increase in cashduring the year of $2,900:

Cash income $13,400Nonoperating receipts 6,500Less nonoperating expenditures (17,000)

Increase in cash during the year $ 2,900

In contrast, the accrual basis income statement for this year would look like this, recognizing this year’s earned revenues and incurred expenses:


NEL

4•11EX

HIBIT

Cash in bank, end of last year $ 2,800Cash receipts:

Collections on last year’s revenue $ 1,600Collections on this year’s revenue 75,200Deposit received on next year’s revenue 1,000Long-term debt issued 6,000Sale of old equipment (proceeds) 500 84,300

$87,100

Cash disbursements:Payment of last year’s expenses $ 900Payment of this year’s expenses 61,300Advance payment on next year’s expenses 2,200Payments on long-term debt 3,000Purchase of new equipment 14,000 81,400

Cash in bank, end of this year $ 5,700

Increase in cash during the year ($5,700 – $2,800) $ 2,900

Additional information:Equipment amortization for this year $ 3,100Uncollected revenue at the end of this year 2,500Unpaid expenses at the end of this year 1,700Book value of old equipment at date of sale 300Gain on sale of equipment

(proceeds – book value = $500 – $300) 200


Revenue ($75,200 cash sales + $2,500 uncollected) $77,700Expenses:

General ($61,300 paid + $1,700 unpaid) $63,000Amortization (specified above) 3,100 66,100

Operating income $11,600Gain on sale of equipment (calculated above) 200

Income for this year $11,800

Because both cash flow and accrual figures are important, we want people to be able tounderstand how they are related to each other, and how they differ. That is what thecash flow statement is for. Here’s what that statement for this year would look like:

You can see that the cash flow statement’s $13,400 “cash from operations” figure(which is derived from the $11,800 accrual basis income) is what you’d have as your cashincome had you done the income statement on the cash basis. This was also demon-strated with the diagram at the end of Section 4.3 and the two ways of doing theRoebuck Industries cash flow statements in Sections 4.4 and 4.5. The cash flow state-ment reconciles the two ways of calculating income. The statement also provides the restof the information (investing and financing) to allow you to see the total effects on cashfor the year.

Therefore, with the accrual basis income statement plus the cash flow statement,you get the broader economic measure of performance that accrual accountingprovides, as well as cash flow information with which to evaluate the company’s cashmanagement. The set of financial statements provides an integrated, mutually reinforc-ing package of information.


NEL

4•12

EXHIBIT

Operations:Income for the year (accrual basis) $ 11,800 Add back noncash expense (amortization) 3,100 Deduct back gain on sale (cash is in “proceeds” below) (200)

$ 14,700 Changes in noncash working capital accounts:

Accounts receivable (up $2,500 – $1,600) $ (900)Prepaid expenses ($2,200 now, none last year) (2,200)Deferred revenue ($1,000 now, none last year) 1,000Accounts payable (up $1,700 – $900) 800 (1,300)

Cash from operations $ 13,400 Investing:

Purchases of new equipment $(14,000)Proceeds from equipment sale 500 $(13,500)

Financing:Issue of long-term debt $ 6,000Repayment of long-term debt (3,000) 3,000

Increase in cash for this year $ 2,900Cash at beginning of this year 2,800

Cash at end of this year $ 5,700


Terms to Be Sure You UnderstandAgain, here are important terms introduced or emphasized in this chapter. Make sure you know what they mean inaccounting. If any are unclear to you, check the chapter again or refer to the glossary of terms at the back of thebook. As was the case for the terms in Chapters 1, 2, and 3, many of these will be used repeatedly as the bookproceeds, so your understanding of them will deepen.

4.10


NEL


1. The owner of Frenzied Productions Inc. was looking at thecompany’s income statement and said, “I understand thisstatement was prepared using accrual accounting. Whatdoes accrual accounting try to do, and why isn’t it goodenough just to report my company’s cash receipts anddisbursements?” Briefly answer the owner’s question.

2. In 2005, Frenzied collected $53,430 from customers forsales made in 2004 and $421,780 for sales made in 2005.In 2006, it collected $46,710 from customers for salesmade in 2005. At that point, all 2004 and 2005 sales hadbeen collected. What were (a) the operating cash receiptsfor 2005 and (b) the accrual accounting revenue for2005?

(a) $53,430 + $421,780 = $475,210; (b) $421,780 + $46,710 = $468,490


Accrual incomeCash flow statementCash from operationsCash incomeCash paymentsCash receiptsChange in cashDirect method of cash flow analysisDisbursements

DisclosureFinancing activitiesFunds statementIndirect method of cash flow

analysisInternal financingInvesting activitiesLiquidityNonoperating cash flows

Notes to the financial statementsOperating activitiesReconcile(s)SolvencyStatement of changes in financial

positionStatement of source and application

of cash


Installment 4 DATA FOR INSTALLMENT 4

In order to prepare for the board of directors’ meeting, Tomas thought it would be agood idea to be able to explain what had happened to the company’s cash during thefirst six months. As a reference, here is the comparative balance sheet we saw inInstallment 3:

4.11 CONTINUING DEMONSTRATION CASE

NEL 257

Mato Inc.Balance Sheets as at August 31 and March 1, 2006

Assets Liabilities and Shareholders’ Equity

August March August March

Current assets: Current liabilities:Cash $ 4,507 $130,000 Bank loan $ 75,000 $ 0Receivables 18,723 0 Payables 45,616 1,100Inventory 73,614 0 Loan payable 15,000 15,000

$ 96,844 $130,000 $135,616 $ 16,100

Noncurrent assets: Shareholders’ equity:Equip. cost $ 54,640 $ 10,000 Share capital $125,000 $125,000Equip. acc. amort. (3,234) 0 Deficit (49,378) 0Leasehold (net)* 57,568 0 $ 75,622 $125,000Software (net)** 4,320 0Incorp. costs 1,100 1,100

$114,394 $ 11,100

TOTAL $211,238 $141,100 TOTAL $211,238 $141,100

* Net book value of leasehold improvements = $63,964 cost – $6,396 accumulated amortization.** Net book value of software = $4,800 – $480 accumulated amortization.

Tomas decided that for his cash analysis, he would define cash and equivalents as justcash, because the demand bank loan was a source of financing the company would likelyrely on for some time, and was not like a temporary bank overdraft. He began his analy-sis by identifying the changes in financial position since March 1, which resulted in theanalysis below.


Changes in Financial Position between March 1 and August 31, 2006

Changes in Assets Changes in Liabilities and Equity

Cash $ (125,493) Bank loan $75,000Receivables 18,723 Payables 44,516Inventory 73,614 Loan payable 0Equipment cost* 44,640 Share capital 0Accum. amort.** (3,234) Deficit (49,378)Leasehold cost 63,964Accum. amort.** (6,396)Software cost 4,800Accum. amort.** (480)Incorp. costs 0

$ 70,138 $70,138

* Computer, $14,900; other equipment and furniture, $29,740.** The changes in accumulated amortization were all due entirely to amortization expenses recorded for the period.

RESULTS FOR INSTALLMENT 4

Tomas then wrote down all the categories of the cash flow statement and filled in theappropriate figures, producing the statement shown below. (The statement is shown in moredetail than might be done in practice, so that you can trace every figure from the balance sheetchange analysis above to the cash flow statement. Make sure you do this, to improve your understanding of the derivation and interpretation of the cash flow statement.)

Mato Inc.Cash Flow Statement

for the Six Months Ended August 31, 2006

Operations:

Net loss for the six months $ (49,378)

Add back amortization for the period ($3,234 + $6,396 + $480) 10,110

$ (39,268)Changes in noncash working capital accounts:

Increase in accounts receivable $(18,723)Increase in inventory (73,614)Increase in accounts payable 44,516 (47,821)

Cash used in operations $(87,089)

Investing activities:Equipment, computer, and furniture acquired $(44,640)Leasehold improvements made (63,964)Software acquired (4,800) (113,404)

Financing activitiesBank loan obtained 75,000

Decrease in cash during the six months $(125,493)Cash on hand, March 1, 2006 130,000

Cash on hand $ 4,507

NEL258


The cash flow statement shows that the dramatic decline in cash has two causes.

• First, day-to-day operations produced a cash loss of $87,089. This was a combinationof expenses exceeding revenues and the buildup of current assets, especially inven-tory. The increase in accounts payable helped to finance this, but even after, inessence, borrowing from suppliers, the company still fell far behind in its cash flow.

• Second, noncurrent asset acquisitions cost $113,404 in cash.

Without the bank loan, cash would have been negative $70,493. The company clearlyhas to get on top of its cash problems quickly.

NEL 259



NEL

Homework and Discussion to Develop Understanding

The problems roughly follow the outline of the chapter. Three main categories of questions are presented.

• Asterisked problems (*) have an informal solution provided in the Student SolutionsManual.

• EXTENDED TIME problems grant a thorough examination of the material andmay take longer to complete.

• CHALLENGING problems are more difficult.

For further explanation, please refer to Section 1.15.

Introduction to the Cash Flow Statement • Sections 4.2 and 4.3

Purpose and Details

PROBLEM 4.1 Discussion of cash flows

In your own words, answer the following questions in a manner that would allow some-one who has not read this book to understand.

a. Why are financing and investing activities of a corporation important to financialstatement readers?

b. How does an increase in accounts receivable during the year affect the cash flowfrom operations?

c. Why is it possible that cash may have decreased during the year, even though therehas been a substantial net income during the same period?

d. Why does net income (loss) for the year not normally equal the cash inflow (outflow)?e. What effect does the declaration of a cash dividend have on cash flow? What effect

does a dividend declared and paid in the same period have? What effect doespayment of a dividend declared in an earlier period have?

PROBLEM 4.2 Explain what the cash flow statement tells about a company

Explain to your uncle (who has never studied accounting) what the cash flow statementtells him about a company in which he owns shares.

PROBLEM 4.3 Cash flow basics

1. What does the cash flow information in the cash flow statement tell you that youcannot get directly, if at all, from the income statement and balance sheet?

2. Beta Company’s cash flow statement showed the following figures: Cash generatedfrom operations, $127,976; Cash used in investing activities, $238,040; and Cashobtained in financing activities, $107,000. What was the net change in thecompany’s cash for the year?

PROBLEM 4.4 Why pay attention to the cash flow statement?

A senior financial executive for a large public company remarked to a stock marketanalyst: “I don’t know why you people worry so much about what is in our cash flowstatement. Managing cash flow is our responsibility as managers; it involves paying closeattention to cash on a daily basis. Why don’t you pay attention to our income performance and just forget about cash flow? We’ll look after that!”

Respond to the executive’s comments. You do not have to agree or disagree entirely.

4.12

hallengingC


PROBLEM 4.5 Why not just have cash-basis accounting?

A business commentator made the following remark during a discussion of the financialperformance of a large, but struggling, company: “These accountants are something tobehold! They spend lots of money to create complicated financial statements, especiallyincome statements, that use what they call ‘accrual’ accounting, and come up with anincome number they expect us to take seriously. Then they spend a whole lot moremoney creating cash flow statements, which are just as complicated as the other statements, and that take away all the accruals and supposedly return us to the cashincome number we would have had anyway, if they hadn’t bothered with accrualaccounting in the first place! Nice work! You get paid to create a dubious income meas-ure and then more money to uncreate it. What kind of idiots do they take the businesscommunity for? Why don’t they just give us the cash income and leave it at that? We canunderstand that, and it would make a simple income statement and no need for a cashflow statement to just cancel out the income number, as we have now.”

If you were an accountant involved in the discussion and everyone turned to you fora response to the commentator, what would you say?

Preparing the Cash Flow Statement • Sections 4.4–4.6

Direct Method

* PROBLEM 4.6 Cash flow analysis from account information

Prepare a cash flow statement from the following cash account information, which is inalphabetical order.

Bank loan obtained 60,000Cash, beginning of year 68,920Cash, end of year 93,620Cash expenses 8,920Cash sales 31,610Collections on accounts receivable 797,640Common shares issued 140,000Cost of redeeming preferred shares 25,000Dividends paid ($20,000 declared) 15,000Employee wages and salaries paid 223,610Income tax paid 14,920Land purchased for cash 81,000Payments to suppliers 513,600Proceeds from sale of old truck 7,000Repayments on mortgage 80,500Truck purchased ($5,000 more still owing) 49,000


NEL

hallengingC


PROBLEM 4.7 Prepare a cash flow statement from account information

Based on the following cash account information (listed in alphabetical order), preparea cash flow statement for Ryley’s Dog Treats Inc.

Bonds issued 90,000Cash, beginning of year 108,270Cash, end of year 39,260Cash expenses 32,400Cash sales 65,580Collections on accounts receivable 919,160Common shares issued 242,000Cost of redeeming preferred shares 44,000Dividends paid ($50,000 declared) 33,000Employee wages and salaries paid 365,730Equipment purchased ($15,000 more still owing) 132,000Income tax paid 32,490Plant purchased for cash 233,750Payments to suppliers 468,380Proceeds from sale of old equipment 29,700Repayments on mortgage 73,700

PROBLEM 4.8 Preparing a cash flow statement from account information

You are an accountant for Hannibal’s Fine Dining Ltd. The owner and head chef is veryupset with you because there is only $148,690 in cash on hand. He knows that there was$146,800 on hand one year ago and cash sales for the year were $850,630. Of that,$20,000 was withdrawn from the line of credit and some old equipment was sold for$6,500. He also recalls that $3,100 was collected from accounts receivable and a newinvestor purchased $30,000 of newly issued common shares. “Where did all this cashgo?” he screams.

You show him that there were cash expenses of $168,580 plus $229,850 in wages andsalaries and another $149,240 was used to reduce accounts payable. Mortgage repay-ments totalled $97,500, $50,000 was paid to redeem preferred shares, and the govern-ment took $63,170 in taxes. “We paid $40,000 for the new furniture and $30,000 for thekitchen equipment, and we declared $90,000 in dividends,” you remind him.

Hannibal replies “Yes, but we still owe $10,000 on the equipment and $10,000 in dividends.”

Fearing for more than just your job, you decide to prepare a cash flow statement tohelp your angry boss understand what the company did with its cash this year.

PROBLEM 4.9 Prepare a cash flow statement from information that is not all relevant

Prepare a cash flow statement from the following information for this year, presented inalphabetical order. Some of the information may not be relevant. (Hint: use the directmethod.)


NEL


Cash sales 860Credit sales 346Cash purchases of inventory 610Inventory purchases on account 135Accounts receivable:

Balance at January 1, 2006 85Balance at December 31,2006 110

Merchandise inventory:Balance at January 1, 2006 185Balance at December 31, 2006 230

Accounts payable:Balance at January 1, 2006 50Balance at December 31, 2006 60

Wages payable:Balance at January 1, 2006 5Balance at December 31, 2006 12

Prepaid rent:Balance at January 1, 2006 0Balance at December 31, 2006 6

Cash paid for expenses 145Fixed assets – Equipment:

Cost (purchased in 2005) 380Annual Amortization 38


NEL

Account receivable written off* 1,200Amortization expense for the year 111,120Bank overdraft, beginning of year 0Cash at the end of the year 43,220Collections on accounts receivable 944,980Customer deposits received 48,000Dividends declared 100,000Dividends payable, beginning of year 0Dividends payable, end of year 20,000Inventory purchased on credit 310,990Investment written down** 33,000New bonded debt issued 463,000New equipment purchased 580,340Old bonded debt repaid 373,000Payments on accounts payable 832,630Proceeds of building sold*** 290,000Shares issued in return for land 145,000Temporary bank overdraft, end of year 17,530

* The account receivable was deemed uncollectible and was written off directly to expense.** The investment was written down from its $50,000 cost to its market value of $17,000.***The building sold had cost $410,000 and had accumulated amortization of $200,000.

Indirect Method

* PROBLEM 4.10 Prepare a cash flow statement for Northern Star Theatre

Near the end of Section 3.8, the balance sheet for Northern Star Theatre Company waspresented, along with the income statement and statement of partners’ capital for thefirst months of the partnership’s existence. Use that information to prepare a cash flowstatement for the partnership for the period to August 26, 2006.

PROBLEM 4.11 Cash vs Accrual Income and the cash flow Statement

The year-end of Micadam Inc. is December 31, 2006. The following summarized dataare taken from its accounting records (amounts are in thousands):

E xtended time

E xtended time


1. Using the above information, complete the following income statements on boththe accrual and cash bases.

Accrual Basis Cash Basis

Sales $ Sales $Cost of goods sold Cost of goods sold

__________ __________Gross profit $ Gross profit $Operating expense Operating expense

Amortization $ Amortization $Miscellaneous MiscellaneousRent RentWages __________ __________ Wages __________ __________

Net income for the Cash income for theyear $ year $

2. Prepare the cash flow from operations portion of the cash flow statement forMicadam Inc. at December 31, 2006.

PROBLEM 4.12 Cash flow analysis with large write-off and other adjustments

Here are the summarized 2007 and 2006 balance sheets for Saint John Enterprises Inc.,showing the changes calculated by subtracting 2006 from 2007. Using them and theadditional information below, prepare the cash flow statement for 2007.

2007 2006 Changes

Cash equivalent assets $ 17,400 $ 14,300 $ 3,100Other current assets 164,100 123,500 40,600Noncurrent assets, net 319,800 286,200 33,600

$501,300 $424,000 $77,300

Cash equivalent liabilities $ 11,200 $ 9,100 $ 2,100Other current liabilities 117,900 90,600 27,300Noncurrent liabilities 174,800 175,300 (500)Share capital 80,000 60,000 20,000Retained earnings 117,400 89,000 28,400

$501,300 $424,000 $77,300

Additional information:

• The 2007 net income was $38,400. This was after recording a large noncurrent assetwrite-off of $112,000, which the company had thought necessary because an investment had gone bad during the year.

• Dividends declared during the year were $10,000.• $1,500 of the dividends were still unpaid at the end of 2007 (there had been none

unpaid at the end of 2006).• There was an expense in 2007 for future income tax, recorded by increasing the

noncurrent income tax liability by $8,800.• The cash equivalent liabilities were temporary bank overdrafts. Some of the

noncurrent liabilities were paid off during the year.• During the year, the company sold for $8,400 a truck that had cost $25,000 and had

accumulated amortization of $17,300. There was thus a gain on sale of $700(proceeds of $8,400 – book value of $7,700 ($25,000 – $17,300)).


NEL

E xtended time


• Amortization expense for the year, shown on the income statement and added tothe accumulated amortization account on the balance sheet, was $37,700.

• Acquisitions of noncurrent assets came to $191,000 for the year.

PROBLEM 4.13 Cash flow for Gronsky’s Great Things Ltd.

If you did Problem 3.40 on Gronsky’s Great Things Ltd., you will have prepared incomeand retained earnings statements and an ending balance sheet for the company. Use thatinformation to prepare a 2007 cash flow statement for the company. Assume thecompany began the year with $18,750 cash, obtained in return for share capital issued toGronsky.

PROBLEM 4.14 Preparation of cash flow statement

The comparative balance sheets for the Wriggle Corp. showed the following atDecember 31, 2006 and 2007:

Debits 2007 2006

Cash $ 15 $ 12Accounts receivable 27 15Merchandise inventory 36 30Long-term investments 15 36Fixed assets at cost 141 90

$234 $183

Credits

Accumulated amortization $21 $15Accounts payable 24 18Notes payable – long-term 60 48Common shares 90 75Retained earnings 39 27

$234 $183

The income statement for 2007 appears below:

Wriggle Corp.Income Statement

For the Year Ended 2007

Revenue $450Cost of sales 300

Gross profit $150Operating expenses:

Expenses including income tax $117Amortization 9 126

Income from operations $ 24Other gains (losses) net of income taxes:

Gain on disposal of fixed assets 3Loss on disposal of investments (6)

Net income $ 21


NEL

E xtended time

E xtended time


Assets Liabilities & Equity Income

2003 2002 2003 2002 2003

CEA $ 2,000 $ 1,000 CEL $ 2,000 $ 3,000 REV $125,000OCA 9,000 8,000 OCL 4,000 2,000 EXP (84,000) (amort.

= $5,000)NCA 37,000 32,000 NCL 17,000 18,000 INT (2,000)

CAP 12,000 10,000 NRE 4,000**RET* 13,000 8,000 TAX (19,000) (future

= $3,000)SEI (13,000)***

$48,000 $41,000 $48,000 $41,000 INC $ 11,000

* Dividend of $6,000 was declared and paid in 2003.** $4,000 nonoperating income is a gain on an NCA sale: proceeds $7,000 minus $3,000 book value.

*** $(13,000) special item = $21,000 write-off minus $8,000 future tax reduction.

Additional information regarding changes in the noncurrent accounts during 2007:

a. Cash dividends paid, $9b. Issuance of shares for cash, $15c. Fixed assets disposed of during the year cost $9

1. Prepare a statement of cash flow in good form.2. Comment on the operations, financing activities and investing activities of Wriggle

Corp. for the year 2007.

PROBLEM 4.15 Prepare a cash flow statement from cash receipts, disbursements, and other information

Below, in alphabetical order, is information about Chantal Inc. Prepare a cash flow statement in good form.

Accumulated amortization on equipment that was sold 10,800Advance payment on next year’s expenses 8,028Amortization for this year 42,221Cash in bank, end of last year 63,419Collections of this year’s revenue 347,085Collections on last year’s revenue 20,516Cost of equipment that was sold 14,400Deposit received on next year’s revenue 5,489Noncurrent debt issued 67,500Payment of this year’s expenses (including income tax) 267,269Payment on last year’s expenses 1,701Proceeds on sale of equipment 2,160Purchase of new equipment 164,178Repayment of noncurrent debt 27,000Uncollected revenue at the end of this year 28,116Unpaid expenses at the end of this year 26,417

* PROBLEM 4.16 Prove given cash flow figures

The following summarized data are from Grantham Inc.’s financial statements. (CEA =cash and equivalent assets; OCA = other current assets; NCA = noncurrent assets; CEL =cash equivalent liabilities (temporary bank overdraft); OCL = other current liabilities; NCL= noncurrent liabilities; CAP = share capital; RET = retained earnings; REV = revenue; EXP= general expenses; INT = interest expense; NRE = nonoperating revenues and expenses;TAX = income tax expense; SEI = special and extraordinary items; INC = net income)


NEL

E xtended time


Show that the following are correct for the 2003 cash flow statement:

a. Cash generated from operations $ 29,000b. Cash obtained from financing activities 0

c. Cash disbursed for investing activities (net) (27,000)d. Increase in cash and equivalents $ 2,000

* PROBLEM 4.17 Correct a badly prepared cash flow statement

Fred talked his way into a job with Aragon Ltd., convincing the company’s boss that hehad enough accounting knowledge to do the company’s accounting. All went well for awhile: Fred managed to get the year’s accounting done and came up with an appropri-ate balance sheet, income statement, and statement of retained earnings. But he justhasn’t been able to get the cash flow statement to work out. He has calculated all thebalance sheet changes correctly, but it just doesn’t work out right. In response to a loud“Help!” you go over to Fred’s desk to see if you can do anything. You find Fred’s draftcash flow statement below, and you are able to determine that all his numbers are takencorrectly from the other statements, so all that is needed is to rearrange Fred’s draft andget everything in the right direction, and it should all work out.

Using Fred’s draft, prepare a cash flow statement for Aragon Ltd. in proper format.

Aragon Ltd.Draft Cash Flow Statement

Operations:Net income for the year $ 216,350Cash on hand 48,340Less amortization for the year $(218,890)Add deferred income tax expense 21,210 (197,680)

Working capital changes:Cash and equivalents $ 62,070Increase in accounts receivable (223,120)Decrease in inventory 80,200Decrease in accounts payable 91,970Increase in current income tax payable (6,530) 4,590

Cash from operations $ 71,600

Investing:Additions to noncurrent assets $(393,980)Proceeds from sales of noncurrent assets (11,260) (405,240)

Financing:New noncurrent debt $(250,500)Repayments of noncurrent debt 78,800Dividends paid 75,000Share capital issued 120,000 126,700

Change in cash for the year $(206,940)

What If Analysis

* PROBLEM 4.18 “What if” questions

Indicate the effect on Beta Company’s cash flow statement of each of the followingevents, if they had occurred during the year:


NEL


a. What if a new truck had been purchased at a cost of $38,950?b. What if $20,000 were borrowed long-term specifically to help pay for the truck?c. What if collections of accounts receivable had been $6,000 less than actually

happened?d. What if the company had paid an additional dividend of $15,000?e. What if the company had borrowed $25,000 from the bank as a demand loan?f. What if the company had decided to record an additional $5,000 in amortization

expense for the year?

PROBLEM 4.19 Effects analysis questions on Tamarack Systems

These two questions are based on the Tamarack Systems information in Problem 4.30*.You can do some analysis without doing that problem, but the specific answers are basedon the cash flow statement required in that problem.

1. What would have changed on Tamarack’s 2007 cash flow statement if the cashreceived for the garage sale had been $40,000 instead of $25,000?

2. What would have changed on the cash flow statement if the accumulated amortiza-tion on the garage had been $82,000 instead of $70,000? (Ignore part 1.)

PROBLEM 4.20 Effects analysis questions on CPR

The following events all occurred on December 30, 2004, and were accidentally omittedfrom the CPR statement of consolidated cash flows in Section 4.7. Indicate what changesto the cash flow statement would result from each event. (Note: For each event, startwith the original statement and ignore the effects of the five other events.)

a. A building was purchased for $25 million.b. $14 million of common shares were issued.c. The chief accountant realized the depreciation and amortization expense was

$10 million larger than it should have been.d. $130 million in long-term debt was repaid.e. An additional $7 million was received from disposal of transportation properties.f. A company paid its bill of $5 million for a shipment of wheat that had been made in

2003. The $5 million revenue was included in net income for 2003.

PROBLEM 4.21 Effects on cash flow statement of unpaid dividends and building disposal

1. You have just prepared a cash flow statement for Frogmorton Corp., and it worksout to the correct change in cash and equivalents. You then discover that includedin the current liabilities is an account for dividends payable that you had not real-ized was there. Explain why the cash from operations and financing figures on yourcash flow statement are incorrect and why the total change in cash is correct in spiteof your error.

2. You are struggling with the cash flow statement for Smithwood Inc. You know thatthe net total change in noncurrent assets over the year is an increase of $382,500and that amortization expense for the year was $159,400. You then learn that duringthe year the company sold a building for $190,000. The building had cost $790,000and there was accumulated amortization on it of $610,000 at the date of sale.a. Calculate the apparent amount spent on acquisitions of noncurrent assets

during the year.b. Calculate the gain or loss on the sale of the building.c. Specify the adjustments to income in the operations section of the cash flow

statement arising from noncurrent assets.d. Specify the figures in the investing activities section of the cash flow statement.


NEL


PROBLEM 4.22 “What if” questions involving cash flow

By making certain business decisions or choosing the location of items in their financialstatements, companies may be able to alter the “story” the cash flow statement tells. Foreach action or choice below, explain what effect (if any) would result in the cash flowstatement for the present year (including cash and equivalents at the bottom) if theaction or choice happened.

1. Company A arranges with the bank to let it have a temporary bank overdraft of$250,000 as a way of getting some immediately needed financing.

2. Company B decides to classify $75,000 of its accounts receivable as long-term assetsinstead of current assets.

3. Company C decides to buy land for $710,000, arranging for 100% long-term debtfinancing instead of issuing new share capital.

4. Company D decides to decrease its amortization expense for this year by $82,000.5. Company E decides to declare a $50,000 dividend to shareholders payable immedi-

ately in cash.6. Company F decides to donate $35,000 to the Poor Accountants’ League (the

donation will be included with business expenses).

Interpreting a Company’s Cash Flow Statement • Sections 4.7 and 4.8

* PROBLEM 4.23 Comment on a company’s cash management

Axiomatic Inc.’s cash flow statement for last year is shown below. Make as many observa-tions as you can about how the company managed its cash during the year.

Axiomatic Inc.Cash Flow Statement for Last Year

Operations:Net income for the year $ 94,900Add back noncash expenses:

Amortization expense $ 216,800Deferred income tax expense 14,200Pension expense 38,900 269,900

Noncash working capital changes:Increase in accounts receivable $(143,900)Increase in inventories (71,600)Increase in accounts payable 87,000 (128,500)

Cash generated by operations $ 236,300Investing activities:

Additions to noncurrent assets $(429,100)Proceeds on disposal of noncurrent assets 27,700 (401,400)

Financing activities:Short-term bank loan $ 30,000Additions to noncurrent debt 343,200Repayments of noncurrent debt (316,000)Share capital issued 200,000Dividends paid during the year (40,000) 217,200

Increase in cash for the year $ 52,100Cash, beginning of year (93,500)

Cash, end of year $ (41,400)


NEL

hallengingC


PROBLEM 4.24 Comment on a company’s cash management

Last year’s cash flow statement for Wemakem Inc. is shown below. Make as many obser-vations as you can about how the company managed its cash during the year.

Wemakem Inc.Cash Flow Statement for the Last Year

Operating ActivitiesNet income for the year $ 575,000Add back noncash expenses:

Amortization expense $ 1,273,000Future income tax expense 104,300Pension expense 391,400 1,768,700

Noncash working capital changes:Increase in accounts payable $ 57,400Decrease in inventories 31,000Increase in accounts receivable (17,800) 70,600

Cash generated by operations $ 2,414,300

Investing ActivitiesAdditions to noncurrent assets $(1,526,700)Proceeds from disposal of noncurrent assets 18,700 (1,508,000)

Financing ActivitiesShort-term debt repaid $ (143,400)Long-term debt repaid (658,900)Common shares issued 54,000Dividends paid (598,000) (1,346,300)

Decrease in cash for the year $ (440,000)Cash on hand at the beginning of the year 1,357,400

Cash on hand at the end of the year $ 917,400

PROBLEM 4.25 Comment on a company’s cash management

Make as many observations as you can about cash management at Enbridge Inc. basedon its cash flow statement.


NEL


Enbridge Consolidated Statements of Cash Flows(Millions of Canadian dollars, except per share amounts)

Year ended December 31, 2004 2003 2002

Restated Restated (Note 2) (Note 2)

Cash Provided by Operating ActivitiesEarnings from continuing operations 652.2 674.1 336.9

Charges/(credits) not affecting cashDepreciation 525.0 443.0 403.9Equity earnings in excess of cash distributions (39.2) (22.1) (44.6)Gain on sale of assets to Enbridge Income Fund – (239.9) –Gain on reduction of ownership interest (29.6) (50.0) (10.0)Gain on sale of investment in AltaGas Income Trust (121.5) – –Gain on sale of securities – – (21.4)Writedown of EGD regulatory receivable – 26.0 –Writedown of Enbridge Midcoast Energy assets – – 122.7Future income taxes 12.7 85.8 (77.8)Other 28.2 21.4 (10.2)

Changes in operating assets and liabilities (Note 19) (141.1) (569.8) 151.6Cash provided by operating activities of discontinued operations – – 26.3

886.7 368.5 877.4

Investing ActivitiesAcquisitions (Note 5) (833.9) (78.3) (289.3)Long-term investments (16.9) (50.5) (1,282.7)Additions to property, plant and equipment (496.4) (391.3) (729.9)Proceeds on redemption of Enbridge Commercial Trust

preferred units – 24.9 –Sale of investment in AltaGas Income Trust 346.7 – –Sale of assets to Enbridge Income Fund (Note 4) – 331.2 –Proceeds on dispositions – – 1,706.9Affiliate loans – 427.2 358.1Changes in construction payable 0.5 (3.7) (14.8)

(999.7) 259.5 (251.7)

Financing ActivitiesNet change in short-term borrowings and short-term debt 738.0 359.8 (1,180.9)Long-term debt issues 500.0 150.0 247.4Long-term debt repayments (450.0) (725.0) (382.7)Non-recourse long-term debt issued by joint ventures – 538.3 –Non-recourse long-term debt repaid by joint ventures (42.9) (663.8) –Non-controlling interests (2.4) (4.0) 0.2Preferred securities (350.0) – 200.0Common shares issued 44.4 70.9 293.1Enbridge Energy Management shares issued (Note 8) – – 421.9Preferred share dividends (6.9) (6.9) (6.9)Common share dividends (315.8) (283.9) (251.1)

114.4 (564.6) (659.0)

Increase/(Decrease) in Cash 1.4 63.4 (33.3)Cash at Beginning of Year 104.1 40.7 74.0

Cash at End of Year 105.5 104.1 40.7

19. Changes in Operating Assets and Liabilities(millions of dollars)

Year ended December 31, 2004 2003 2002

Accounts receivable and other (347.4) (346.9) 81.5Inventory 35.3 (232.4) 69.5Deferred amounts and other assets (94.2) (78.9) 72.4Accounts payable and other 278.3 93.9 (76.4)Interest payable (13.1) (5.5) 4.6

(141.1) (569.8) 151.6

Changes in accounts payable exclude changes in construction payables which are investing activities.


NEL


* PROBLEM 4.26 Interpret a simple cash flow statement and answer “what if” questions

A high-school friend of yours, Natasha Wheeler, is currently in second-year fine arts and,in addition to many other talents, happens to have an entrepreneurial flair. For the lasttwo summers, she has operated a bicycle rental business near a local park. Last year(2006), even though the business was just getting started, she made enough money toget herself through the school year. Encouraged by this initial success, she boughtseveral more bikes this year (2007) and constructed a movable shed out of which sheoperated her business and serviced the bikes.

Business was even better this summer, but Natasha is confused. While her businessincome was much up from last year, there is no cash for her to withdraw. She does notknow how she will pay her university expenses this year.

Knowing that you are taking an accounting course, she comes to you for help. Sherealizes that you cannot lend her any money, but thinks that maybe you can explainwhat is going on with her business. (Ignore income tax throughout.)

1. Using the cash flow statement below, explain to Natasha how it is possible that theincome statement can show a profit, while there is no cash for her to withdraw fromthe business. Explain to her where all the cash went.

2. In order to be able to pay herself a dividend, Natasha proposes to have her businessborrow another $5,000 from her parents, who will not expect her to repay themoney in the near future, and another $2,000 from the bank, which is looking verycarefully at Natasha’s cash position (and at her very saleable bicycles) and expectingto be repaid as soon as possible. Ignoring any dividend she might pay, what effectwill these two events have on the cash flow statement?

3. Is it a good idea to borrow to pay a dividend? Does Natasha have any other alternatives?

Wheeler’s Bicycle Rental Ltd.Cash Flow Statement for the Year Ended August 31, 2007

with Comparative Figures for 2006

2007 2006

Operations:Net income $ 9,000 $ 5,500Add back amortization expense 3,000 1,000

Cash from operations $12,000 $ 6,500Investing:

Purchases of bikes (15,000) (5,000)Purchase of shed (5,000) —

Financing:Bank loan 7,000 —Loan from parents — 3,000Share capital issued — 2,000Dividend paid — (5,500)

(Decrease) or increase in cash $ (1,000) $ 1,000Cash balance—beginning of year 1,000 0

Cash balance—end of year $ 0 $ 1,000


NEL


* PROBLEM 4.27 Prepare a cash flow analysis from a narrative

You’re having lunch with a family friend, the president of a local company you wouldn’tmind working for some day. She starts to complain about the company’s cash problems,and you decide to impress her by doing an analysis of those problems. So as she talks,you scribble the figures she mentions down on your napkin, with a plan to organizethose into an analysis.

Here’s what she said. Use the information to prepare a rough cash flow statementand then use that to provide helpful comments to her.

“You students often complain about being short of cash. The problem can affectcompanies too. Look at my company. Last year, we had $50,000 in the bank, a good solidposition, and we didn’t owe the bank anything. Now, we have only $5,000 and we owethe bank $90,000 in short-term loans, and I worry about how to pay the loans. It is hardto understand how we got into this difficulty. Part of it was because we had to finance abig expansion in our factory—that cost $600,000, and we only got $30,000 back fromselling off some old equipment. The bank was sticky about lending money for theexpansion, but we were able to increase our mortgage by $250,000, and we got another$100,000 from issuing some more shares. It was too bad we had the cash problems thisyear, because we had a good income, $100,000, and only paid out $40,000 of that in divi-dends. Our accountant said we brought in more cash than that, said it had to do withthe $200,000 amortization, but I didn’t really catch what that meant, because I knowthat amortization doesn’t actually involve any cash. I do know that we have had increas-ing difficulty collecting from our customers, because some of them seem to have cashproblems as well, so our accounts receivable are up $150,000 from last year. And theaccountant said that our inventories were getting a bit high, being up $25,000 from lastyear. It’s been frustrating—we earn income but don’t seem to have cash!”

PROBLEM 4.28 Interpret trends in cash management

Apex Accessories Inc. makes, imports, and sells various goods for the fashion trade,including costume jewellery, belts and other leather goods, hats, and many kinds ofapparel. The business is both seasonal and unstable, with products coming and going asfashions and availability from foreign suppliers change. During a “business issues” TVprogram about the fashion industry, some of Apex’s financial results were displayed inan on-screen table, while a narrator gushed about the marvellous management thecompany had. Here is that table:

Year-end Year-end total Net income Year’s cash flowYear total assets bank borrowing for the year from operations

1994 $24,400,000 $ 8,300,000 $2,100,000 $3,200,0001995 29,100,000 9,600,000 2,400,000 3,900,0001996 28,500,000 8,900,000 2,300,000 3,200,0001997 34,700,000 10,300,000 2,600,000 2,500,0001998 37,800,000 12,000,000 2,800,000 2,200,0001999 35,400,000 14,100,000 3,000,000 1,800,0002000 37,000,000 14,200,000 3,100,000 3,800,0002001 39,600,000 15,200,000 3,300,000 3,400,0002002 43,000,000 16,400,000 3,200,000 2,800,0002003 45,700,000 18,500,000 3,400,000 1,900,000

1. Which column of figures do you suppose the narrator was referring to when gushing about the “marvellous management”?

2. Provide as many comments as you can about the company’s results. Do you thinkthe management is marvellous?


NEL

hallengingC


3. For this particular company (which is listed on a stock exchange), would you expectmarket traders to respond much to the cash flow information once they know thenet income figures? Put another way, do you think the cash flow information has anyadded value to the net income information?

Integrated

Prepare and Comment on the Cash Flow Statement

* PROBLEM 4.29 Prepare a cash flow statement from balance sheet changes

Lambic Beverages Inc. makes special high-powered beers, some fermented in the bottle,and nonalcoholic sparkling drinks. Below are the company’s balance sheets for the endof this year and last year, and some information about income and dividends during thisyear. From this information, prepare a cash flow statement for this year and commenton what it tells you. While you’re at it, calculate the company’s working capital ratio anddebt–equity ratio for both years and comment on those, in relation to the cash flowanalysis.

* PROBLEM 4.30 Prepare the cash flow statement from complete balance sheet

Here are the balance sheet changes between 2006 and 2007 for Tamarack Systems Inc.


NEL

E xtended time

Lambic Beverages Inc.Comparative Balance Sheets for This Year and Last Year

Assets Liabilities and Equity

This Year Last Year This Year Last YearCurrent assets: Current Liabilities:

Cash $ 560 $ 1,120 Bank loan $ 400 $ 1,500Accounts receivable 3,210 2,060 Accounts payable 7,240 6,220Inventory 4,440 4,910 Income tax payable 0 330

$ 8,210 $ 8,090 $ 7,640 $ 8,050

Noncurrent assets: Noncurrent liabilities:Property and plant $26,670 $24,820 Long-term debt $12,740 $13,280Accumulated amort. (7,760) (5,130) Future income tax 1,320 1,070

$18,910 $19,690 $14,060 $14,350

Shareholders’ equity:Share capital $ 1,500 $ 1,200Retained earnings 3,920 4,180

$ 5,420 $ 5,380

$27,120 $27,780 $27,120 $27,780

Other information:• The company had a net loss of $210 for this year. Not expecting that, the company paid a $50 dividend early in the year.• Amortization expense for the year was $2,630 and future income tax expense was $250.

E xtended time


Tamarack Systems Inc.Balance Sheets for 2006 and 2007,

with Changes Calculated

2007 2006 Change

AssetsCurrent assets:

Cash $ 16,064 $ 12,440 $ 3,624Temporary investments 0 65,000 (65,000)Accounts receivable 220,668 143,962 76,706Inventories 176,962 187,777 (10,815)Prepaid expenses 9,004 14,321 (5,317)

Total current assets $422,698 $423,500 $ (802)

Noncurrent assets:Land cost $ 82,500 $ 75,000 $ 7,500Building cost 600,898 420,984 179,914Accumulated amortization (243,224) (173,320) (69,904)

Net total noncurrent assets $440,174 $322,664 $117,510

Totals $862,872 $746,164 $116,708

Liabilities and EquityCurrent liabilities:

Bank loan $ 64,900 $ 43,200 $ 21,700Accounts payable 199,853 163,866 35,987Income taxes payable 17,228 16,090 1,138Dividends payable 0 6,000 (6,000)Current portion of bonds payable 22,000 20,000 2,000

Total current liabilities $303,981 $249,156 $ 54,825

Noncurrent liabilities:Bonds payable $213,000 $235,000 $ (22,000)Provision for warranty costs 8,925 11,850 (2,925)Future income tax 43,439 38,923 4,516

Total noncurrent liabilities $265,364 $285,773 $ (20,409)

Equity:Share capital issued $150,000 $100,000 $ 50,000Retained earnings 143,527 111,235 32,292

Total equity $293,527 $211,235 $ 82,292

Totals $862,872 $746,164 $116,708

Further information:

1. The change in retained earnings is composed of net income $56,292 minus dividends declared of $24,000.

2. Land that had cost $35,000 was written off to expense as being worthless.3. Payments to customers for warranty claims during 2007 equalled $7,000.4. Land costing $5,000 was obtained in exchange for shares issued.5. During 2007, a garage was sold for $25,000 cash. The cost of the garage was

$100,000, and its accumulated amortization at the date of sale was $70,000.


NEL


From this information, prepare a cash flow statement for Tamarack for 2007 andcomment on what the statement shows about the company’s cash management.

PROBLEM 4.31 Prepare and interpret basic cash flow analysis from balance sheet changes

Another student has been having an awful time trying to prepare a cash flow statementfor Greenplace Restaurants Inc. for the 2006 fiscal year. You go over to help and find thedisorganized list of balance sheet changes below. About all that can be said for it is thatit does balance, so the student has managed to identify all the changes from 2005.

1. Take the list below and prepare a cash flow statement for Greenplace for 2006.2. Explain what your statement reveals about the company’s 2006 cash management.

List of Balance Sheet Changes forGreenplace Restaurants Inc. for Fiscal Year 2006

Direction A↑, L↓, E↓ A↓, L↑, E↑

Trade payables Up $ 37,970Accumulated amortization Up 47,110Cash in bank Up $ 3,030Receivables Down 24,489Bank loan Up 24,780Inventories Up 37,241Net income Positive 61,140Dividends declared and paid Positive 21,000Prepaid expenses Up 8,778Buildings, equipment Up 206,942Mortgage payable Up 45,500Taxes payable Down 9,498Share capital Up 35,000Term deposits (30 days) Down 10,500

Sums of changes $286,489 $286,789

PROBLEM 4.32 Prepare and interpret a basic cash flow analysis from financial statements

1. Prepare a cash flow statement from the following financial statements of FuzzyWuzzy Wines Ltd.

2. Comment on what your statement tells you about the company’s cash managementduring the year ended August 31, 2006. If you were a shareholder in Fuzzy Wuzzy,would you be happy with management’s performance?


NEL

E xtended time

E xtended time


Fuzzy Wuzzy Wines Ltd.Statement of Income and Retained Earnings

for the Year Ended August 31, 2006

Revenue $3,000Expenses:

Amortization $ 210Building write-off* 45General 2,320 2,575

Income before income tax $ 425Income tax expense 190

Net income for the year $ 235Retained earnings—beginning of year 300Dividends declared and paid (110)

Retained earnings—end of year $ 425

* Building written off cost $130 and had accumulated amortization of $85.

PROBLEM 4.33 Prepare cash flow statement with several accrual adjustments and commenton it

Using the following comparative balance sheets and additional information for PrairieProducts Inc., prepare a cash flow statement for the year ended November 30, 2007.State any assumptions you find necessary. Comment on what your statement showsabout the company’s cash management for 2007.


NEL

Balance Sheets as at August 31, 2006 and 2005


2006 2005 2006 2005

Current assets: Current liabilities:Cash $ 80 $ 175 Bank loan $ 140 $ 100Short-term investment 0 150 Payables 425 200Receivables 520 350 $ 565 $ 300Inventories 340 250 Noncurrent liabilities:

$ 940 $ 925 Long-term loans 225 400

Noncurrent assets: $ 790 $ 700Factory cost $1,450 $ 925 Shareholders’ equity:Accum. amort. (475) (350) Share capital $ 700 $ 500

$ 975 $ 575 Retained earnings 425 300

$1,125 $ 800

$1,915 $1,500 $1,915 $1,500

E xtended time


Additional information for 2007 (all figures are in thousands of dollars):

a. Net income was $98 and dividends of $40 were declared.b. A building was sold for $42 that had cost $110 and had accumulated amortization of

$56. c. Amortization expense for the year was $118.d. One of the noncurrent investments, which had cost $73, was sold for $102. e. The change in future income tax liability was entirely due to the future (deferred)

portion of income tax expense.f. The change in warranty liability was composed of warranty expense of $23 minus

payouts on warranties of $15.


NEL

Prairie Products Inc.Balance Sheet at November 30, 2007

with 2006 Figures for Comparison (in thousands of dollars)


2007 2006 2007 2006

Current assets Current liabilitiesCash $ 31 $ 38 Bank loan $ 25 $ 30Marketable securities 100 200 Accounts payable 195 284Accounts receivable 281 315 Taxes payable 34 20Inventories 321 239 Dividends payable 20 30Prepaid expenses 12 18 $ 274 $ 364

$ 745 $ 810 Noncurrent liabilitiesNoncurrent assets Mortgage payable $ 240 $ 280Land cost $ 182 $ 70 Bonds payable 200 0Buildings cost 761 493 Future income tax 138 111Equipment cost 643 510 Warranty liability 126 118

$1,586 $1,073 $ 704 $ 509

Accum. amortization 631 569 Shareholders’ equity$ 955 $ 504 Share capital $ 600 $ 450

Investments, cost 365 438 Retained earnings 487 429

$1,320 $ 942 $1,087 $ 879

TOTAL $2,065 $1,752 TOTAL $2,065 $1,752


Assorted Problems

* PROBLEM 4.34 Cash versus accrual income and cash from operations

From the following information:

1. Calculate cash income for the year.2. Calculate accrual net income for the year.3. Explain why they are different by showing cash from operations as calculated by the

indirect method.4. Calculate cash from operations by the direct method.


NEL

Collections: On last year’s revenue 46,665On this year’s revenue 848,911On next year’s revenue 20,000

Payments: On last year’s expenses 78,640On this year’s expenses 649,925On next year’s expenses 14,610

Sale of land for cash (cost $80,000) 135,000Paid to purchase new noncurrent assets 441,486Still owing on those noncurrent assets 61,000

Cash proceeds on new shares issued 210,000Cost of issuing new shares 4,622Amortization expense for the year 114,618Uncollected revenue: Beginning of year 53,116

End of year 73,007Unpaid expenses: Beginning of year 78,640

End of year 115,304Cash: Beginning of year 13,023

End of year 84,316

PROBLEM 4.35 Effects on income and cash of big accounting changes

When the new president of Lefton Inc. took office, she decided that the previous presi-dent had made some poor business decisions and that “the balance sheet needs to becleaned up.” Accordingly, the following accounting changes were implemented at thepresident’s instruction:

• Uncollectible accounts receivable of $645,000 were written off directly to expense.• Long-term investments costing $12,750,000 were written down to their estimated

market value of $6,000,000.• An investment in a foreign country, costing $4,800,000, was written off altogether.• Liability for future warranty payments was increased by $495,000 additional

expense.• Income tax savings of $3,310,000 were expected from all this.

Before the new president took office, net income for the year was $784,000 and cashfrom operating activities was negative $442,000.

1. Calculate the revised net income for the year.2. Calculate the revised cash from operations for the year.3. A commentator criticized the new president for implementing a “Big Bath.” What

are your views about the propriety of the president’s actions?


hallenging andC

E xtended time


NEL

TGIF Industries Ltd.Balance Sheet at December 31, 2006

(in thousands of dollars)


Current assets Current liabilitiesCash on hand $ 19 Demand bank loan $ 2,205Cash in bank 238 Other bank indebtedness 840Accounts receivable 2,868 Accounts payable, accruals 1,948Inventories 2,916 Income, other taxes payable 213Prepaid expenses 184 $ 5,206

$ 6,225Noncurrent liabilities

Noncurrent assets Mortgage payable $ 516Land cost $ 416 Loans from shareholders 600Automotive equipment cost 892 Other long-term loans 318Buildings cost 2,411 Deferred (future) income tax 248Equipment cost 1,020 Estimated pension liability 163

$ 4,739 $ 1,845Accumulated amortization 863 Shareholders’ equity

$ 3,876 Share capital $ 1,000Investments, cost 740 Retained earnings 2,790

$ 4,616 $ 3,790

TOTAL $10,841 TOTAL $10,841

PROBLEM 4.36 Use a cash flow statement to derive an ending balance sheet

Give your knowledge of the financial statement relationships a workout by deriving thebalance sheet of TGIF Industries Ltd. at the end of 2007 from the two statements givenbelow (the balance sheet at the end of 2006 and the cash flow statement for 2007).When you have done that, prepare some comments on what the company’s cashmanagement strategy seemed to be for 2007, and whether that left the company financially stronger or weaker at the end of 2007 than at the end of 2006.


TGIF Industries Ltd.Cash Flow Statement for the Year Ended December 31, 2007

(in thousands of dollars)

Operations:Net income for the year $ 614Add expenses (deduct revenues) not

involving cash:Amortization expense $ 291Loss on sale of investments 85Deferred (future) income tax expense 68Estimated pension expense 53Gain on sale of land (210)Gain on sale of building (38) 249

Add (deduct) effects of changes in noncash working capital:Accounts receivable $ 1,134Inventories 647Prepaid expenses 37Accounts payable, accruals (587)Income, other taxes payable (14) 1,217

Cash generated by operations $ 2,080

Investing activities:Investment in term deposits $ (100)Proceeds from sales of long-term assets:

Investments (cost $560) 475Land (cost $80) 290Building (cost $890) 514

Cost of acquisitions of long-term assets:New building (1,670)New equipment (643) (1,134)

Financing activities:Decrease in demand bank loan $(1,137)Decrease in other bank indebtedness (360)Payments on mortgage (103)Additional loans from shareholders 250Debenture debt issued 300Payments of other long-term loans (74)Payments of employee pensions (43)Share capital issued 250Dividends paid ($100 declared) (40) (957)

Decrease in cash (cash on hand up $6, cash in bank down $17) $ (11)


NEL


PROBLEM 4.37 Prepare a full set of statements, including cash flow

Grandin Ltd. manufactures a single product and has revenue from related service activi-ties. The company had been growing slowly but steadily until this year (2007), whenrevenue, especially from services, increased substantially.

The company’s bookkeeper was part way through preparing the 2007 financial state-ments (with 2006 for comparison) and asked you for help in completing them. Whenyou went to the company’s offices you got the information below. Assume these figuresare correct.

Account Name 2007 2006

Accounts payable $ 12,300 $ 8,900Accounts receivable 44,200 21,300Accumulated amortization 36,000 32,000Administrative expenses 14,600 11,900Bank loan—current 29,000 19,000Cash 4,700 5,400Cost of goods sold 103,190 71,650Current income tax expense 5,200 3,000Future income tax expense 250 500Future income tax liability 4,350 4,100Amortization 4,000 5,800Dividends paid 4,000 6,000Equipment 87,000 87,000Equipment financing 20,000 24,000Income taxes payable 2,200 1,000Interest expense 4,800 3,900Inventory 42,500 37,000Packaging and shipping expense 8,100 7,500Prepaid expenses 2,100 800Retained earnings—beginning 37,500 33,300Revenue—product sales 163,290 116,250Revenue—service 73,700 32,600Service wage expense 69,500 28,200Share capital 25,000 25,000Utilities expense 9,200 6,200

1. Prepare a comparative balance sheet, income statement, and statement of retainedearnings for 2007 and 2006.

2. Prepare a cash flow statement for 2007 (you do not have the information to docomparative figures for 2006).


NEL

hallenging andC

E xtended time


PROBLEM 4.38 Ethics of cash flow manipulation

There is an interesting ethical issue behind the very reason the cash flow statement isthought by some people to have advantages over the income statement. The reason isthat people are often mistrustful of the income statement because they feel its accrualaccounting methods can be used to manipulate net income as a measure of perform-ance, and they think that the cash flow figures are more “real.” For example, a companymight claim large revenues, not yet collected, that make its income higher (and becausethe revenues are not collected, the accounts receivable are also higher), but if the cashhas not been collected, the increase in accounts receivable will be deducted from netincome on the cash flow statement, and the lack of “real” cash inflow will be apparentbecause cash from operations will be lower than would be expected from the incomenumber. Thus, it is thought that the cash flow statement’s cash from operations figure ismore believable than net income and, if it is too different from net income, will unmaskmanipulations of the net income.

The ethical issue is that it is possible to manipulate the cash flow figures too. Forexample, a company might accelerate or delay receivables collections in order to changethe cash flow figures, whether or not the net income is also being manipulated. Theremay be a difference from manipulating net income because changing cash flow figuresrequires real actions, affecting customers or suppliers or employees, so there are realconsequences, such as irritating customers or having to offer inducements for earlypayment. Nevertheless, it can be done.

It seems that most people would feel that altering the accruals just to make netincome better (or worse, or smoother) is ethically questionable, even if it is understand-able because of the way management is evaluated and rewarded. But is altering the cashflow ethically questionable? Is there an ethical problem if management decides to putpressure on customers to accelerate collections and improve the company’s cash position? Sounds like good management, not like manipulation.

Suggest two or three ways, not included above, in which operating, investing, orfinancing cash flows could be altered from their normal levels. For each, discusswhether, or under what conditions, you would think there is an ethical problem in suchalteration.


NEL

hallengingC


CASE 4ADISCUSS ISSUES RELATED TO CASH FLOW ANALYSIS

The three financial statements included inChapters 2 and 3 are all based on accrualaccounting, which generates a net income

figure and related balance sheet accounts thatattempt to measure the enterprise’s economicperformance and position. In this chapter, the cashflow statement was used to report the enterprise’sresults as if accrual accounting had not been used,focusing instead on cash flow. Discuss the followingquestions, using as an example CPR (see its state-ments in Sections 2.10, 3.4, and 4.7), Enbridge,Petro-Canada, TD Bank or any company whose state-ments you can obtain from the company Web pageor the library. (For current information about CPR,go to www.cpr.ca.)

1. Does the cash flow statement really help theperson who is trying to understand the enter-prise’s performance, or is it just another compli-cated accounting statement that is mysterious tononaccountants? Which parts of it are mostunderstandable and which parts are least understandable?

2. Is it a good idea to indicate, by preparing thecash flow statement, that knowing about anenterprise’s income performance is not enough?What does the presence of the cash flow state-ment say about the value of the income measure?

Conversely, what does the presence of thebroader income measure say about the value ofthe more narrowly defined cash flow measure?

3. For CPR (or any other company you select), isthe story told by the cash flow statement consis-tent with or supportive of the story told by theincome statement? Would you expect goodperformance in one to imply good performancein the other, long-term or short-term? Whatkinds of differences in the stories the two state-ments tell would you expect to be significantenough for readers of the statement to react to(such as by buying or selling shares of thecompany and so changing its share price)?

4. Are there events you would like to see reflected,or separately disclosed, in the cash flow state-ment that are not? Are there things in the cashflow statement you think are unnecessary? (Forexample, do you think people need the reconcili-ation with accrual income in the cash from oper-ations section, or would it be satisfactory to juststate what cash from operations is without all thereconciling items?)

5. What sorts of clues about the enterprise’s busi-ness and financial strategies can you get from thecash flow statement? Are there other issues thestatement can raise questions about, even if italone cannot answer them?


NEL


CASE 4BDISCUSS A CONFERENCE CALL ON A COMPANY’S FINANCIAL

PERFORMANCE

Serena was nervous as she walked into theboardroom for her company’s quarterly confer-ence call with financial analysts and other inter-

ested people. In a few hours, she would be on a livephone call (also Webcast) with more than a hundredpeople. She would be responding to analysts’ ques-tions and comments about the company’s perform-ance from the boardroom, in the company of hercompany’s top managers: the chair of the board ofdirectors, the president and chief executive officer,and her immediate boss, the chief financial officer.Serena was newly appointed as the company’s chiefaccountant, after a very successful career in publicaccounting. She felt that she knew her accounting,but still expected the conference call would be anordeal.

Here are the accounting-related questions andcomments from the analysts. Discuss how Serena orother of the top managers might have responded tothem, individually or as a set. Also discuss what thequestions add up to as an overall portrayal of the analysts’ concerns about the company’s performance.

1. We’ve been expecting the company to makeabout $3.50 EPS, compared to last year’s $3.35. Itdid make that, actually hitting $3.65, but I noticethat the cash flow per share is down to $4.80from last year’s $5.25. Does this mean thecompany’s performance is slipping in spite ofthe better accrual income?”

2. To follow the previous question, I am veryconcerned that cash flow per share is higherthan EPS. It looks as if EPS is well below what itshould be, even if you did make the EPS target.

3. We all know that in the long run, on average,earnings and cash flow correlate positively. Butin this year, you have a negative correlation: EPSgoing up but cash flow per share going down. Isuspect either your cash flow or accrual earningsfigure is wrong.

4. Your cash flow statement shows a large increasein accounts receivable and inventories. Thisseems to be why the cash flow has fallen. Thereceivables increase in particular seems to indi-cate problems with collection, or, and this iswhat I am worried about, you may have recorded

more revenue than you should have and justadded that to the accounts receivable. I’m notaccusing, but as you know we are all sensitivethese days about companies trying to boost theirearnings.

5. The cash flow statement also indicates that thecompany is bringing in many millions of dollarsin cash from depreciation and amortization.What have you done with all that cash?

6. Following up on the previous question, yourincome statement showed a big restructuringcharge, but on the cash flow statement, most ofit is added to income. Does that mean therestructuring charge is just an estimate, notreally incurred yet or paid out?

7. The previous questions have focused on opera-tions. I am more concerned about thecompany’s risk. The cash flow statement indi-cates significant borrowing this year, more thanwas issued in new shares. Such borrowingincreases the debt-equity ratio and the risk. Sinceyou did generate some cash from operations,why would you have to borrow? Even with theborrowing, your cash hardly went up at all.

8. There is another risk here. Your working capitalis up, but it is largely noncash, so you don’t reallyhave the cash you need to operate properly andpay your bills.

9. An earlier question mentioned depreciation andamortization. I see that this amounts to morethan a hundred million dollars this year, butyour spending on new property and plant assetswas only about half that. As I understand thenumbers, there is a greater increase in accountsreceivable and inventory than there is in prop-erty and plant. Is your strategy to shrink ratherthan to grow?

10. The financing information in your cash flowstatement indicates that your long-term borrow-ing was used in part to pay dividends. That seemsunwise—you should pay dividends only if youhave lots of internal financing from operations.

11. On the other hand, I note that your long-termborrowing was about the same amount as youradditions to property and plant, so it does makesense to finance long-term assets with long-term


NEL


NOTES

borrowing. Would be even better to finance withpermanent capital, though.

12. I’ve been looking at some patterns. Over the lastthree years, your cash from operations has gonesteadily down, and your cash from borrowing hasgone steadily up. It seems to me you are gettinginto some financial trouble.

13. I represent a large pension fund that has thou-sands of shares of the company. We areconcerned that the company’s share price hasweakened in the last year or so in spite of growthin earnings per share. All these questions suggestto me that the share price is falling because you

are having cash problems rather than earningsproblems.

14. We’ve been talking about the past year most ofthe time. If I look forward, I see that you have alarge debt repayment due next year. Since youwere already borrowing this year, will you have toborrow to make that repayment? Your cash flowdifficulties this year were in spite of not having torepay any debt, so you will need more cash flownext year to stay out of serious trouble. Do youhave plans to improve cash from operations bygetting those inventories and receivables down?

1. There have been many research papers on the correla-tion between accrual income and operating cash flowsover time. A recent paper, for example, showed thatthe ability to predict future cash flows from presentaccrual incomes appears to have been increasing fromthe 1980s to the 1990s. (W. Kross and M.S. Kim, “TheAbility of Earnings to Predict Future Operating CashFlows Has Been Increasing—Not Decreasing,” workingpaper, Purdue University and University of Missouri,2002.

2. For more information on the “cash flow” researchresults, see W.H. Beaver, Financial Reporting: An

Accounting Revolution, 2nd ed. (Englewood Cliffs:Prentice-Hall, 1989), 116; or P.A. Griffin, ed., Usefulnessto Investors and Creditors of Information Provided byFinancial Reporting, 2nd ed. (Stamford: FinancialAccounting Standards Board, 1987), 144–45.Accounting research journals such as The AccountingReview, Contemporary Accounting Research, Journal ofAccounting and Economics, and Journal of AccountingResearch occasionally have articles examining cash flowor comparing cash flow to accrual net income.


NEL


measuring and evaluating cash flow - university of albertacsproat/homework/acctg...

Documents