Chapter 06 - Answer

MANAGEMENT ACCOUNTING - Solutions Manual

CHAPTER 6 CASH FLOW ANALYSIS I.

Questions 1. Purposes of the Statement of Cash Flows a. To predict future cash flows b. To evaluate management decisions c. To determine the ability to pay dividends to shareholders and interest and principal to creditors d. To show the relationship of net income to changes in the business’s cash. 2. Comparative balance sheets present the financial position of the enterprise at two points in time. The income statement for the period between the two balance sheets describes how the income-producing activities affected the financial position. Because cash flows from operating activities may differ substantially from net income, and because numerous other financing and investing activities have an impact on financial position, the statement of cash flows is necessary. The statement emphasizes changes in the cash balances that result from changes in assets, liabilities and equity accounts caused by operating, investing and financing activities. 3. The most important source of cash for many successful companies is from operating activities. A large positive operating cash flow is a good sign because it means funds have been internally generated with no fixed obligations or commitment to return such to anybody. 4. It is possible for cash to decrease during a year when income is high because cash may be used not only for operating activities but also for investing and financing activities. 5. Transactions involving accounts payable are not considered to be financing activities because such transactions are used to obtain goods and services rather than to obtain cash. Furthermore, purchases of goods and services relate to a company’s day-to-day operating activities.

6-1

Chapter 6 Cash Flow Analysis

6. The loss is added back to net income to avoid double counting since the entire proceeds from the sale (net book value minus loss on sale) will appear as a cash inflow from investing activities. 7. Three categories of transactions that may result in increases in cash are a. Operating activities b. Investing activities (e.g., sale of investments or other assets). c. Financing activities (e.g., borrowing or sale of shares). These activities are sources of cash when cash is increased as a result of the particular activity. 8. Three categories of transactions that may result in decreases in cash are a. Operating activities b. Investing activities (e.g., purchase of investments or other assets). c. Financing activities (e.g., repayment of debt or retirement of shares). These activities are uses of cash when cash is decreased as a result of the particular activity. 9. Noncash transactions do not provide or consume cash even though they may result in significant changes in financial position. Examples are the issuance of share capital for plant assets and the conversion of debt or preference shares into ordinary shares. Such transactions are not presented in the body of the statement of cash flows but rather disclosed in a separate schedule as financing or investing activities. 10. While net loss is usually associated with a decrease in cash, it may be a source of cash if noncash expenses are greater than the amount of the net loss. For example, if a net loss of P100,000 included amortization and depreciation of P125,000 and no noncash revenues existed, cash provided by operating activities would be P25,000, computed as follows: Net loss Add: Expenses not requiring cash – depreciation and amortization Net cash provided by operating activities

P(100,000) P

125,000 25,000

11. The change in cash is the difference between cash at the beginning and end of the accounting period. The net amount of cash provided by or used 6-2

Cash Flow Analysis Chapter 6

in operating, investing and financing activities must equal this change in cash. For example, if cash increased by P150,000 during the year, total sources from operating, investing, and financing activities must exceed total uses by P150,000. Also, if cash decreased by P25,000 during the year, total uses of cash must exceed total sources by P25,000. 12. (a) The use of cash does not occur until the cash dividend is actually paid in the next period. The declaration of the dividend does affect financial position, however, and should be disclosed as a noncash financing activity in a separate schedule accompanying the statement of cash flows. (b) Because the dividend was declared and paid in the same accounting period, it appears in the statement of cash flows as a cash decrease in the financing activities category. 13. Disagree. The refunding of 10% debt by the 8% debt represents a significant financing activity, even though the net impact of the exchange on the balance sheet or on the amount of cash is not material. The issuance of 8% bonds and the retirement of 10% bonds should be reported as noncash financing transactions in a schedule accompanying the statement of cash flows. 14. The net income figure includes P150,000 as an expense. Only P112,500 of this amount resulted in a decrease in cash, because P37,500 represents an increase in the deferred income tax liability account. In determining cash provided by operating activities, the amount of income tax paid is P112,500 (direct method). Alternatively, under the indirect method, P37,500 must be added to net income to determine cash flows from operating activities. 15. The loss is omitted when listing expenses requiring cash payment (direct approach) or added back to net income (indirect approach) in determining cash provided by operating activities. This eliminates the impact of the transaction from cash provided by operating activities. Then, the proceeds from the sale are included as a source of cash in the investing activities category of the statement of cash flows. Any tax effects of the transaction are included in the tax expense figure and remain a part of cash flows from operating activities. 16. (1) Operating activities: Transactions that affect current assets, current liabilities, or net income.

6-3

Chapter 6 Cash Flow Analysis

(2) Investing activities: Transactions that involve the acquisition or disposition of noncurrent assets. (3) Financing activities: Transactions (other than the payment of interest) involving borrowing from creditors, and any transactions (involving the owners of a company. 17. Interest is included as an operating activity since it is part of net income. Financing activities are narrowly defined to include only the principal amount borrowed or repaid. 18. Since the entire proceeds from a sale of an asset (including any gain) appear as a cash inflow from investing activities, the gain must be deducted from net income to avoid double counting. 19. The direct method reconstructs the income statement on a cash basis by restating revenues and expenses in terms of cash inflows and outflows. The indirect method starts with net income and adjusts it to a cash basis to determine the cash provided by operating activities. 20. An increase in the Accounts Receivable account must be deducted from net income under the indirect method because this is an increase in a noncash asset. 21. A decrease in the Accounts Payable account must be added to cost of goods sold under the direct method. The cost of goods sold is increased by the amount of the decrease in accounts payable. Because the cost of goods sold is increased, the net cash flow provided by operating activities is decreased. The effect of a decrease in a liability is a decrease in cash. 22. A sale of equipment for cash would be classified as an investing activity. Any transaction involving the acquisition or disposition of noncurrent assets is classified as an investing activity.

II. Exercises Exercise 1 Net income................................................................... 6-4

P84,000

Cash Flow Analysis Chapter 6 Adjustments to convert net income to a cash basis: Depreciation charges for the year............................ Increase in accounts receivable................................ Increase in inventory................................................ Decrease in prepaid expenses.................................. Increase in accounts payable.................................... Decrease in accrued liabilities................................. Increase in deferred income taxes........................... Net cash provided by operating activities....................

P50,000 (60,000) (77,000) 2,000 30,000 (4,000) 6,000

(53,000) P31,000

Exercise 2 Sales..................................................................... Adjustments to a cash basis: Less increase in accounts receivable.............

P1,000,000

Cost of goods sold................................................ Adjustments to a cash basis: Plus increase in inventory............................. Less increase in accounts payable.................

580,000

Selling and administrative expenses...................... Adjustments to a cash basis: Less decrease in prepaid expenses................ Plus decrease in accrued liabilities................ Less depreciation charges............................. Income taxes........................................................ Adjustments to a cash basis: Less increase in deferred income taxes..........

–  60,000

P940,000

+  77,000 –  30,000

627,000

300,000 –  2,000 +  4,000 –  50,000

252,000

36,000 – 

6,000

30,000 P 31,000

Net cash provided by operating activities.............

Note that the P31,000 agrees with the cash provided by operating activities figure under the indirect method in the previous exercise. Exercise 3 Item Accounts Receivable...................... Accrued Interest Receivable........... Inventory....................................... Prepaid Expenses........................... Accounts Payable.......................... Accrued Liabilities.........................

Amount P70,000 decrease P6,000 increase P110,000 increase P3,000 decrease P40,000 decrease P9,000 increase 6-5

Add X

Deduct X X

X X X

Chapter 6 Cash Flow Analysis

Deferred Income Taxes Liability.... Sale of equipment.......................... Sale of long-term investments........

P15,000 increase P8,000 gain P12,000 loss

X X X

Exercise 4 Requirement (1) Net income............................................................................... Adjustments to convert net income to a cash basis: Depreciation charges............................................................ Decrease in accounts receivable............................................ Increase in inventory............................................................. Decrease in prepaid expenses............................................... Increase in accounts payable................................................ Decrease in accrued liabilities............................................... Increase in taxes payable...................................................... Increase in deferred taxes..................................................... Loss on sale of long-term investments.................................. Gain on sale of land.............................................................. Net cash provided by operating activities.................................

P75 P40 10 (30) 5 20 (10) 10 5 5 (40)

15 P90

Requirement (2) Swan Company Statement of Cash Flows Operating activities: Net cash provided by operating activities (see above)................... Investing activities: Proceeds from sale of long-term investments................................ P 45 Proceeds from sale of land........................................................... 70 Additions to long-term investments.............................................. (20) 6-6

P 90

Cash Flow Analysis Chapter 6

Additions to plant & equipment.................................................... (150) Net cash used for investing activities............................................

(55)

Financing activities: Decrease in bonds payable........................................................... Increase in ordinary shares........................................................... Cash dividends............................................................................. Net cash used by financing activities............................................

(15)

(20) 40 (35)

Net increase in cash (net cash flow)............................................. Cash balance, beginning............................................................... Cash balance, ending....................................................................

20 100 P120

While not a requirement, a worksheet may be helpful.

Change

Source Cash or Flow AdjustUse? Effect ments

Assets (except cash and cash equivalents) Current assets: Accounts receivable.................................... Inventory..................................................... Prepaid expenses....................................... Noncurrent assets: Long-term investments...............................

–10 +30 –5

Source +10 Use –30 Source +5

–30

Plant and equipment................................... Land............................................................

+150 –30

Source +30 – Use 150 Source +30

Liabilities, Contra assets, and Shareholders’ Equity Contra assets: Accumulated depreciation........................... +40 Current liabilities: Accounts payable....................................... +20 Accrued liabilities........................................ –10 Taxes payable............................................. +10 Noncurrent liabilities: Bonds payable............................................ –20 Deferred income taxes................................ +5 Shareholders’ equity: Ordinary shares.......................................... +40 Retained earnings: Net income............................................ +75 Dividends............................................... –35 Additional entries Proceeds from sale of investments..................

Classification

+10 –30 +5

Operating Operating Operating

–50

–20

Investing

–30

–150 0

Investing Investing

Source +40

+40

Operating

Source +20 Use –10 Source +10

+20 –10 +10

Operating Operating Operating

Use –20 Source +5

–20 +5

Financing Operating

Source +40

+40

Financing

Source +75 Use –35

+75 –35

Operating Financing

+45

Investing

+45

6-7

Adjusted Effect

Chapter 6 Cash Flow Analysis Loss on sale of investments............................ Proceeds from sale of land.............................. Gain on sale of land......................................... Total

+20

+5 +70  –40    0

+5 +70  –40  +20

Operating Investing Operating

Exercise 5 Sales.............................................................................. Adjustments to a cash basis: Decrease in accounts receivable............................. Cost of goods sold.......................................................... Adjustments to a cash basis: Increase in inventory.............................................. Increase in accounts payable.................................. Selling and administrative expenses............................... Adjustments to a cash basis: Decrease in prepaid expenses................................. Decrease in accrued liabilities................................ Depreciation charges.............................................. Income taxes.................................................................. Adjustments to a cash basis: Increase in taxes payable........................................ Increase in deferred taxes....................................... Net cash provided by operating activities....................... Exercise 6

P600 +10 250 +30 –20 280 –5 +10 –40 30 –10 –5

P610

260

245

15 P 90

Requirements (1) and (2) Stephenie Company Statement of Cash Flows For the Year Ended December 31, 2008 Operating activities: Net income........................................................................... Adjustments to convert net income to cash basis: Depreciation charges.................................................... Increase in accounts receivable.................................... Decrease in inventory................................................... Increase in prepaid expenses........................................ Increase in accounts payable........................................ Decrease in accrued liabilities...................................... Gain on sale of investments.......................................... Loss on sale of equipment............................................ 6-8

P 56 25 (80) 35 (2) 75 (10) (5) 2

Cash Flow Analysis Chapter 6

Increase in deferred income taxes................................. Net cash provided by operating activities.............................

8

Investing activities: Proceeds from sale of long-term investments........................ Proceeds from sale of equipment.......................................... Additions to plant and equipment......................................... Net cash used for investing activities...................................

12 18 (110)

Financing activities: Increase in bonds payable.................................................... Decrease in ordinary shares................................................. Cash dividends..................................................................... Net cash used for financing activities...................................

25 (40) (16)

48 104

(80)

(31)

Net decrease in cash............................................................. Cash balance, January 1, 2008............................................ Cash balance, December 31, 2008.......................................

(7) 11 P  4

While not a requirement, a worksheet may be helpful.

Assets (except cash and cash equivalents) Current assets: Accounts receivable............................. Inventory.............................................. Prepaid expenses................................ Noncurrent assets: Plant and equipment............................ Long-term investments.........................

Change

Sourc e or Use?

Cash Flow Effect

+80 –35 +2

Use Source Use

–80 +35 –2

+80 –7

Use Source

–80 +7

Source

+15

Source Use

Liabilities, Contra assets, and Shareholders’ Equity Contra assets: Accumulated depreciation.................... +15 Current liabilities: Accounts payable................................. +75 Accrued liabilities................................. –10 Noncurrent liabilities: Bonds payable..................................... +25 Deferred income taxes......................... +8 Shareholders’ equity: Ordinary shares.................................... –40 Retained earnings: Net income...................................... +56 Dividends........................................ –16

6-9

Adjust -ments

Adjuste d Effect

Classification

–80 +35 –2

Operating Operating Operating

–30 –7

–110 0

Investing Investing

+10

+25

Operating

+75 –10

+75 –10

Operating Operating

Source Source

+25 +8

+25 +8

Financing Operating

Use

–40

–40

Financing

Source Use

+56 –16

+56 –16

Operating Financing

Chapter 6 Cash Flow Analysis Additional entries Proceeds from sale of equipment.............. Loss on sale of equipment........................ Proceeds from sale of long-term investments.......................................... Gain on sale of long-term investments......  –7

Total

+18 +2

+18 +2

Investing Operating

+12  –5

+12   –5

Investing Operating

  0

  –7

II. Problems Problem 1 1.

2. 3. 4. 5. 6. 7. 8.

Transaction Operating Investing Financing Short-term investment securities were purchased X ..................................... Equipment was purchased X ..................................... Accounts payable increased X ..................................... Deferred taxes decreased X ..................................... Long-term bonds were issued X ..................................... Ordinary shares were sold X ..................................... Interest was paid to long-term creditors X ..................................... A long-term mortgage was entirely paid off X ..................................... 6-10

Source

Use X X

X X X X X X

Cash Flow Analysis Chapter 6 9.

A cash dividend was declared and paid ..................................... 10. Inventories decreased. . . 11. Accounts receivable increased ...................................... 12. Depreciation charges totaled P200,000 for the year ......................................

X X

X X

X

X

X

X

Problem 2 (Analysis of Cash Flow Transactions) Requirement (a) The eight items should be presented in the statement of cash flows as follows: 1. Net income is the basis for the calculation of cash flows from operating activities by starting with that number and adjusting for noncash revenue and expense transactions (indirect method) or by computing by the direct method the positive cash flows from revenues, less the negative cash flows from expenses. The cash flows from the transaction giving rise to the extraordinary loss is reclassified as an investing activity. 2. The acquisition of intangibles is a negative cash flow from investing activities. The amortization is a noncash expense in determining cash flows from operating activities. 3. The payment of a cash dividend is a negative cash flow that is presented in the financing activities section of the statement. 4. The purchase of treasury share is a negative cash flow in the financing activities section of the statement. 5. The depreciation expense recognized during the year is a noncash expense in determining cash flows from operating activities. 6. The conversion of convertible bonds into ordinary shares is a noncash financing activity that requires disclosure in a separate schedule. 7. The changes in plant asset accounts – land, equipment, and building – represent activities whose cash flow effects are presented in the investing activities section of the statement. 8. The increase in working capital also represents the change in cash because all other current assets and current liabilities remained constant. The net of all cash flows from operating, investing and financing activities must reconcile with the change in cash in the statement of cash flows. 6-11

Chapter 6 Cash Flow Analysis

Requirement (b) 1. Net cash provided by operating activities Net income Noncash expense adjustments: Depreciation expense Amortization expense Reclassification of extraordinary loss

P145,000 46,250 6,000 15,000 P212,250

2. Net cash used in investing activities Purchase of intangible assets Purchase of land Purchase of equipment Purchase of building Sale of land

P (34,000) (130,000) (60,000) (100,000) 165,000 P(159,000)

3. Net cash used in financing activities Purchase of treasury shares Payment of dividends

P(31,000) (12,500) P(43,500)

Computations: Depreciation expense Change in accumulated depreciation account Accumulated depreciation on fully depreciated assets disposed Purchase of land Change in land account Cost of land sold in condemnation proceedings

P35,000 11,250 P46,250 P (50,000) 180,000 P130,000

Problem 3 (Cash Flow from Operating Activities) Cash received from customers: Total revenues Less: Note receivable Cash disbursed for expenses: Total expenses (P173,000 + P4,200) Less: Income taxes deferred 6-12

P185,000 (15,000) P177,200 (1,260)

P170,000

Cash Flow Analysis Chapter 6

Depreciation Amortization Net cash provided by operating activities

(25,000) (7,000)

(143,940) P 26,060

Problem 4 (Cash Flow from Operating Activities) Cash received from customers (1) Cash paid for expenses: Cost of goods sold Selling Salaries and wages (2) Interest (3) Miscellaneous operating Incomes taxes (4) Net cash provided by operating activities Computations:

P5,237,000 P3,150,000 246,000 394,400 65,200 5,000 335,000

4,195,600 P1,041,400

1. Revenue from sales Less: Note receivable Land

P5,432,000 (120,000) (75,000) P5,237,000

2. Salaries and wages expense Less: Increase in accrued salaries and wages (P45,600 – P40,000)

P 400,000

3. Interest expense Less: Discount amortization

P

(5,600) P 394,400

P 4. Income tax expense Less: Deferred portion

72,000 (6,800) 65,200

P 445,000 (110,000) P 335,000

Problem 5 (Statement of Cash Flows Preparation – Indirect) Green Tea Company Statement of Cash Flows For the Year Ended December 31, 2005 Cash flows from operating activities Net income* 6-13

P8,500

Chapter 6 Cash Flow Analysis

Adjustments to reconcile net income to net cash flows provided by operating activities: Depreciation Amortization of intangibles Increase in current assets Increase in current liabilities Net cash provided by operating activities Cash flows from financing activities Dividends paid Retirement of long-term liabilities Net cash used in financing activities Net increase in cash Cash, January 1, 2005 Cash, December 31, 2005

1,000 1,000 (6,000) 3,000 P7,500 (1,500) (1,000) (2,500) P 5,000 10,000 P15,000

Problem 6 (Cash Flow Statement Preparation – Direct) Requirement (a) Hundred Acre Company Statement of Cash Flows For the Year Ended December 31, 2005 Cash flows from operating activities Cash received from customers Cash paid for expense Net cash provided by operating activities Cash flow from investing activities Sale of equipment Sale of investments Acquisition of equipment Net cash used in investing activities Cash flows from financing activities Sale of ordinary shares Payment of cash dividends Net cash used in financing activities Net increase in cash Cash, January 1, 2005 *

Increase in retained earnings (P20,000 – P13,000) Dividends declared Net income 6-14

P74,000 67,000 P7,000 9,500 15,000 (53,000) (28,500) 40,000 (8,500) 31,500 P10,000 20,000 P7,000 1,500 P8,500

Cash Flow Analysis Chapter 6

Cash, December 31, 2005

P30,000

Reconciliation of net income to net cash provided by operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense Amortization expense Increase in accounts receivable Decrease in accrued expenses Net cash provided by operating activities

P15,000 24,500* 1,000 (33,000) (500) P 7,000

Computations: Cash received from customers: Revenues Deduct: Increase in accounts receivable (P78,000 – P45,000) Cash paid for expenses: Expenses Add: Decrease in accrued expenses (P7,500 – P7,000) Deduct: Depreciation expense (P33,600 – P27,100 + P18,000) Amortization Cash from sale of equipment: Cost Deduct: Accumulated depreciation Cash received on sale at book value Cash paid to acquire equipment: Increase in property, plant and equipment (P118,100 – P92,600) Cost of machinery sold

P107,000 33,000 P 74,000 P 92,000 500 (24,500) (1,000) P 67,000 P 27,500 (18,000) P 9,500

P 25,500 27,500 P 53,000

Cash received on sale of shares: Increase in ordinary shares amount *

Net increase during 2005 (P33,600 – P27,100) Accumulated depreciation on assets sold Depreciation expense for 2005 6-15

P 6,500 18,000 P24,500

Chapter 6 Cash Flow Analysis

(P100,000 – P75,000) Increase in additional paid-in capital account (P55,000 – P40,000) Cash dividends: Increase in retained earnings (P21,000 – P14,500) Net income (P107,000 – P92,000)

P 25,000 15,000 P 40,000 P

6,500 (15,000) P 8,500

Requirement (b) The reconciliation of net income to net cash provided by or used in operating activities is required to be disclosed in order to show more clearly the relationship and emphasize the differences between the two. Users of financial statements are often not as aware of the accrual concepts, which determine net income, as are preparers of those statements. The reconciliation of net income to net cash flows from operating activities clearly demonstrates that the two are different and details those events and transactions that account for the difference. Problem 7 (Interpretation of Cash Flow Statement) Requirement (a) The two companies are similar in the following respects: 1. 2. 3. 4.

Overall size. Industry in which they operate. Current ratio (2.4 to 1). Overall peso amounts of cash provided and used:

Ebony Company Ivory Company

Range, 2002-2005 Cash Provided Cash Used P125,000 – P168,000 P115,000 – P170,000 P135,000 – P160,000 P125,000 – P165,000

5. Net increase in working capital is identical for each year, 2002 – 2005. Requirement (b) The two companies are dissimilar in the makeup of the sources of cash, as indicated in the following analysis: 6-16

Cash Flow Analysis Chapter 6

2002 Ebony Ivory Cash provided: Operations Long-term debt Share capital Asset disposition

80 8 -12 100

37 56 -7 100

Sources of Cash in Percentages 2003 2004 Ebony Ivory Ebony Ivory 77 -16 7 100

21 10 52 17 100

70 --30 100

2005 Ebony Ivory

(38) 44 63 31 100

76 9 -15 100

7 -56 37 100

Ebony Company has relied much more heavily on operations to provide cash and to a very limited extent on debt and equity financing and asset disposition. On the other hand, Ivory Company has not been able to provide cash from operations and has been required to rely on the alternatives of debt and equity financing and asset disposition. Requirement (c) Ebony Company is in a considerably stronger position (as determined by the data given) and thus should be considered the better investment and credit risk. The following points are significant: 1. Ebony Company has provided 70%-80% of its cash via operating activities, supplementing with other means to maintain a current ratio at the industry average. Ebony has not had to rely consistently on any alternative source of funding. 2. Ivory Company has apparently been forced to rely continuously on debt financing except in 2005, perhaps because of the inability to obtain such financing. The year 2004 is particularly weak for Ivory, with operations resulting in a P60,000 reduction in cash. The ability of Ivory to sustain its present financial position (i.e., current ratio, etc.) is questionable in light of its history. III. Multiple Choice Questions 1. D 2. C 3. D

4. D 5. B 6. D

7. C 8. B 9. A

6-17

10. B 11. A 12. D