managerial account

Financial Statement Analysis

LEARNING OBJECTIVES After you have mastered the material in this chapter, you will be able to:

LO 13-1 Differentiate between horizontal and vertical analysis.

LO 13-2 Calculate ratios for assessing a company’s liquidity.

LO 13-3 Calculate ratios for assessing a company’s solvency.

LO 13-4 Calculate ratios for assessing a company’s managerial effectiveness.

LO 13-5 Calculate ratios for assessing a company’s position in the stock market.

Video lectures and accompanying self-assessment quizzes are available in Connect®  for all learning objectives.

CHAPTER 13

CHAPTER OPENING

Expressing financial statement information in the form of ratios enhances its usefulness.

Ratios permit comparisons over time and among companies, highlighting similarities, differ-

ences, and trends. Proficiency with common financial statement analysis techniques bene-

fits both internal and external users. Before beginning detailed explanations of numerous

ratios and percentages, however, we consider factors relevant to communicating useful

information.

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The Curious Accountant

Precision Castings Corp.  manufactures metal components and products, and provides castings, forgings, fastener systems, and other structures for customers in the aerospace and power industries. On August 10, 2015, Berkshire Hathaway, Inc., which is run by Warren Buffett, purchased Precision Castings Corp. for $235 per share, or $32.4 billion in total. This price of $235 per share was 21 percent higher than the stock was currently trading on the New York Stock Exchange.

On September 2, 2013, Microsoft Corp. announced that it had purchased the cell phone business of Nokia Corp. for $7 billion. As a part of the acquisition, 32,000 employees of Nokia would now work for Microsoft. At least one observer on CNBC noted that Microsoft probably could have purchased Nokia for 25 percent less a year or so earlier.

How do companies such as Berkshire Hathaway and Microsoft determine that a business they want to own is worth more than the current market price? What types of analysis would they use to make such decisions? Do you think the highly educated, experienced, and well-paid individuals involved in making these high-dollar acquisitions made the right decisions? (Answer on page 595.)

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© Kunanon Tuntasoot/123RF

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FACTORS IN COMMUNICATING USEFUL INFORMATION

The primary objective of accounting is to provide information useful for decision making. To provide information that supports this objective, accountants must consider the intended users, the types of decisions users make with financial statement information, and available means of analyzing the information.

The Users Users of financial statement information include managers, creditors, stockholders, potential investors, and regulatory agencies. These individuals and organizations use financial statements for different purposes and bring varying levels of sophistication to understanding business activities. For example, investors range from private individuals who know little about financial statements to large investment brokers and institutional investors capable of using complex statistical analysis techniques. At what level of user knowledge should financial statements be aimed? Condensing and reporting complex business transactions at a level easily understood by nonprofessional investors is increas- ingly difficult. Current reporting standards target users that have a reasonably informed knowledge of business, though that level of sophistication is difficult to define.

The Types of Decisions Just as the knowledge level of potential users varies, the information needs of users varies, depending on the decision at hand. A supplier considering whether or not to sell goods on account to a particular company wants to evaluate the likelihood of getting paid; a potential investor in that company wants to predict the likelihood of increases in the market value of the company’s common stock. Financial statements, however, are designed for general pur- poses; they are not aimed at any specific user group. Some disclosed information, therefore, may be irrelevant to some users but vital to others. Users must employ different forms of analysis to identify information most relevant to a particular decision.

Financial statements can provide only highly summarized economic information. The costs to a company of providing excessively detailed information would be prohibitive. In addition, too much detail leads to information overload, the problem of having so much data that important information becomes obscured by trivial information. Users faced with reams of data may become so frustrated attempting to use it that they lose the value of key information that is provided.

Information Analysis Because of the diversity of users, their different levels of knowledge, the varying informa- tion needs for particular decisions, and the general nature of financial statements, a variety of analysis techniques has been developed. In the following sections, we explain several common methods of analysis. The choice of method depends on which technique appears to provide the most relevant information in a given situation.

METHODS OF ANALYSIS

Financial statement analysis should focus primarily on isolating information useful for making a particular decision. The information required can take many forms but usually involves comparisons, such as comparing changes in the same item for the same company over a number of years, comparing key relationships within the same year, or comparing the operations of several different companies in the same industry. This chapter discusses three categories of analysis methods: horizontal, vertical, and ratio. Exhibits 13.1 and 13.2 present comparative financial statements for Milavec Company. We refer to these statements in the examples of analysis techniques.

© Susan van Etten/PhotoEdit

Differentiate between horizontal and vertical analysis.

LO 13-1

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EXHIBIT 13.1

MILAVEC COMPANY Income Statements and Statements of

Retained Earnings For the Years Ending December 31

2018 2017

Sales $900,000 $800,000 Cost of goods sold Beginning inventory 43,000 40,000 Purchases 637,000 483,000 Goods available for sale 680,000 523,000 Ending inventory 70,000 43,000 Cost of goods sold 610,000 480,000 Gross margin 290,000 320,000 Operating expenses 248,000 280,000 Income before taxes 42,000 40,000 Income taxes 17,000 18,000 Net income 25,000 22,000 Plus: Retained earnings, beginning balance 137,000 130,000 Less: Dividends 0 15,000 Retained earnings, ending balance $162,000 $137,000

EXHIBIT 13.2

MILAVEC COMPANY Balance Sheet

As of December 31

2018 2017

Assets Cash $ 20,000 $ 17,000 Marketable securities 20,000 22,000 Notes receivable 4,000 3,000 Accounts receivable 50,000 56,000 Merchandise inventory 70,000 43,000 Prepaid expenses 4,000 4,000 Property, plant, and equipment (net) 340,000 310,000 Total assets $508,000 $455,000

Liabilities and Stockholders’ Equity Accounts payable $ 40,000 $ 38,000 Salaries payable 2,000 3,000 Taxes payable 4,000 2,000 Bonds payable, 8% 100,000 100,000 Preferred stock, 6%, $100 par, cumulative 50,000 50,000 Common stock, $10 par 150,000 125,000 Retained earnings 162,000 137,000 Total liabilities and stockholders’ equity $508,000 $455,000

Horizontal Analysis Horizontal analysis, also called trend analysis, refers to studying the behavior of indi- vidual financial statement items over several accounting periods. These periods may be several quarters within the same fiscal year or they may be several different years. The analysis of a given item may focus on trends in the absolute dollar amount of the item or trends in percentages. For example, a user may observe that revenue increased from one period to the next by $42 million (an absolute dollar amount) or that it increased by a per- centage such as 15 percent.

Absolute Amounts The absolute amounts of particular financial statement items have many uses. Various national economic statistics, such as gross domestic product and the amount spent to replace productive capacity, are derived by combining absolute amounts reported by businesses. Financial statement users with expertise in particular industries might evaluate amounts reported for research and development costs to judge whether a company is spending exces- sively or conservatively. Users are particularly concerned with how amounts change over time. For example, a user might compare a pharmaceutical company’s revenue before and after the patent expired on one of its drugs.

Comparing only absolute amounts has drawbacks, however, because materiality levels differ from company to company or even from year to year for a given company. The materiality of information refers to its relative importance. An item is considered material if knowledge of it would influence the decision of a reasonably informed user. Generally accepted accounting principles permit companies to account for immaterial items in the most convenient way, regardless of technical accounting rules. For example, companies may expense, rather than capitalize and depreciate, relatively inexpensive long-term assets like pencil sharpeners or wastebaskets even if the assets have useful lives of many years. The

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concept of materiality, which has both quantitative and qualitative aspects, underlies all accounting principles.

It is difficult to judge the materiality of an absolute financial statement amount without considering the size of the company reporting it. For reporting purposes, Exxon Corporation’s financial statements are rounded to the nearest million dollars. For Exxon, a $400,000 increase in sales is not material. For a small company, however, $400,000 could represent total sales, a highly material amount. Meaningful comparisons between the two companies’ operating performance are impossible using only absolute amounts. Users can surmount these difficulties with percentage analysis.

Percentage Analysis Percentage analysis involves computing the percentage relationship between two amounts. In horizontal percentage analysis, a financial statement item is expressed as a

percentage of the previous balance for the same item. Percentage analysis sidesteps the materiality problems of comparing different size companies by measuring changes in per- centages rather than absolute amounts. Each change is converted to a percentage of the base year. Exhibit 13.3 presents a condensed version of Milavec’s income statement with horizontal percentages for each item.

The percentage changes disclose that, even though Milavec’s net income increased slightly more than sales, products may be underpriced. Cost of goods sold increased much more than sales, resulting in a lower gross margin. Users would also want to investigate why operating expenses decreased substantially despite the increase in sales.

Whether basing their analyses on absolute amounts, percentages, or ratios, users must

avoid drawing overly simplistic conclusions about the reasons for the results. Numerical relationships flag conditions requiring further study. Recall that a change that appears favorable on the surface may not necessarily be a good sign. Users must evaluate the under- lying reasons for the change.

EXHIBIT 13.3

MILAVEC COMPANY Comparative Income Statements

For the Years Ending December 31

Percentage 2018 2017 Difference

Sales $900,000 $800,000 +12.5%* Cost of goods sold 610,000 480,000 +27.1 Gross margin 290,000 320,000 −9.4 Operating expenses 248,000 280,000 −11.4 Income before taxes 42,000 40,000 +5.0 Income taxes 17,000 18,000 −5.6 Net income $ 25,000 $ 22,000 +13.6

*($900,000 − $800,000) ÷ $800,000; all changes expressed as percentages of previous totals.

CHECK YOURSELF 13.1

The following information was drawn from the annual reports of two retail companies (amounts are shown in millions). One company is an upscale department store; the other is a discount store. Based on this limited information, identify which company is the upscale department store.

Jenkins Co. Horn’s, Inc.

Sales $325 $680 Cost of goods sold 130 408 Gross margin $195 $272

Answer Jenkins’ gross margin represents 60 percent ($195 ÷ $325) of sales. Horn’s gross margin represents 40 percent ($272 ÷ $680) of sales. Since an upscale department store would have higher margins than a discount store, the data suggest that Jenkins is the upscale department store.

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When comparing more than two periods, analysts use either of two basic approaches: (1) choosing one base year from which to calculate all increases or decreases or (2) calculating each period’s percentage change from the preceding figure. To illustrate, assume Milavec’s sales for 2015 through 2018 are as follows:

2018 2017 2016 2015

Sales $900,000 $800,000 $750,000 $600,000 Increase over 2015 sales 50.0% 33.3% 25.0% — Increase over preceding year  12.5%   6.7% 25.0% —

Analysis discloses that Milavec’s 2018 sales represented a 50 percent increase over 2015 sales, and a large increase (25 percent) occurred in 2016. From 2016 to 2017, sales increased only 6.7 percent but in the following year, sales increased much more (12.5 percent).

Obviously  Berkshire Hathaway’s and

Microsoft’s acquisitions were based on

a desire to make a profit on their investments. Even though Berkshire’s $235 was higher than Precision Castparts’ cur-

rent market price, in the past couple of years the stock had traded for as much as $275 per share. One of the company’s

major customer bases is the gas and oil industry.  Gas and oil prices were depressed in August 2015, which made the

stock market cautious about Precision Castparts’ stock. However, Mr. Buffett, Berkshire’s CEO, believed the company

was a good long-term investment and that the current low price presented a good buying opportunity.

Microsoft wanted to acquire Nokia’s cell phone business to try to increase the use of Microsoft’s Windows operating

system for mobile phones, a segment where Apple and Android dominated. By owning both the hardware and software

aspect of the phone, Microsoft predicted its profit would increase from less than $10 per phone to $40.

How do companies decide what another company is worth? Valuing a potential investment is the result of extensive

financial analysis, as discussed in this chapter, along with capital budgeting techniques, which were discussed in

Chapter 10. As you have seen in these chapters, such decision making is based on estimates about future events.

Predicting the future is imperfect, no matter how well trained the forecaster might be.

How good were the decisions of Berkshire Hathaway and Microsoft? It is too early to say for the purchase of

Precision Castparts, but since Mr. Buffett bought Berkshire Hathaway in 1965, the company’s return has been double

that of the S&P 500 index. As for Microsoft’s purchase of Nokia, things did not turn out well. In July 2015, just two

years after its acquisition, Microsoft announced it was writing down $7.6 billion of its Nokia investment, and eliminat-

ing 7,800 jobs.

Does this mean that financial analysis is useless? No. Assume you were planning to drive across the United States.

Would you prefer to take the trip with a map or without? Obviously you would prefer to have a map or GPS, even though

you know neither device is perfect. Financial analysis can be of great benefit when making business decisions, but there

are always uncertainties about future events that mathematics cannot eliminate.

Sources: Companies’ documents, The Wall Street Journal, and Reuters.

Answers to The Curious Accountant

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Vertical Analysis Vertical analysis uses percentages to compare individual components of financial state- ments to a key statement figure. Horizontal analysis compares items over many time peri- ods; vertical analysis compares many items within the same time period.

Vertical Analysis of the Income Statement Vertical analysis of an income statement (also called a common size income statement) in- volves converting each income statement component to a percentage of sales. Although vertical analysis suggests examining only one period, it is useful to compare common size income statements for several years. Exhibit 13.4 presents Milavec’s income statements, along with vertical percentages, for 2018 and 2017. This analysis discloses that cost of goods sold increased significantly as a percentage of sales. Operating expenses and income taxes, however, decreased in relation to sales. Each of these observations indicates a need for more analysis regarding possible trends for future profits.

EXHIBIT 13.4

MILAVEC COMPANY Vertical Analysis of Comparative Income Statements

2018 2017

Percentage* Percentage* Amount of Sales Amount of Sales

Sales $900,000 100.0% $800,000 100.0%   Cost of goods sold    610,000   67.8   480,000 60.0 Gross margin   290,000   32.2   320,000 40.0 Operating expenses   248,000   27.6   280,000   35.0 Income before taxes      42,000     4.7     40,000    5.0 Income taxes       17,000     1.9      18,000     2.3 Net income $  25,000       2.8% $  22,000 2.8%

*Percentages may not add exactly due to rounding.

Vertical Analysis of the Balance Sheet Vertical analysis of the balance sheet involves converting each balance sheet component to a percentage of total assets. The vertical analysis of Milavec’s balance sheets in Exhibit 13.5 discloses few large percentage changes from the preceding year. Even small individual percentage changes, however, may represent substantial dollar increases. For example, in- ventory constituted 9.5 percent of total assets in 2017 and 13.8 percent in 2018. While this appears to be a small increase, it actually represents a 62.8 percent increase in the inventory account balance [($70,000 − $43,000) ÷ $43,000] from 2017 to 2018. Careful analysis re- quires considering changes in both percentages and absolute amounts.

RATIO ANALYSIS

Ratio analysis involves studying various relationships between different items reported in a set of financial statements. For example, net earnings (net income) reported on the income statement may be compared to total assets reported on the balance sheet. Analysts calculate many different ratios for a wide variety of purposes. The remainder of this chapter is devoted to discussing some of the more commonly used ratios.

Objectives of Ratio Analysis As suggested earlier, various users approach financial statement analysis with many different objectives. Creditors are interested in whether a company will be able to repay its

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debts on time. Both creditors and stockholders are concerned with how the company is financed, whether through debt, equity, or earnings. Stockholders and potential investors analyze past earnings performance and dividend policy for clues to the future value of their investments. In addition to using internally generated data to analyze operations, company managers find much information prepared for external purposes useful for examining past operations and planning future policies. Although many of these objec- tives are interrelated, it is convenient to group ratios into categories such as measures of debt-paying ability and measures of profitability.

MEASURES OF DEBT-PAYING ABILITY

Liquidity Ratios Liquidity ratios indicate a company’s ability to pay short-term debts. They focus on current assets and current liabilities. The examples in the following section use the financial state- ment information reported by Milavec Company.

Working Capital Working capital is current assets minus current liabilities. Current assets include assets most likely to be converted into cash in the current operating period. Current liabilities represent debts that must be satisfied in the current period. Working capital therefore

EXHIBIT 13.5

MILAVEC COMPANY Vertical Analysis of Comparative Balance Sheets

Percentage* Percentage* 2018 of Total 2017 of Total

Assets Cash $  20,000       3.9% $  17,000 3.7% Marketable securities     20,000    3.9     22,000     4.8 Notes receivable        4,000    0.8        3,000     0.7  Accounts receivable     50,000    9.8     56,000    12.3  Merchandise inventory     70,000   13.8      43,000     9.5  Prepaid expenses        4,000    0.8       4,000       0.9    Total current assets    168,000    33.1    145,000    31.9  Property, plant, and equipment   340,000  66.9    310,000   68.1   Total assets $508,000    100.0% $455,000      100.0%   Liabilities and Stockholders’ Equity Accounts payable $  40,000       7.9% $  38,000        8.3%  Salaries payable       2,000    0.4        3,000    0.7 Taxes payable        4,000    0.8        2,000     0.4  Total current liabilities     46,000     9.1      43,000     9.4  Bonds payable, 8%    100,000   19.7    100,000    22.0   Total liabilities    146,000  28.8    143,000    31.4  Preferred stock 6%, $100 par     50,000    9.8     50,000     11.0  Common stock, $10 par    150,000  29.5    125,000  27.5 Retained earnings    162,000   31.9    137,000    30.1    Total stockholders’ equity   362,000   71.2    312,000   68.6  Total liabilities and stockholders’ equity $508,000    100.0% $455,000    100.0%

*Percentages may not add exactly due to rounding.

Calculate ratios for assessing a company’s liquidity.

LO 13-2

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measures the excess funds the company will have available for operations, excluding any new funds it generates during the year. Think of working capital as the cushion against short-term debt-paying problems. Working capital at the end of 2018 and 2017 for Milavec Company was as follows:

2018 2017

Current assets $168,000 $145,000 − Current liabilities 46,000 43,000 Working capital $122,000 $102,000

Milavec Laroque

Current assets (a) $168,000 $500,000 − Current liabilities (b) 46,000 378,000 Working capital $122,000 $122,000 Current ratio (a ÷ b) 3.65:1 1.32:1

Milavec’s working capital increased from 2017 to 2018, but the numbers themselves say little. Whether $122,000 is sufficient or not depends on such factors as the industry in which Milavec operates, its size, and the maturity dates of its current obligations. We can see, however, that the increase in working capital is primarily due to the increase in inventories.

Current Ratio Working capital is an absolute amount. Its usefulness is limited by the materiality difficul- ties discussed earlier. It is hard to draw meaningful conclusions from comparing Milavec’s working capital of $122,000 with another company that also has working capital of $122,000. By expressing the relationship between current assets and current liabilities as a ratio, however, we have a more useful measure of the company’s debt-paying ability relative to other companies. The current ratio, also called the working capital ratio, is calculated as follows:

Current ratio = Current assets Current liabilities

To illustrate using the current ratio for comparisons, consider Milavec’s current position relative to that of Laroque’s, a larger firm with current assets of $500,000 and current liabil- ities of $378,000.

The current ratio is expressed as the number of dollars of current assets for each dollar of current liabilities. In the above example, both companies have the same amount of work- ing capital. Milavec, however, appears to have a much stronger working capital position. Any conclusions from this analysis must take into account the circumstances of the particu- lar companies; there is no single ideal current ratio that suits all companies. In recent years, the average current ratio of the nonfinancial companies that constitute the Dow Jones Indus- trial Average (DJIA) was around 1.54:1. The individual company ratios, however, ranged from 0.77:1 to 3.39:1. A current ratio can be too high. Money invested in factories and developing new products is usually more profitable than money held as large cash balances or invested in inventory.

Quick Ratio The quick ratio, also known as the acid-test ratio, is a conservative variation of the cur- rent ratio. The quick ratio measures a company’s immediate debt-paying ability. Only

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cash, receivables, and current marketable securities (quick assets) are included in the numerator. Less liquid current assets, such as inventories and prepaid expenses, are omitted. Inventories may take several months to sell; prepaid expenses reduce otherwise necessary expenditures but do not lead eventually to cash receipts. The quick ratio is computed as follows:

Quick ratio = Quick assets Current liabilities

Milavec Company’s current ratios and quick ratios for 2018 and 2017 follow:

2018 2017

Current ratio 168,000 ÷ 46,000 145,000 ÷ 43,000 3.65:1 3.37:1 Quick ratio 94,000 ÷ 46,000 98,000 ÷ 43,000 2.04:1 2.28:1

The decrease in the quick ratio from 2017 to 2018 reflects both a decrease in quick as- sets and an increase in current liabilities. The result indicates that the company is less liquid (has less ability to pay its short-term debt) in 2018 than it was in 2017.

Accounts Receivable Ratios Offering customers credit plays an enormous role in generating revenue, but it also increases expenses and delays cash receipts. To minimize bad debts expense and collect cash for use in current operations, companies want to collect receivables as quickly as possible without losing customers. Two relationships are often examined to assess a company’s collection record: accounts receivable turnover and average days to collect receivables (average collection period).

Accounts receivable turnover is calculated as follows:

Accounts receivable turnover = Net credit sales Average accounts receivable

Net credit sales refers to total sales on account less sales discounts and returns. When most sales are credit sales or when a breakdown of total sales between cash sales and credit sales is not available, the analyst must use total sales in the numerator. The denominator is based on net accounts receivable (receivables after subtracting the allowance for doubtful accounts). Since the numerator represents a whole period, it is preferable to use average receivables in the denominator if possible. When comparative statements are available, the average can be based on the beginning and ending balances. Milavec Company’s accounts receivable turnover is computed as follows:

*The 2017 beginning receivables balance was drawn from the 2016 financial statements, which are not included in the illustration.

2018 2017

Net sales (assume all on account) (a) $900,000 $800,000 Beginning receivables (b) $ 56,000 $ 55,000* Ending receivables (c) 50,000 56,000 Average receivables (d) = (b + c) ÷ 2 $ 53,000 $ 55,500 Accounts receivable turnover (a ÷ d) 16.98 14.41

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The 2018 accounts receivable turnover of 16.98 indicates Milavec collected its average receivables almost 17 times that year. The higher the turnover, the faster the collections. A company can have cash flow problems and lose substantial purchasing power if resources are tied up in receivables for long periods.

Average days to collect receivables, or the average collection period, is calculated as follows:

Average days to collect receivables = 365 days Accounts receivable turnover

This ratio offers another way to look at turnover by showing the number of days, on average, it takes to collect a receivable. If receivables were collected 16.98 times in 2018, the average collection period was 21 days, 365 ÷ 16.98 (the number of days in the year divided by accounts receivable turnover). For 2017, it took an average of 25 days (365 ÷ 14.41) to collect a receivable.

Although the collection period improved, no other conclusions can be reached without considering the industry, Milavec’s past performance, and the general economic environment. In recent years, the average time to collect accounts receivable for the 26  nonfinancial companies that make up the DJIA was around 37 days. (Financial firms are excluded because, by the nature of their business, they have very long collec- tion periods.)

Inventory Ratios A fine line exists between having too much and too little inventory in stock. Too little inven- tory can result in lost sales and costly production delays. Too much inventory can use needed space, increase financing and insurance costs, and become obsolete. To help analyze how efficiently a company manages inventory, we use two ratios similar to those used in analyz- ing accounts receivable.

Inventory turnover indicates the number of times, on average, that inventory is totally replaced during the year. The relationship is computed as follows.

Inventory turnover = Cost of goods sold Average inventory

The average inventory is usually based on the beginning and ending balances that are shown in the financial statements. Inventory turnover for Milavec was as follows:

2018 2017

Cost of goods sold (a) $610,000 $480,000 Beginning inventory (b) $ 43,000 $ 40,000* Ending inventory (c) 70,000 43,000 Average inventory (d) = (b + c) ÷ 2 $ 56,500 $ 41,500 Inventory turnover (a ÷ d) 10.80 11.57

*The 2017 beginning inventory balance was drawn from the company’s 2016 financial statements, which are not included in the illustration.

Generally, a higher turnover indicates that merchandise is being handled more effi- ciently. Trying to compare firms in different industries, however, can be misleading. Inven- tory turnover for grocery stores and many retail outlets is high. Because of the nature of the goods being sold, inventory turnover is much lower for appliance and jewelry stores. We look at this issue in more detail when we discuss return on investment.

Average days to sell inventory, or average days in inventory, is determined by divid- ing the number of days in the year by the inventory turnover as follows:

Average days to sell inventory = 365 days Inventory turnover

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The result approximates the number of days the firm could sell inventory without purchas- ing more. For Milavec, this figure was 34 days in 2018 (365 ÷ 10.80) and 32 days in 2017 (365 ÷ 11.57). In recent years it took around 66 days, on average, for the companies in the DJIA that have inventory to sell their inventory. The time it took individual companies to sell their inventory varied by industry, ranging from 7 days to 216 days.

Solvency Ratios Solvency ratios are used to analyze a company’s long-term debt-paying ability and its financing structure. Creditors are concerned with a company’s ability to satisfy outstanding obligations. The larger a company’s liability percentage, the greater the risk that the com- pany could fall behind or default on debt payments. Stockholders, too, are concerned about a company’s solvency. If a company is unable to pay its debts, the owners could lose their investment. Each user group desires that company financing choices minimize its investment risk, whether the investment is in debt or stockholders’ equity.

Debt Ratios The following ratios represent two different ways to express the same relationship. Both are frequently used. ■ Debt to assets ratio. This ratio measures the percentage of a company’s assets that are

financed by debt. ■ Debt to equity ratio. As used in this ratio, equity means stockholders’ equity. The debt

to equity ratio compares creditor financing to owner financing. It is expressed as the dollar amount of liabilities for each dollar of stockholders’ equity.

These ratios are calculated as follows:

Debt to assets = Total liabilities Total assets

Debt to equity = Total liabilities Total stockholders’ equity

Applying these formulas to Milavec Company’s results produces the following:

Calculate ratios for assessing a company’s solvency.

LO 13-3

2018 2017

Total liabilities (a) $146,000 $143,000 Total stockholders’ equity (b) 362,000 312,000 Total equities (Liabilities + Stockholders’ equity) (c) $508,000 $455,000 Debt to assets (a ÷ c) 29% 31% Debt to equity ratio (a ÷ b) 0.40:1 0.46:1

Each year, less than one-third of the company’s assets were financed with debt. The amount of liabilities per dollar of stockholders’ equity declined by 0.06. It is difficult to judge whether the reduced percentage of liabilities is favorable. In general, a lower level of liabilities provides greater security because the likelihood of bankruptcy is reduced. Per- haps, however, the company is financially strong enough to incur more liabilities and benefit from financial leverage. The 26 nonfinancial companies that make up the DJIA report around 41 percent of their assets, on average, are financed through borrowing. The debt to asset ratios of these companies ranged from 9 to 90 percent.

Number of Times Interest Is Earned This ratio measures the burden a company’s interest payments represent. Users often con- sider the number of times interest is earned along with the debt ratios when evaluating financial risk. The numerator of this ratio uses earnings before interest and taxes (EBIT),

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rather than net earnings, because the amount of earnings before interest and income taxes is available for paying interest.

Number of times interest is earned =

Earnings before interest and taxes expense Interest expense

Dividing EBIT by interest expense indicates how many times the company could have made its interest payments. Obviously, interest is paid only once, but the more times it could be paid, the bigger the company’s safety net. Although interest is paid from cash, not accrual earnings, it is standard practice to base this ratio on accrual-based EBIT, not a cash-based amount. For Milavec, this calculation is as follows:

*Interest on bonds: $100,000 × 0.08 = $8,000.

2018 2017

Income before taxes $42,000 $40,000 Interest expense (b) 8,000 8,000* Income before taxes and interest (a) $50,000 $48,000 Times interest earned (a ÷ b) 6.25 times 6 times

Any expense or dividend payment can be analyzed this way. Another frequently used cal- culation is the number of times the preferred dividend is earned. In that case, the numerator is net income (after taxes) and the denominator is the amount of the annual preferred dividend.

CHECK YOURSELF 13.2

Selected data for Riverside Corporation and Academy Company follow (amounts are shown in millions):

Riverside Academy Corporation Company

Total liabilities (a) $650 $450 Stockholders’ equity (b) 300 400 Total liabilities + Stockholders’ equity (c) $950 $850 Interest expense (d) $ 65 $ 45 Income before taxes (e) 140 130 Income before taxes and interest (f ) $205 $175

Riverside Academy Corporation Company

Debt to assets ratio (a ÷ c) 68.4% 52.9% Times interest earned (f ÷ d) 3.15 times 3.89 times

Based on this information alone, which company would likely obtain the less favorable interest rate on additional debt financing?

Answer Interest rates vary with risk levels. Companies with less solvency (long-term debt-paying ability) generally must pay higher interest rates to obtain financing. Two solvency measures for the two companies follow. Recall:

Total assets = Liabilities + Stockholders’ equity

Since Riverside has a higher percentage of debt and a lower times interest earned ratio, the data suggest that Riverside is less solvent than Academy. Riverside would therefore likely have to pay a higher interest rate to obtain additional financing.

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Plant Assets to Long-Term Liabilities Companies often pledge plant assets as collateral for long-term liabilities. Financial state- ment users may analyze a firm’s ability to obtain long-term financing on the strength of its asset base. Effective financial management principles dictate that asset purchases should be financed over a time span about equal to the expected lives of the assets. Short-term assets should be financed with short-term liabilities; the current ratio, introduced earlier, indicates how well a company manages current debt. Long-lived assets should be financed with long- term liabilities, and the plant assets to long-term liabilities ratio shows the amount of assets per each dollar of long term debt. It is calculated as follows.

Plant assets to long-term liabilities = Net plant assets Long-term liabilities

For Milavec Company, these ratios follow:

2018 2017

Net plant assets (a) $340,000 $310,000 Bonds payable (b) 100,000 100,000 Plant assets to long-term liabilities (a ÷ b) 3.4:1 3.1:1

Calculate ratios for assessing a company’s managerial effectiveness.

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2018 2017

Net income (a) $ 25,000 $ 22,000 Net sales (b) 900,000 800,000 Net margin (a ÷ b) 2.78% 2.75%

MEASURES OF PROFITABILITY

Profitability refers to a company’s ability to generate earnings. Both management and external users employ profitability ratios to assess a company’s success in generating profits and how these profits are used to reward investors. Some of the many ratios available to measure different aspects of profitability are discussed in the following two sections.

Measures of Managerial Effectiveness The most common ratios used to evaluate managerial effectiveness measure what percent- age of sales results in earnings and how productive assets are in generating those sales. As mentioned earlier, the absolute amount of sales or earnings means little without also consid- ering company size.

Net Margin (or Return on Sales) Gross margin and gross profit are alternate terms for the amount remaining after subtracting the expense cost of goods sold from sales. Net margin, sometimes called operating margin, profit margin, or the return on sales ratio, describes the percentage of each sales dollar remaining after subtracting other expenses as well as cost of goods sold. Net margin can be calculated in several ways; some of the more common methods subtract only normal operat- ing expenses or all expenses other than income tax expense. For simplicity, our calculation uses net income (we subtract all expenses). Net income divided by net sales expresses net income (earnings) as a percentage of sales:

Net margin = Net income Net sales

For Milavec Company, the net margins for 2018 and 2017 were as follows:

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Milavec has maintained approximately the same net margin. Obvi- ously, the larger the percentage, the better; a meaningful interpretation, however, requires analyzing the company’s history and comparing the net margin to other companies in the same industry. The average net margin for the 26 nonfinancial companies that make up the Dow Jones Industrial Average (DJIA) has been around 13 percent in recent years; some compa- nies, such as Cisco with 28 percent, have been much higher than the aver- age. Of course, if a company has a net loss, its net margin for that year will be negative.

Asset Turnover Ratio The asset turnover ratio (sometimes called turnover of assets ratio) measures how many sales dollars were generated for each dollar of assets invested. As with many ratios used in financial statement analysis, users may define the numerator and denominator of this ratio in different ways. For example, they may use total assets or only include operating assets. Since the numerator represents a whole period, it is preferable to use average assets in the denominator if possible, especially if the amount of assets changed significantly during the year. We use average total assets in our illustration.

Asset turnover = Net sales Average total assets

For Milavec, the asset turnover ratios were as follows:

© AP Photo/Paul Sakura

2018 2017

Net sales (a) $900,000 $800,000 Beginning assets (b) $455,000 $420,000* Ending assets (c) 508,000 455,000 Average assets (d) = (b + c) ÷ 2 $481,500 $437,500 Asset turnover (a ÷ d) 1.87 1.83 *The 2017 beginning asset balance was drawn from the 2016 financial statements, which are not included in the illustration.

As with most ratios, the implications of a given asset turnover ratio are affected by other considerations. Asset turnover will be high in an industry that requires only minimal invest- ment to operate, such as real estate sales companies. On the other hand, industries that require large investments in plant and machinery, like the auto industry, are likely to have lower asset turnover ratios. The asset turnover ratios of the nonfinancial companies that make up the DJIA have averaged around 1.28 in recent years. This means that annual sales have averaged 128 percent of their assets.

Return on Investment Return on investment (ROI), also called return on assets or earning power, is the ratio of wealth generated (net income) to the amount invested (average total assets) to generate the wealth. ROI can be calculated as follows:1

ROI = Net income Average total assets

1Detailed coverage of the return on investment ratio is provided in introductory managerial accounting courses, which will explain how companies frequently manipulate the formula to improve managerial motivation and performance. For example, instead of using net income, companies frequently use operating income because net income may be affected by items that are not controllable by management such as loss on a plant closing, storm damage, and so on.

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For Milavec, ROI was as follows:

2018

$25,000 ÷ $481,500* = 5.19%

2017

$22,000 ÷ $437,500* = 5.03% *The computation of average assets is shown previously.

In general, higher ROIs suggest better performance. The return on investment ratios of the large nonfinancial companies that make up the DJIA have averaged around 9 percent in recent years. These data suggest that Milavec is performing below average and therefore signal a need for further evaluation.

Return on Equity Return on equity (ROE) is often used to measure the profitability of the stockholders’ investment. ROE is usually higher than ROI because of financial leverage. Financial lever- age refers to using debt financing to increase the assets available to a business beyond the amount of assets financed by owners. As long as a company’s ROI exceeds its cost of bor- rowing (interest expense), the owners will earn a higher return on their investment in the company by using borrowed money. For example, if a company borrows money at 8 percent and invests it at 10 percent, the owners will enjoy a return that is higher than 10 percent. ROE is computed as follows:

ROE = Net income Average total stockholders’ equity

2018 2017

Net income (a) $ 25,000 $ 22,000 Preferred stock, 6%, $100 par, cumulative 50,000 50,000 Common stock, $10 par 150,000 125,000 Retained earnings 162,000 137,000 Ending stockholders’ equity (b) $362,000 $312,000 Beginning stockholders’ equity (c) 312,000 268,000* Average stockholders’ equity (d) = (b = c) ÷ 2 337,000 290,000 ROE (a ÷ d)          7.4%          7.6%

*The 2017 beginning stockholders’ equity balance was drawn from the 2016 financial statements, which are not included in the illustration.

The slight decrease in ROE is due primarily to the increase in common stock. The effect of the increase in total stockholders’ equity offsets the effect of the increase in earnings. It is interesting to note that Milavec’s ROEs of 7.6 percent and 7.4 percent are low in relation to real-world companies that make up the DJIA. Recently, the average ROE for the these companies was 25 percent. One contributing factor explaining this difference is that most companies in the DJIA are more highly leveraged.

Stock Market Ratios Existing and potential investors in a company’s stock use many common ratios to analyze and compare the earnings and dividends of different size companies in different industries. Purchasers of stock can profit in two ways: through receiving dividends and through increases in stock value. Investors consider both dividends and overall earnings performance as indicators of the value of the stock they own.

Calculate ratios for assessing a company’s position in the stock market.

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Earnings per Share Perhaps the most frequently quoted measure of earnings performance is earnings per share (EPS). EPS calculations are among the most complex in accounting, and more ad- vanced textbooks devote entire chapters to the subject. At this level, we use the following basic formula.

Earnings per share = Net earnings available for common stock Average number of outstanding common shares

EPS pertains to shares of common stock. Limiting the numerator to earnings available for common stock eliminates the annual preferred dividend (0.06 × $50,000 = $3,000) from the calculation. Exhibit 13.1 shows that Milavec did not pay the preferred dividends in 2018. Since the preferred stock is cumulative, however, the preferred dividend is in arrears and not available to the common stockholders. The number of common shares outstanding is determined by dividing the book value of the common stock by its par value per share ($150,000 ÷ $10 = 15,000 for 2018 and $125,000 ÷ $10 = 12,500 for 2017). Using these data, Milavec’s 2018 EPS is calculated as follows:

$25,000 (net income) − $3,000 (preferred dividend) (15,000 + 12,500)∕2 (average outstanding common shares) = $1.60 per share

Investors attribute a great deal of importance to EPS figures. The amounts used in  calculating EPS, however, have limitations. Many accounting choices, assumptions, and estimates underlie net income computations, including alternative deprecia- tion  methods, different inventory cost flow assumptions, and estimates of future bad debt or warranty expenses, to name only a few. The denominator is also inexact because various factors (discussed in intermediate accounting courses) affect the number of shares to include. Numerous opportunities therefore exist to manipulate EPS figures. Prudent investors consider these variables in deciding how much weight to attach to earnings per share.

Book Value Book value per share is another frequently quoted measure of a share of stock. It is calcu- lated as follows:

Book value per share = Stockholders’ equity − Preferred stockOutstanding common shares

Instead of describing the numerator as stockholders’ equity, we could have used assets minus liabilities, the algebraic computation of a company’s “net worth.” Net worth is a misnomer. A company’s accounting records reflect book values, not worth. Because assets are recorded at historical costs and different methods are used to transfer asset costs to expense, the book value of assets after deducting liabilities is difficult to interpret. Neverthe- less, investors use the term book value per share frequently. Milavec’s book value per share for 2018 is calculated as follows:

$362,000 − $50,000 15,000 shares = $20.80 per share

Price-Earnings Ratio The price-earnings (P/E) ratio compares the earnings per share of a company to the market price for a share of the company’s stock. Assume Avalanche Company and Brushfire Company each report earnings per share of $3.60. For the same year, Cyclone Company reports EPS of $4.10. Based on these data alone, Cyclone stock may seem to be the best investment. Suppose, however, that the price for one share of stock in each company is $43.20, $36.00, and $51.25, respectively. Which stock would you buy?

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Cyclone’s stock price is the highest, but so is its EPS. The P/E ratio provides a common base of comparison.

Price-earnings ratio = Market price per shareEarnings per share

The P/E ratios for the three companies are:

Avalanche Brushfire Cyclone

12.0 10.0 12.5

Dragonfly Elk

Dividends per share (a) $ 1.80 $ 3.00 Market price per share (b) 40.00 75.00 Dividend yield (a ÷ b) 4.5% 4.0%

Brushfire might initially seem to be the best buy for your money. Yet there must be some reason that Cyclone’s stock is selling at 12½ times earnings. In general, a higher P/E ratio indicates the market is more optimistic about a company’s growth potential than it is about a company with a lower P/E ratio. The market price of a company’s stock reflects judgments about both the company’s current results and expectations about future results. Investors cannot make informed use of these ratios for investment decisions without examin- ing the reasons behind the ratios. In early March 2016, when the Dow Jones Industrial Aver- age was around 17,000 points, the average P/E ratio for the companies included in the DJIA was around 18.

Dividend Yield There are two ways to profit from a stock investment. One, investors can sell the stock for more than they paid to purchase it (if the stock price rises). Two, the company that issued the stock can pay cash dividends to the shareholders. Most investors view rising stock prices as the primary reward for investing in stock. The importance of receiving dividends, however, should not be overlooked. Evaluating dividend payments is more complex than simply com- paring the dividends per share paid by one company to the dividends per share paid by an- other company. Receiving a $1 dividend on a share purchased for $10 is a much better return than receiving a $1.50 dividend on stock bought for $100. Computing the dividend yield simplifies comparing dividend payments. Dividend yield measures dividends received as a percentage of a stock’s market price.

Dividend yield = Dividends per shareMarket price per share

To illustrate, consider Dragonfly, Inc. and Elk Company. The information for calculating dividend yield follows:

Even though the dividend per share paid by Elk Company is higher, the yield is lower (4.0 percent versus 4.5 percent) because Elk’s stock price is so high. The dividend yields for the companies included in the DJIA were averaging around 2.7 percent in March 2016.

Other Ratios Investors can also use a wide array of other ratios to analyze profitability. Most profit- ability ratios use the same reasoning. For example, you can calculate the yield of a

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variety of financial investments. Yield is determined by dividing the amount of the return (the dividend or interest earned) by the amount of the investment. The dividend yield explained previously could be calculated for either common or preferred stock. Investors could measure the earnings yield by calculating earnings per share as a percentage of market price. Yield on a bond can be calculated the same way: interest received divided by the price of the bond.

The specific ratios presented in this chapter are summarized in Exhibit 13.6.

EXHIBIT 13.6

Summary of Key Relationships

Liquidity Ratios  1. Working capital Current assets − Current liabilities  2. Current ratio Current assets ÷ Current liabilities  3. Quick (acid-test) ratio (Current assets − Inventory − Prepaids) ÷ Current liabilities  4. Accounts receivable turnover Net credit sales ÷ Average receivables  5. Average days to collect receivables 365 ÷ Accounts receivable turnover  6. Inventory turnover Cost of goods sold ÷ Average inventory  7. Average days to sell inventory 365 ÷ Inventory turnover Solvency Ratios  8. Debt to assets ratio Total liabilities ÷ Total assets  9. Debt to equity ratio Total liabilities ÷ Total stockholders’ equity 10. Number of times interest is earned Earnings before interest and taxes ÷     Interest expense 11. Plant assets to long-term liabilities Net plant assets ÷ Long-term liabilities Profitability Ratios 12. Net margin Net income ÷ Net sales 13. Asset turnover Net sales ÷ Average total assets 14. Return on investment (also: return on assets) Net income ÷ Average total assets 15. Return on equity Net income ÷ Average total stockholders’ equity Stock Market Ratios 16. Earnings per share Net earnings available for common stock ÷ Average outstanding common shares 17. Book value per share (Stockholders’ equity − Preferred stock) ÷ Outstanding common shares 18. Price-earnings ratio Market price per share ÷ Earnings per share 19. Dividend yield Dividends per share ÷ Market price per share

LIMITATIONS OF FINANCIAL STATEMENT ANALYSIS

Analyzing financial statements is analogous to choosing a new car. Each car is different, and prospective buyers must evaluate and weigh myriad features: gas mileage, engine size, man- ufacturer’s reputation, color, accessories, and price, to name a few. Just as it is difficult to compare a Toyota minivan to a Ferrari sports car, so it is difficult to compare a small textile firm to a giant oil company. To make a meaningful assessment, the potential car buyer must focus on key data that can be comparably expressed for each car, such as gas mileage. The superior gas mileage of the minivan may pale in comparison to the thrill of driving the sports car, but the price of buying and operating the sports car may be the characteristic that determines the ultimate choice.

External users can rely on financial statement analysis only as a general guide to the potential of a business. They should resist placing too much weight on any particular figure or trend. Many factors must be considered simultaneously before making any judgments. Furthermore, the analysis techniques discussed in this chapter are all based on historical in- formation. Future events and unanticipated changes in conditions will also influence a com- pany’s operating results.

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Different Industries Different industries may be affected by unique social policies, special accounting proce- dures, or other individual industry attributes. Ratios of companies in different industries are not comparable without considering industry characteristics. A high debt to assets ratio is more acceptable in some industries than others. Even within an industry, a particular business may require more or less working capital than the industry average. If so, the work- ing capital and quick ratios would mean little compared to those of other firms, but may still be useful for trend analysis.

Because of industry-specific factors, most professional analysts specialize in one, or only a few, industry. Financial institutions such as brokerage houses, banks, and insur- ance companies typically employ financial analysts who specialize in areas such as min- eral or oil extraction, chemicals, banking, retail, insurance, bond markets, or automobile manufacturing.

Changing Economic Environment When comparing firms, analysts must be alert to changes in general economic trends from year to year. Significant changes in fuel costs and interest rates in recent years make old rule-of-thumb guidelines for evaluating these factors obsolete. In addition, the presence or absence of inflation affects business prospects.

Accounting Principles Financial statement analysis is only as reliable as the data on which it is based. Al- though most firms follow generally accepted accounting principles, a wide variety of acceptable accounting methods is available from which to choose, including different inventory and depreciation methods, different schedules for recognizing revenue, and

The single most important source of financial information is a company’s annual report, but decision makers should also con- sider other sources. Interested persons can access quarterly and annual reports through the SEC’s EDGAR database and often from company websites as well. Many companies will provide printed versions of these reports upon request. Companies also post in- formation on their websites that is not included in their annual reports. For example, some automobile companies provide very detailed production data through their corporate websites.

Users can frequently obtain information useful in analyz- ing a particular company from independent sources as well as from the company itself. For example, the websites of popular news services, such as CNN (www.money.cnn.com) and CNBC (www.cnbc.com) provide archived news stories and indepen- dent financial information about many companies. The web- sites of brokerage houses like www.schwab.com offer free financial information about companies. Finally, libraries often subscribe to independent services that evaluate companies as potential investments. One example worth reviewing is Value Line Investment Survey.

REALITY BYTES

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different ways to account for oil and gas exploration costs. Analyzing statements of companies that seem identical may produce noncomparable ratios if the companies have used different accounting methods. Analysts may seek to improve comparability by trying to recast different companies’ financial statements as if the same accounting methods had been applied.

Accrual accounting requires the use of many estimates; bad debt expense, warranty expense, asset lives, and salvage value are just a few. The reliability of the resulting financial reports depends on the expertise and integrity of the persons who make the estimates.

The quality and usefulness of accounting information are influenced by underlying ac- counting concepts. Two particular concepts, conservatism and historical cost, have a tre- mendous impact on financial reporting. Conservatism dictates recognizing estimated losses as soon as they occur, but gain recognition is almost always deferred until the gains are actu- ally realized. Conservatism produces a negative bias in financial statements. There are per- suasive arguments for the conservatism principle, but users should be alert to distortions it may cause in accounting information.

The pervasive use of the historical cost concept is probably the greatest single cause of distorted financial statement analysis results. The historical cost of an asset does not repre- sent its current value. The asset purchased in 2010 for $10,000 is not comparable in value to the asset purchased in 2015 for $10,000 because of changes in the value of the dollar. Using historical cost produces financial statements that report dollars with differing purchasing power in the same statement. Combining these differing dollar values is akin to adding miles to kilometers. To get the most from analyzing financial statements, users should be cogni- zant of these limitations.

CHECK YOURSELF 13.3

The return on equity for Gup Company and Hunn Company is 23.4 percent and 17 percent, respectively. Does this mean Gup Company is better managed than Hunn Company?

Answer No single ratio can adequately measure management performance. Even analyzing a wide range of ratios provides only limited insight. Any useful interpretation requires the analyst to recognize the limitations of ratio analysis. For example, ratio norms typically differ between industries and may be affected by temporary economic factors. In addition, companies’ use of different accounting practices and procedures produces different ratio results even when underlying circumstances are comparable.

<< A Look Back

Financial statement analysis involves many factors, among them user characteristics, infor- mation needs for particular types of decisions, and how financial information is analyzed. Analytical techniques include horizontal, vertical, and ratio analysis. Users commonly cal- culate ratios to measure a company’s liquidity, solvency, and profitability. The specific ratios presented in this chapter are summarized in Exhibit 13.6. Although ratios are easy to calcu- late and provide useful insights into business operations, when interpreting analytical re- sults, users should consider limitations resulting from differing industry characteristics, differing economic conditions, and the fundamental accounting principles used to produce reported financial information.

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Video lectures and accompanying self-assessment quizzes are available in Connect

for all learning objectives.

SELF-STUDY REVIEW PROBLEM

Financial statements for Stallings Company follow:

Balance Sheets As of December 31

2018 2017

Assets Current assets Cash $ 6,500 $ 11,500 Accounts receivable 51,000 49,000 Inventories 155,000 147,500 Total current assets 212,500 208,000 Plant and equipment (net) 187,500 177,000 Total assets $400,000 $385,000

Liabilities and Stockholders’ Equity Liabilities Current liabilities Accounts payable $ 60,000 $ 81,500 Other 25,000 22,500 Total current liabilities 85,000 104,000 Bonds payable 100,000 100,000 Total liabilities 185,000 204,000 Stockholders’ equity Common stock (50,000 shares, $3 par) 150,000 150,000 Paid-in capital in excess of par 20,000 20,000 Retained earnings 45,000 11,000 Total stockholders’ equity 215,000 181,000 Total liabilities and stockholders’ equity $400,000 $385,000

Income Statement For the Years Ended December 31

2018 2017

Revenues Net sales $ 315,000 $ 259,000 Expenses Cost of goods sold (189,000) (154,000) Selling, general, and administrative expenses (54,000) (46,000) Interest expense (4,000) (4,500) Income before taxes 68,000 54,500 Income tax expense (40%) (27,200) (21,800) Net income $ 40,800 $ 32,700

Required

a. Use horizontal analysis to determine which expense item increased by the highest percentage from 2017 to 2018.

b. Use vertical analysis to determine whether the inventory balance is a higher percentage of total assets in 2017 or 2018.

c. Calculate the following ratios for 2017 and 2018. When data limitations prohibit computing aver- ages, use year-end balances in your calculations.

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(1) Net margin (2) Return on investment (3) Return on equity (4) Earnings per share (5) Price-earnings ratio (market price per share at the end of

2018 and 2017 was $12.04 and $8.86, respectively) (6) Book value per share of common stock (7) Times interest earned (8) Working capital (9) Current ratio (10) Acid-test ratio (11) Accounts receivable turnover (12) Inventory turnover (13) Debt to equity

Solution to Requirement a Income tax expense increased by the greatest percentage. Computations follow:

Cost of goods sold ($189,000 – $154,000) ÷ $154,000 = 22.73% Genera1, selling, and administrative ($54,000 – $46,000) ÷ $46,000 = 17.39% Interest expense decreased. Income tax expense ($27,200 – $21,800) ÷ $21,800 = 24.77%

Solution to Requirement b

2017: $147,500 ÷ $385,000 = 38.31% 2018: $155,000 ÷ $400,000 = 38.75% Inventory is slightly larger relative to total assets in 2018.

Solution to Requirement c

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

13. $204,000 $181,000

� 112.71% $185,000 $215,000

� 86.05% Total liabilities

Total stockholders’ equity

$154,000 $147,500

� 1.04 times $189,000 $151,250

� 1.25 times Cost of goods sold Average inventory

$259,000 $49,000

� 5.29 times $315,000 $50,000

� 6.3 times Net credit sales

Average accounts receivable

$60,500 $104,000

� 0.58:1 $57,500 $85,000

� 0.68:1 Quick assets

Current liabilities

$208,000 $104,000

� 2:1 $212,500 $85,000

� 2.5:1 Current assets

Current liabilities

$208,000 � $104,000 � $104,000$212,500 � $85,000 � $127,500Current assets � Current liabilities

$32,700 � $21,800 � $4,500 $4,500

� 13.1 times $40,800 � $27,200 � $4,000

$4,000 � 18 times

Net income � Taxes � Interest expense Interest expense

$181,000 50,000 shares

� $3.62 $215,000

50,000 shares � $4.30

Stockholders’ equity � Preferred rights Outstanding common shares

$8.86 $0.654

� 13.55 times $12.04 $0.816

� 14.75 times Market price per share

Earnings per share

$32,700 50,000 shares

� $0.654 $40,800

50,000 shares � $0.816

Net income Average common shares outstanding

$32,700 $181,000

� 18.07% $40,800

$198,000 � 20.61%

Net income Average total stockholders’ equity

$32,700 $385,000

� 8.49% $40,800

$392,500 � 10.39%

Net income Average total assets

$32,700 $259,000

� 12.63% $40,800

$315,000 � 12.95%

Net income Net sales

20172018

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Absolute amounts 593 Accounts receivable

turnover 599 Acid-test ratio 598 Asset turnover ratio 604 Average days to collect

accounts receivables (average collection period) 600

Average days to sell inventory (average days in inventory) 600

Book value per share 606 Current ratio (working

capital ratio) 598 Debt to assets ratio 601 Debt to equity ratio 601 Dividend yield 607 Earnings per share

(EPS) 606 Horizontal analysis 593 Information overload 592 Inventory turnover 600 Liquidity ratios 597

Materiality 593 Net margin 603 Number of times interest

is earned 601 Percentage analysis 594 Plant assets to long-term

liabilities 603 Price-earnings (P/E)

ratio 606 Profitability ratios 603 Quick ratio 598 Ratio analysis 596

Return on assets 604 Return on equity

(ROE) 605 Return on investment

(ROI) 604 Solvency ratios 601 Trend analysis 593 Vertical analysis 596 Working capital 597 Working capital

ratio 598

KEY TERMS

1. Why are ratios and trends used in financial analysis?

2. What do the terms liquidity and solvency mean?

3. What is apparent from a horizontal presentation of financial statement information? A vertical presentation?

4. What is the significance of inventory turnover, and how is it calculated?

5. What is the difference between the current ratio and the quick ratio? What does each measure?

6. Why are absolute amounts of limited use when comparing companies?

7. What is the difference be- tween return on investment and return on equity?

8. Which ratios are used to measure long-term

debt-paying ability? How is each calculated?

9. What are some limitations of the earnings per share figure?

10. What is the formula for calculating return on investment (ROI)?

11. What is information overload?

12. What is the price-earnings ratio? Explain the differ- ence between it and the dividend yield.

13. What environmental factors must be considered in analyzing companies?

14. How do accounting principles affect financial statement analysis?

QUESTIONS

MULTIPLE-CHOICE QUESTIONS

Multiple-choice questions are available in Connect.

All applicable Exercises in Series A are available in Connect.

Exercise 13-1A Horizontal analysis

Winthrop Corporation reported the following operating results for two consecutive years:

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EXERCISES—SERIES A

2018 2017 Percentage Change

Sales $1,200,000 $1,000,000 Cost of goods sold     720,000    640,000 Gross margin $ 480,000 $ 360,000 Operating expenses     200,000    160,000 Income before taxes $ 280,000 $ 200,000 Income taxes      56,000      40,000 Net income $ 224,000 $ 160,000

Required

a. Compute the percentage changes in Winthrop Corporation’s income statement components be- tween the two years. Round percentages to one decimal point.

b. Comment on apparent trends revealed by the percentage changes computed in Requirement a.

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Exercise 13-2A Vertical analysis

Sharma Company reported the following operating results for two consecutive years:

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2018 Amount Percentage of Sales

Sales $ 800,000 Cost of goods sold      450,000 Gross margin on sales 350,000 Operating expenses 100,000 Income before taxes 250,000 Income taxes 50,000 Net income $ 200,000

2019 Amount Percentage of Sales

Sales $1,000,000 Cost of goods sold 590,000 Gross margin on sales      410,000 Operating expenses      120,000 Income before taxes      290,000 Income taxes       60,000 Net income $ 230,000

Required

Express each income statement component for each of the two years as a percentage of sales. Round percentages to one decimal point.

Exercise 13-3A Horizontal and vertical analysis

Income statements for Burch Company for 2018 and 2019 follow:

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2019 2018

Sales $240,000 $200,000 Cost of goods sold 180,000    124,000 Selling expenses 26,000     20,000 Administrative expenses 12,000     18,000 Interest expense       7,500       8,000 Total expenses $225,500 $170,000 Income before taxes     14,500     30,000 Income taxes expense      1,200      3,000 Net income $  13,300 $  27,000

Required

Round all percentages to one decimal point.

a. Perform a horizontal analysis, showing the percentage change in each income statement compo- nent between 2018 and 2019.

b. Perform a vertical analysis, showing each income statement component as a percentage of sales for each year.

Exercise 13-4A Inventory turnover

Selected financial information for Edwards Company for 2019 follows:

LO 13-2

Sales $800,000 Cost of goods sold   500,000 Merchandise inventory Beginning of year       37,500 End of year       42,500

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Financial Statement Analysis 615

Required

Assuming that the merchandise inventory buildup was relatively constant, how many times did the merchandise inventory turn over during 2019?

Exercise 13-5A Current ratio

Swartz Corporation wrote off a $1,600 uncollectible account receivable against the $48,000 balance in its allowance account.

Required

Explain the effect of the write-off on Swartz’s current ratio.

LO 13-2

Exercise 13-6A Working capital and current ratio

On June 30, 2018, Franza Company’s total current assets were $900,000 and its total current liabilities were $360,000. On July 1, 2018, Franza issued a short-term note to a bank for $72,000 cash.

Required

a. Compute Franza’s working capital before and after issuing the note. b. Compute Franza’s current ratio before and after issuing the note. Round ratios to two decimal points.

LO 13-2

Exercise 13-7A Working capital and current ratio

On June 30, 2018, Franza Company’s total current assets were $900,000 and its total current liabilities were $360,000. On July 1, 2018, Franza issued a long-term note to a bank for $72,000 cash.

Required

Round computations to one decimal point.

a. Compute Franza’s working capital before and after issuing the note. b. Compute Franza’s current ratio before and after issuing the note.

LO 13-2

Exercise 13-8A Ratio analysis

The balance sheet for Shankland Corporation follows:

LO 13-2, 13-3

Current assets $ 600,000 Long-term assets (net) 1,900,000 Total assets $2,500,000 Current liabilities $ 400,000 Long-term liabilities 1,200,000 Total liabilities 1,600,000 Common stock and retained earnings 900,000 Total liabilities and stockholders’ equity $2,500,000

Required

Compute the following and round ratios to one decimal point:

Working capital Current ratio Debt to assets ratio Debt to equity ratio

Exercise 13-9A Comprehensive analysis

The December 31, 2019, balance sheet for Burdette Corporation is presented here. These are the only accounts on Burdette’s balance sheet. Amounts indicated by question marks (?) can be calculated us- ing the following additional information:

LO 13-2, 13-3

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616 Chapter 13

Required

Determine the following:

a. The balance in trade accounts payable as of December 31, 2019. b. The balance in retained earnings as of December 31, 2019. c. The balance in the inventory account as of December 31, 2019. (Assume that the level of inven-

tory did not change from last year.)

Assets

Cash $ 30,000 Accounts receivable (net) ? Inventory ? Property, plant, and equipment (net) 352,800 $ 518,400

Liabilities and Stockholders’ Equity

Accounts payable (trade) $ ? Income taxes payable (current) 30,000 Long-term debt ? Common stock 360,000 Retained earnings               ? $ ?

Additional Information

Current ratio (at year end) 1.5 to 1.0 Total liabilities ÷ Total stockholders’ equity 80% Gross margin percentage 30% Inventory turnover (Cost of goods sold ÷ Ending inventory) 10.5 times Gross margin for 2019 $ 378,000

Exercise 13-10A Number of times interest earned

The following data come from the financial records of Fargo Corporation for 2018:

LO 13-3

Sales $640,000 Interest expense       6,000 Income tax expense      12,000 Net income     42,000

Required

How many times was interest earned in 2018?

Balance Sheets As of December 31

2018 2017

Accounts receivable $600,000 $480,000 Allowance for doubtful accounts    (40,000) (20,000) Net accounts receivable $560,000 $460,000 Inventories, lower of cost or market $500,000 $400,000

Exercise 13-11A Accounts receivable turnover, inventory turnover, and net margin

Selected data from Emporia Company follow:

LO 13-2, 13-4

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Financial Statement Analysis 617

Required

Compute the following and round computations to two decimal points:

a. The accounts receivable turnover for 2018. b. The inventory turnover for 2018. c. The net margin for 2017.

Income Statement For the Years Ended December 31

2018 2017

Net credit sales $2,400,000 $1,950,000 Net cash sales 600,000 450,000 Net sales 3,000,000 2,400,000 Cost of goods sold 1,800,000 1,520,000 Selling, general, and administrative expenses 300,000 240,000 Other expenses 80,000 50,000 Total operating expenses $2,180,000 $1,810,000

Exercise 13-12A Ratio analysis

During 2018, Blue Ridge Corporation reported after-tax net income of $4,150,000. During the year, the number of shares of stock outstanding remained constant at 15,000 of $100 par, 9 percent preferred stock and 400,000 shares of common stock. The company’s total stockholders’ equity is $20,000,000 at De- cember 31, 2018. Blue Ridge Corporation’s common stock was selling at $80 per share at the end of its fiscal year. All dividends for the year have been paid, including $4.80 per share to common stockholders.

Required

Compute the following by rounding to two decimal points:

a. Earnings per share. b. Book value per share of common stock. c. Price-earnings ratio. d. Dividend yield.

LO 13-5

Exercise 13-13A Ratio analysis

Compute the specified ratios using Duluth Company’s balance sheet for 2018:

LO 13-2, 13-3, 13-4, 13-5

Assets

Cash $ 36,000 Marketable securities 24,000 Accounts receivable 50,000 Inventory 44,000 Property and equipment 320,000 Accumulated depreciation (74,000) Total assets $400,000

Liabilities and Stockholders’ Equity

Accounts payable $ 23,000 Current notes payable 7,000 Mortgage payable 8,000 Bonds payable 43,000 Common stock 200,000 Retained earnings 119,000 Total liabilities and stockholders’ equity $400,000

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618 Chapter 13

The average number of common stock shares outstanding during 2018 was 880 shares. Net income for the year was $40,000.

Required

Compute each of the following and round computations to two decimal points:

a. Current ratio. b. Earnings per share. c. Quick (acid-test) ratio. d. Return on investment. e. Return on equity. f. Debt to equity ratio.

Exercise 13-14A Ratio analysis

Required

Match each of the following ratios with the formula used to compute it:

LO 13-2, 13-3, 13-4 ,13-5

1. Working capital 2. Current ratio 3. Quick ratio 4. Accounts receivable turnover 5. Average days to collect 6. Inventory turnover

7. Average days to sell inventory

8. Debt to assets ratio 9. Debt to equity ratio 10. Return on investment 11. Return on equity 12. Earnings per share

a. Net income ÷ Average total stockholders’ equity b. Cost of goods sold ÷ Average inventory c. Current assets – Current liabilities d. 365 ÷ Inventory turnover e. Net income ÷ Average total assets f. (Net income – Preferred dividends) ÷ Average

outstanding common shares g. (Current assets – Inventory – Prepaid expenses) ÷

Current liabilities h. Total liabilities ÷ Total assets i. 365 ÷ Accounts receivable turnover j. Total liabilities ÷ Total stockholders’ equity k. Net credit sales ÷ Average accounts receivables l. Current assets ÷ Current liabilities

Exercise 13-15A Comprehensive analysis

Required

Indicate the effect of each of the following transactions on (1) the current ratio, (2) working capital, (3) stockholders’ equity, (4) book value per share of common stock, and (5) retained earnings. Assume that the current ratio is greater than 1:1.

a. Collected account receivable. b. Wrote off account receivable. c. Converted a short-term note payable to a long-term note payable. d. Purchased inventory on account. e. Declared cash dividend. f. Sold merchandise on account at a profit. g. Issued stock dividend. h. Paid account payable. i. Sold building at a loss.

LO 13-2, 13-3, 13-4, 13-5

PROBLEMS—SERIES A

All applicable Problems in Series A are available in Connect.

Problem 13-16A Vertical analysis

The following percentages apply to Thornton Company for 2018 and 2019:

LO 13-1

G A T E S , D E A N D R A 1 1 2 3 T S

Financial Statement Analysis 619

Required

Assuming that sales were $800,000 in 2019 and $960,000 in 2019, prepare income statements for the two years.

2019 2018

Sales 100.0% 100.0%  Cost of goods sold 61.0 64.0 Gross margin 39.0 36.0 Selling and administrative expense 26.5 20.5 Interest expense 2.5 2.0 Total expenses 29.0 22.5 Income before taxes 10.0 13.5 Income tax expense 5.5 7.0 Net income 4.5% 6.5%

CHECK FIGURES NI of 2019: $43,200 Total expenses of 2018: $180,000

Problem 13-17A Horizontal analysis

Financial statements for Allendale Company follow:

LO 13-1

CHECK FIGURES Total assets: +11.1% Total liabilities: +14.4%ALLENDALE COMPANY

Balance Sheets As of December 31

2019 2018 Assets Current assets Cash $ 40,000 $ 36,000 Marketable securities 20,000 6,000 Accounts receivable (net) 54,000 46,000 Inventories 135,000 143,000 Prepaid items 25,000 10,000 Total current assets 274,000 241,000 Investments 27,000 20,000 Plant (net) 270,000 255,000 Land    29,000 24,000 Total assets $600,000 $540,000

Liabilities and Stockholders’ Equity Liabilities Current liabilities Notes payable $ 17,000 $ 6,000 Accounts payable 113,800 100,000 Salaries payable 21,000 15,000 Total current liabilities 151,800 121,000 Noncurrent liabilities Bonds payable 100,000 100,000 Other 32,000 27,000 Total noncurrent liabilities 132,000 127,000 Total liabilities 283,800 248,000 Stockholders’ equity Preferred stock (par value $10, 4% cumulative, nonparticipating; 8,000 shares authorized and issued) 80,000 80,000 Common stock (no par; 50,000 shares authorized; 10,000 shares issued) 80,000 80,000 Retained earnings 156,200 132,000 Total stockholders’ equity 316,200 292,000 Total liabilities and stockholders’ equity $600,000 $540,000

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620 Chapter 13

Required

Prepare a horizontal analysis of the balance sheet and income statement for 2019 and 2018. Round percentages to one decimal point.

Problem 13-18A Vertical analysis

Required

Use the financial statements for Allendale Company from Problem 13-17A to perform a vertical analysis of both the balance sheets and income statements for 2019 and 2018. Round computations to two decimal points.

Problem 13-19A Effect of transactions on current ratio and working capital

Riley Manufacturing has a current ratio of 3:1 on December 31, 2018. Indicate whether each of the following transactions would increase (+), decrease (−), or have no effect (NA) on Riley’s current ratio and its working capital.

Required

a. Paid cash for a trademark. b. Wrote off an uncollectible account receivable. c. Sold equipment for cash. d. Sold merchandise at a profit (cash). e. Declared a cash dividend. f. Purchased inventory on account. g. Scrapped a fully depreciated machine (no gain or loss). h. Issued a stock dividend. i. Purchased a machine with a long-term note. j. Paid a previously declared cash dividend. k. Collected accounts receivable. l. Invested in current marketable securities.

LO 13-1

CHECK FIGURE 2019 Retained earnings: 26.03%

LO 13-2

ALLENDALE COMPANY Statements of Income and Retained Earnings

For the Years Ended December 31

2019 2018

Revenues Sales (net) $230,000 $210,000 Other revenues 8,000 5,000 Total revenues 238,000  215,000 Expenses Cost of goods sold 120,000 103,000 Selling, general, and administrative 55,000 50,000 Interest expense 8,000 7,200 Income tax expense 23,000 22,000 Total expenses  206,000 182,200 Net earnings (net income) 32,000 32,800 Retained earnings, January 1 132,000 107,000 Less: Preferred stock dividends 3,200 3,200 Common stock dividends 4,600      4,600 Retained earnings, December 31 $156,200 $132,000

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Financial Statement Analysis 621

Problem 13-20A Supply missing balance sheet numbers

The bookkeeper for Packard’s Country Music Bar left this incomplete balance sheet. Packard’s work- ing capital is $90,000 and its debt to assets ratio is 40 percent.

LO 13-2, 13-3

CHECK FIGURES d: $337,500 f: $97,500

Assets

Current assets Cash $ 21,000 Accounts receivable 42,000 Inventory (A) Prepaid expenses 9,000  Total current assets (B) Long-term assets Building (C) Less: Accumulated depreciation (39,000) Total long-term assets 210,000 Total assets $ (D)

Liabilities and Stockholders’ Equity

Liabilities Current liabilities Accounts payable $ (E) Notes payable 12,000 Income tax payable  10,500 Total current liabilities 37,500 Long-term liabilities Mortgage payable (F) Total liabilities (G) Stockholders’ equity Common stock 105,000 Retained earnings (H) Total stockholders’ equity (I) Total liabilities and stockholders’ equity $ (J)

Earnings (net income) $ 97,800 Preferred stock (13,200 shares at $25 par, 4%) $330,000 Common stock (45,000 shares no par, market value $28) 255,000 Retained earnings    281,250 $866,250 Less: Treasury stock Preferred (1,800 shares) $27,000 Common (1,800 shares)  12,000 39,000 Total stockholders’ equity $827,250

Required

Complete the balance sheet by supplying the missing amounts.

Problem 13-21A Ratio analysis

Selected data for Dalton Company for 2018 and additional information on industry averages follow:

LO 13-5

CHECK FIGURE Earnings per share: $2

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622 Chapter 13

Required

a. Calculate and compare Dalton Company’s ratios with the industry averages. b. Discuss factors you would consider in deciding whether to invest in the company.

Problem 13-22A Ratio analysis

Otis Company’s income statement information follows:

LO 13-3, 13-4, 13-5

CHECK FIGURES a. 2018: 13.33 times c. 2018: 7.58 times

2018 2017

Net sales $480,000 $320,000 Income before interest and taxes 120,000 98,000 Net income after taxes 81,000 72,000 Interest expense 9,000 8,000 Stockholders’ equity, December 31 (2016: $200,000) 300,000 240,000 Common stock, December 31 240,000 200,000

2019 2018

Revenues Net sales $420,000 $350,000 Other revenues 16,000      10,000 Total revenues 436,000 360,000 Expenses Cost of goods sold 252,000 206,000 Selling expenses 42,000 38,000 General and administrative expenses 22,000 20,000 Interest expense 6,000 6,000 Income tax expense 42,000 36,000 Total expenses 364,000 306,000 Net income $ 72,000 $ 54,000

continued

The average number of shares outstanding was 9,600 for 2018 and 8,000 for 2017.

Required

Compute the following ratios for Otis for 2018 and 2017 and round the computation to two decimal points:

a. Number of times interest was earned. b. Earnings per share based on the average number of shares outstanding. c. Price-earnings ratio (market prices: 2018, $64 per share; 2017, $78 per share). d. Return on average equity. e. Net margin.

Problem 13-23A Ratio analysis

The following financial statements apply to Karl Company:

LO 13-2, 13-3, 13-4, 13-5

CHECK FIGURES d. 2019: $0.72 k. 2018: 5.47 times

Industry averages Earnings per share $ 2.60  Price-earnings ratio 9.50  Return on equity 11.20%

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Financial Statement Analysis 623

Required

Calculate the following ratios for 2018 and 2019. When data limitations prohibit computing averages, use year-end balances in your calculations. Round computations to two decimal points.

a. Net margin. b. Return on investment. c. Return on equity. d. Earnings per share. e. Price-earnings ratio (market prices at the end of 2018 and 2019 were $11.88 and $9.54, respectively). f. Book value per share of common stock. g. Times interest earned. h. Working capital. i. Current ratio. j. Quick (acid-test) ratio. k. Accounts receivable turnover. l. Inventory turnover.

m. Debt to equity ratio. n. Debt to assets ratio.

Problem 13-24A Ratio analysis

Required

Use the financial statements for Allendale Company from Problem 13-17A to calculate the following ratios for 2019 and 2018:

a. Working capital. b. Current ratio.

LO 13-2, 13-3, 13-4, 13-5

CHECK FIGURES k. 2019: 2.0:1 p. 2018: $2.96

2019 2018

Assets Current assets Cash $ 8,000 $ 16,000 Marketable securities 2,000 2,000 Accounts receivable 70,000 64,000 Inventories 200,000 192,000 Prepaid expenses 6,000      4,000 Total current assets 286,000 278,000 Plant and equipment (net) 210,000 210,000 Intangibles 40,000 0 Total assets $536,000 $488,000

Liabilities and Stockholders’ Equity Liabilities Current liabilities Accounts payable $ 80,000 $108,000 Other 34,000 30,000 Total current liabilities 114,000 138,000 Bonds payable    132,000    134,000 Total liabilities 246,000 272,000 Stockholders’ equity Common stock (100,000 shares) 230,000 230,000 Retained earnings 60,000   (14,000) Total stockholders’ equity 290,000 216,000 Total liabilities and stockholders’ equity $536,000 $488,000

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624 Chapter 13

c. Quick ratio. d. Receivables turnover (beginning receivables at January 1, 2018, were $47,000). e. Average days to collect accounts receivable. f. Inventory turnover (beginning inventory at January 1, 2018, was $140,000). g. Number of days to sell inventory. h. Debt to assets ratio. i. Debt to equity ratio. j. Number of times interest was earned. k. Plant assets to long-term debt. l. Net margin.

m. Turnover of assets. n. Return on investment. o. Return on equity. p. Earnings per share. q. Book value per share of common stock. r. Price-earnings ratio (market price per share: 2018, $11.75; 2019, $12.50). s. Dividend yield on common stock.

EXERCISES—SERIES B

Exercise 13-1B Horizontal analysis

Haskell Corporation reported the following operating results for two consecutive years.

LO 13-1

2019 2018 Percentage Change

Sales $550,000 $500,000 Cost of goods sold 327,600 312,000 Gross margin 222,400 188,000 Operating expenses    87,400    76,000 Income before taxes 135,000 112,000 Income taxes 34,000 24,000 Net income $101,000 $  88,000

Required

a. Compute the percentage changes in Haskell Corporation’s income statement components for the two years. Round percentages to one decimal point.

b. Comment on apparent trends revealed by the percentage changes computed in Requirement a.

Exercise 13-2B Vertical analysis

Sperry Company reported the following operating results for two consecutive years.

LO 13-1

2018 Amount Percentage of Sales

Sales $250,000 Cost of goods sold 150,000 Gross margin 100,000 Operating expenses 30,000 Income before taxes 70,000 Income taxes 14,000 Net income $ 56,000

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Financial Statement Analysis 625

Required

Express each income statement component for each of the two years as a percentage of sales. Round percentages to one decimal point.

Exercise 13-3B Horizontal and vertical analysis

Alpena Company reported the following operating results for 2019 and 2018.

LO 13-1

2019 Amount Percentage of Sales

Sales $300,000 Cost of goods sold  192,000 Gross margin  108,000 Operating expenses    32,000 Income before taxes    76,000 Income taxes    16,000 Net income $ 60,000

2019 2018

Sales $250,000 $240,000 Cost of goods sold  132,500 129,600 Selling expenses 15,250 14,400 Administrative expenses 19,000 16,800 Interest expense 7,000 8,400 Total expenses 173,750  169,200 Income before taxes 76,250 70,800 Income taxes expense 19,250    17,700 Net income $ 57,000 $ 53,100

Sales $3,200,000 Cost of goods sold 2,100,000 Merchandise inventory Beginning of year 350,000 End of year 490,000

Required

Round percentages to one decimal point.

a. Perform a horizontal analysis, showing the percentage change in each income statement compo- nent between 2019 and 2018.

b. Perform a vertical analysis, showing each income statement component as a percent of sales for each year.

Exercise 13-4B Inventory turnover

Selected financial information for Purdy Company for 2019 follows.

LO 13-2

Required

Assuming that the merchandise inventory buildup was relatively constant, how many times did the merchandise inventory turn over during 2019?

Exercise 13-5B Current ratio

Bruno Corporation purchased $480 of merchandise on account.

Required

Explain the effect of the purchase on Bruno’s current ratio.

LO 13-2

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626 Chapter 13

Exercise 13-6B Working capital and current ratio

On October 31, 2019, Corona Company’s total current assets were $160,000 and its total current liabili- ties were $40,000. On November 1, 2019, Corona purchased marketable securities for $20,000 cash.

Required

a. Compute Corona’s working capital before and after the securities purchase. b. Compute Corona’s current ratio before and after the securities purchase.

Exercise 13-7B Working capital and current ratio

On October 31, 2019, Corona Company’s total current assets were $160,000 and its total current liabili- ties were $40,000. On November 1, 2019, Corona bought manufacturing equipment for $20,000 cash.

Required

a. Compute Corona’s working capital before and after the equipment purchase. b. Compute Corona’s current ratio before and after the equipment purchase.

Exercise 13-8B Ratio analysis

Balance sheet data for the Beech Corporation follows.

LO 13-2

LO 13-2

LO 13-2, 13-3

Current assets $ 80,000 Long-term assets (net) 320,000 Total assets $400,000 Current liabilities $ 36,000 Long-term liabilities 144,000 Total liabilities 180,000 Common stock and retained earnings 220,000 Total liabilities and stockholders’ equity $ 400,00

Assets

Cash $ 15,000 Accounts receivable (net) ? Inventory ? Property, plant, and equipment (net)  278,000 $ ?

Liabilities and Stockholders’ Equity

Accounts payable (trade) $ 26,000 Income taxes payable (current) 14,000 Long-term debt ? Common stock $160,000 Retained earnings ? $ ?

continued

Required

Compute the following and round computations to one decimal point.

a. Working capital b. Current ratio c. Debt to assets ratio d. Debt to equity ratio

Exercise 13-9B Comprehensive analysis

December 31, 2019, balance sheet data for Hestand Company follow. All accounts are represented. Amounts indicated by question marks (?) can be calculated using the following additional information.

LO 13-2, 13-3

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Financial Statement Analysis 627

Required

Determine the following:

a. The balance in accounts receivable as of December 31, 2019. b. The turnover of assets for 2019. c. The balance of long-term debt as of December 31, 2019. d. The balance in retained earnings as of December 2019.

Exercise 13-10B Number of times interest earned

The following data come from the financial records of Welch Corporation for 2018.

LO 13-3

Additional Information

Quick ratio (at year end) 1.3 to 1 Working capital $42,000 Inventory turnover (cost of goods sold ÷ ending inventory) 12 times Debt to equity ratio 80% Gross margin for 2019 $126,000

Sales $320,000 Interest expense 9,000 Income tax 36,000 Net income 99,000

Balance Sheet Data As of December 31

2019 2018

Accounts receivable $360,000 $320,000 Allowance for doubtful accounts    (30,000)    (20,000) Net accounts receivable $330,000 $300,000 Inventories, lower of cost or market $225,000 $250,000

Income Statement Data Year Ended December 31

2019 2018

Net credit sales $2,500,000 $1,800,000 Net cash sales 500,000 400,000 Net sales $3,000,000 $2,200,000 Cost of goods sold $1,750,000 $1,300,000 Selling, general, and administrative expenses 300,000 160,000 Other expenses 150,000 120,000 Total operating expenses $2,200,000 $1,580,000

Required

How many times was interest earned in 2018?

Exercise 13-11B Accounts receivable turnover, inventory turnover, and net margin

Selected data from Goode Company follow.

LO 13-2, 13-4

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628 Chapter 13

Required

Compute the following and round computations to two decimal points. a. The accounts receivable turnover for 2019. b. The inventory turnover for 2019. c. The net margin for 2018.

Exercise 13-12B Ratio analysis

During 2019, Roper Corporation reported net income after taxes of $1,200,000. During the year, the number of shares of stock outstanding remained constant at 20,000 shares of $100 par, 8 percent pre- ferred stock and 200,000 shares of common stock. The company’s total equities at December 31, 2019, were $3,500,000, which included $640,000 of liabilities. The common stock was selling for $40 per share at the end of the year. All dividends for the year were declared and paid, including $3.60 per share to common stockholders.

Required

Compute the following and round computations to two decimal points. a. Earnings per share b. Book value per share c. Price-earnings ratio d. Dividend yield

Exercise 13-13B Ratio analysis

Compute the specified ratios using the following December 31, 2018, statement of financial position for Palmer Company.

LO 13-5

LO 13-2, 13-3, 13-4, 13-5

Assets

Cash $110,000  Marketable securities 10,000  Accounts receivable 120,000  Inventory 160,000  Property and equipment 250,000  Accumulated depreciation (50,000) Total assets $600,000 

Liabilities and Stockholders’ Equity

Accounts payable $ 86,000  Current notes payable 4,000  Mortgage payable 130,000  Bonds payable 82,000  Common stock 200,000  Retained earnings    98,000  Total liabilities and stockholders’ equity $600,000 

The average number of common shares outstanding during 2018 was 1,500. Net income for the year was $60,000.

Required

Compute each of the following and round computations to two decimal points. a. Current ratio b. Earnings per share c. Acid-test ratio d. Return on investment e. Return on equity f. Debt to equity ratio

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Financial Statement Analysis 629

Exercise 13-14B Ratio analysis

Match each of the following ratios with its formula.

LO 13-2, 13-3, 13-4, 13-5

_______ 1. Price-earnings ratio _______ 2. Dividend yield _______ 3. Book value per share _______ 4. Plant assets to long-term liabilities

_______ 5. Times interest earned

_______ 6. Earnings per share _______ 7. Net margin _______ 8. Debt to equity ratio _______ 9. Current ratio _______ 10. Turnover of assets _______ 11. Days to collect A/R _______ 12. Number of days to sell inventory

a. Total liabilities ÷ Total stockholders’ equity b. Current assets ÷ Current liabilities c. 365 ÷ Accounts receivable turnover d. (Net income − Preferred dividends) ÷ Average

outstanding common shares e. (Stockholders’ equity − Preferred rights) ÷

Outstanding common shares f. 365 ÷ Inventory turnover g. Dividends per share ÷ Market price per share h. Net plant assets ÷ Long-term liabilities i. Market price per share ÷ Earnings per share j. Net income ÷ Net sales k. Net sales ÷ Average total assets l. Income before taxes and interest expense ÷

Interest expense

Exercise 13-15B Comprehensive analysis

The following is a list of transactions.

a. Paid cash for short-term marketable securities. b. Purchased a computer, issuing a short-term note for the purchase price. c. Purchased factory equipment, issuing a long-term note for the purchase price. d. Sold merchandise on account at a profit. e. Paid cash on accounts payable. f. Received cash from issuing common stock. g. Sold a factory for cash at a profit. h. Purchased raw materials on account. i. Paid cash for property taxes on administrative buildings.

Required

Indicate the effect of each of the preceding transactions on (a) the quick ratio, (b) working capital, (c) stockholders’ equity, (d) the debt/equity ratio, and (e) retained earnings. Assume that the current ratio is greater than 1:1.

LO 13-2, 13-3, 13-4, 13-5

PROBLEMS—SERIES B

Problem 13-16B Vertical analysis

Burton Corporation’s controller has prepared the following vertical analysis for the president:

LO 13-1

2019 2018

Sales 100.0% 100.0% Cost of goods sold 57.0 54.0 Gross margin 43.0 46.0 Selling and administrative expense 18.0 20.0 Interest expense 2.8 4.0 Total expenses 20.8 24.0 Income before taxes 22.2 22.0 Income tax expense 10.0 8.0 Net income 12.2% 14.0%

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630 Chapter 13

Required

Sales were $800,000 in 2018 and $900,000 in 2019. Convert the analysis to income statements for the two years.

Problem 13-17B Horizontal analysis

Bluffton Company’s stock is quoted at $16 per share at December 31, 2019 and 2018. Bluffton’s financial statements follow:

LO 13-1

BLUFFTON COMPANY Balance Sheets

As of December 31 (In thousands)

2019 2018 Assets Current assets Cash $ 8,000 $ 6,000 Marketable securities at cost which approximates market 5,000 4,000 Accounts receivable, net of allowance for doubtful accounts 47,000 44,000 Inventories, lower of cost or market 50,000 60,000 Prepaid expenses 2,000 1,000 Total current assets 112,000 115,000 Property, plant, and equipment, net of accumulated depreciation 100,000 105,000 Investments 1,000 1,000 Long-term receivables 3,000 2,000 Goodwill and patents, net of accumulated amortization 2,000 4,000 Other assets 2,000 3,000 Total assets $220,000 $230,000

Liabilities and Stockholders’ Equity Current liabilities Notes payable $ 3,000 $ 5,000 Accounts payable 12,000 16,000 Accrued expenses 9,000 11,000 Income taxes payable 1,000 1,000 Payments due within one year 3,000 2,000 Total current liabilities 28,000 35,000 Long-term debt 50,000 60,000 Deferred income taxes 30,000 27,000 Other liabilities 5,000 4,000 Total liabilities 113,000 126,000 Stockholders’ equity 5% cumulative preferred stock, par value $100 per share; $100 liquidating value; authorized 250,000 shares;issued and outstanding 200,000 shares 20,000 20,000 Common stock, no par; 10,000,000 shares authorized and 5,000,000 shares issued and outstanding 40,000 40,000 Retained earnings 47,000 44,000 Total stockholders’ equity 107,000 104,000 Total liabilities and stockholders’ equity $220,000 $230,000

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Financial Statement Analysis 631

Required

Prepare a horizontal analysis of the balance sheet and income statement for 2019 and 2018. Round percentages to one decimal point.

BLUFFTON COMPANY Statements of Income and Retained Earnings

For the Years Ended December 31 (In thousands)

2019 2018

Net sales $180,000 $150,000 Expenses Cost of goods sold 147,000 120,000 Selling, general, and administrative expenses 20,000 18,000 Other 2,000 2,000 Total expenses 169,000 140,000 Income before income taxes 11,000 10,000 Income taxes 5,000 4,000 Net income 6,000 6,000 Retained earnings at beginning of period 40,000 38,000 Less: Dividends on common stock 3,000 3,000 Dividends on preferred stock 1,000 1,000 Retained earnings at end of period $ 42,000 $ 40,000

Problem 13-18B Vertical analysis

Required

Use the financial statements for Bluffton Company from Problem 13-17B to perform a vertical analy- sis (based on total assets, total equities, and sales) of both the balance sheets and income statements for 2019 and 2018. Round computations to one decimal point.

LO 13-1

Problem 13-19B Effect of transactions on current ratio and working capital

Lowery Company has a current ratio of 2:1 on June 30, 2018. Indicate whether each of the following transactions would increase (+), decrease (−), or not affect (NA) Lowery’s current ratio and its work- ing capital.

Required

a. Issued 10-year bonds for $300,000 cash. b. Paid cash to settle an account payable. c. Sold merchandise for more than cost. d. Recognized depreciation on plant equipment. e. Purchased a machine by issuing a long-term note payable. f. Purchased merchandise inventory on account. g. Received customer payment on account receivable. h. Paid cash for federal income tax expense (assume that the expense has not been previously

accrued). i. Declared cash dividend payable in one month. j. Received cash for interest on a long-term note receivable (assume that interest has not been previ-

ously accrued). k. Received cash from issuing a short-term note payable. l. Traded a truck for a sedan.

LO 13-2

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632 Chapter 13

Problem 13-20B Supply missing balance sheet numbers

Rustin Craft discovered a piece of wet and partially burned balance sheet after his office was destroyed by fire. He could recall a current ratio of 1.75 and a debt to assets ratio of 45 percent.

LO 13-2, 13-3

Assets

Current assets Cash $ 150,000  Accounts receivable (A) Inventory 252,000  Prepaid expenses 54,000  Total current assets (B) Long-term assets Building (C) Less: Accumulated depreciation (180,000) Total long-term assets 1,080,000 Total assets $ (D)

Liabilities and Stockholders’ Equity

Liabilities Current liabilities Accounts payable $ 252,000  Notes payable (E) Income tax payable 108,000  Total current liabilities 480,000  Long-term liabilities Bonds payable 270,000  Mortgage payable (F) Total liabilities (G) Stockholders’ equity Common stock 540,000  Retained earnings (H) Total stockholders’ equity (I) Total liabilities and stockholders’ equity $ (J)

Earnings (net income) $120,000 Preferred stock (16,000 shares at $17.50 par, 6%) $280,000 Common stock (40,500 shares no par, market value $15.20) 342,000 Retained earnings 240,000 862,000 Less: Treasury stock Preferred (1,000 shares) $14,400 Common (500 shares) 6,400 20,800 Total stockholders’ equity $841,200

Required

Complete the balance sheet by supplying the missing amounts.

Problem 13-21B Ratio analysis

Selected data for Hoback Company for 2018 and additional information on industry averages follow:

LO 13-5

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Financial Statement Analysis 633

Required

Round computations to two decimal points.

a. Calculate and compare Hoback Company’s ratios with the industry averages. b. Discuss factors you would consider in deciding whether to invest in the company.

Industry averages Earnings per share $2.00 Price-earnings ratio 8.00 Return on equity 7.30%

Problem 13-22B Ratio analysis

Information from Forman Company’s financial statements follows:

LO 13-3, 13-4, 13-5

2018 2017

Net sales $1,000,000 $800,000 Income before interest and taxes 180,000 150,000 Net income after taxes 128,000 108,000 Bond interest expense 20,000 16,000 Stockholders’ equity, December 31 (2016: $240,000) 360,000 300,000 Common stock, par $12, December 31 210,000 180,000

Average number of shares outstanding was 16,000 for 2018 and 15,000 for 2017.

Required

Compute the following ratios for Forman Company for 2018 and 2017 and round computations to two decimal points.

a. Number of times interest was earned. b. Earnings per share based on the average number of shares outstanding. c. Price-earnings ratio (market prices: 2018, $30 per share; 2017, $24 per share). d. Return on equity. e. Net margin.

Problem 13-23B Ratio analysis

The following financial statements apply to Bedford Appliances, Inc.:

LO 13-2, 13-3, 13-4, 13-5

BEDFORD APPLIANCES, INC. Balance Sheets

As of December 31

2019 2018 Assets Current assets Cash $118,000 $ 91,000 Marketable securities 24,000 18,000 Accounts receivable (net) 112,000 108,000 Inventories 180,000 192,000 Prepaid expenses 27,000 14,000 Total current assets 461,000 423,000 Investments 120,000 120,000 Plant (net) 260,000 254,000 Other 81,000 74,000 Total assets $922,000 $871,000

continued

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634 Chapter 13

2019 2018 Liabilities and Stockholders’ Equity Liabilities Current liabilities Notes payable $ 20,000 $ 15,000 Accounts payable 80,000 38,000 Other 66,000 9,000 Total current liabilities 166,000 62,000 Noncurrent liabilities Bonds payable 110,000 210,000 Other 26,000 12,000 Total noncurrent liabilities 136,000 222,000 Total liabilities 302,000 284,000 Stockholders’ equity Preferred stock ($100 par, 4% cumulative, non- participating; $100 liquidating value; 1,000 shares authorized and issued; no dividends in arrears) 100,000 100,000 Common stock (no par; 50,000 shares authorized; 12,000 shares issued) 240,000 240,000 Retained earnings 280,000 247,000 Total stockholders’ equity 620,000 587,000 Total liabilities and stockholders’ equity $922,000 $871,000

BEDFORD APPLIANCES, INC. Statements of Income and Retained Earnings

For the Years Ended December 31

2019 2018 Revenues Sales (net) $240,000 $230,000 Other revenues 7,000 4,000 Total revenues 247,000 234,000 Expenses Cost of goods sold 143,000 130,000 Selling, general, and administrative 46,000 57,000 Bond interest expense 7,000 10,000 Income tax expense 8,000 14,000 Total expenses 204,000 211,000 Net income 43,000 23,000 Retained earnings, January 1 247,000 234,000 Less: Preferred stock dividends 4,000 4,000 Common stock dividends 6,000 6,000 Retained earnings, December 31 $280,000 $247,000

Required

Calculate the following ratios for 2019 by rounding to two decimal points:

a. Working capital. b. Current ratio. c. Quick ratio. d. Accounts receivable turnover. e. Average days to collect accounts receivable. f. Inventory turnover. g. Average days to sell inventory. h. Debt to assets ratio. i. Debt to equity ratio. j. Times interest was earned.

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Financial Statement Analysis 635

k. Plant assets to long-term debt. l. Net margin.

m. Turnover of assets. n. Return on investment. o. Return on equity. p. Earnings per share. q. Book value per share. r. Price-earnings ratio (market price: $13.26). s. Dividend yield on common stock.

Problem 13-24B Ratio analysis

Required

Use the financial statements for Bluffton Company from Problem 13-17B to compute the following for 2019. Round percentages to two decimal points.

a. Current ratio. b. Quick (acid-test) ratio. c. Average days to collect accounts receivable, assuming all sales on account. d. Inventory turnover. e. Book value per share of common stock. f. Earnings per share on common stock. g. Price-earnings ratio on common stock. h. Debt to assets ratio. i. Return on investment. j. Return on equity.

LO 13-2, 13-3, 13-4, 13-5

ANALYZE, THINK, COMMUNICATE

ATC 13-1 Business Applications Case Analyzing Kroger and Whole Foods

The following information relates to The Kroger Company for its 2015 and 2014 fiscal years, and Whole Foods Market, Inc. for its 2014 and 2013 fiscal years.

THE KROGER COMPANY Selected Financial Information

(amounts in millions, except per share amounts)

January 31, February 1, 2015 2014

Total current assets $ 8,911 $ 8,830 Merchandise inventory 8,178 7,951 Property and equipment, net of depreciation 17,912 16,893 Total assets 30,556 29,281 Total current liabilities 11,403 10,705 Total long-term liabilities 13,711 13,181 Total liabilities 25,114 23,886 Total shareholders’ equity 5,442 5,395 Revenue 108,465 98,375 Cost of goods sold 85,512 78,138 Gross profit 22,953 20,237 Operating income 3,137 2,725 Earnings from continuing operations before income tax expense 2,649 2,282 Income tax expense 902 751 Net earnings 1,747 1,531 Basic earnings per share $ 1.75 $ 1.47

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636 Chapter 13

Required

a. Compute the following ratios for the companies’ 2014 fiscal years: (1) Current ratio. (2) Average days to sell inventory. (Use average inventory.) (3) Debt to assets ratio. (4) Return on investment. (Use average assets and use “earnings from continuing operations”

rather than “net earnings.”) (5) Gross margin percentage. (6) Asset turnover. (Use average assets.) (7) Return on sales. (Use “earnings from continuing operations” rather than “net earnings.”) (8) Plant assets to long-term debt ratio.

b. Which company appears to be more profitable? Explain your answer and identify which ratio(s) from Requirement a you used to reach your conclusion.

c. Which company appears to have the higher level of financial risk? Explain your answer and iden- tify which ratio(s) from Requirement a you used to reach your conclusion.

d. Which company appears to be charging higher prices for its goods? Explain your answer and identify which ratio(s) from Requirement a you used to reach your conclusion.

e. Which company appears to be the more efficient at using its assets? Explain your answer and identify which ratio(s) from Requirement a you used to reach your conclusion.

WHOLE FOODS MARKET, INC. Selected Financial Information

(amounts in millions except per share data)

September 28, September 29, 2014 2013

Total current assets $ 1,756 $ 1,980 Merchandise inventory 441 414 Property and equipment, net of depreciation 2,923 2,428 Total assets 5,744 5,538 Total current liabilities 1,257 1,088 Total long-term liabilities 674 572 Total liabilities 1,931 1,660 Total stockholders’ equity 3,813 3,878

Revenues 14,194 12,917 Cost of goods sold 9,150 8,288 Gross profit 5,044 4,629 Operating income 934 883 Earnings from continuing operations before income taxes 946 894 Income tax expense 367 343 Net earnings 579 551 Basic earnings per share $ 1.57 $ 1.48

ATC 13-2 Group Assignment Ratios and basic logic

Presented here are selected data from the 10-K reports of four companies for their 2015 fiscal years. The four companies, in alphabetical order, are:

Caterpillar, Inc., a company that manufactures heavy machinery. Oracle Corporation, a company that develops software. Starbucks, a company that sells coffee products. Tiffany & Company, a company that operates high-end jewelry and department stores.

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Financial Statement Analysis 637

The data for the companies, presented in the order of the amount of their sales in millions of dollars, are as follows:

Required

a. Divide the class into groups of four or five students per group and then organize the groups into four sections. Assign Task 1 to the first section of groups, Task 2 to the second section, Task 3 to the third section, and Task 4 to the fourth section.

Group Tasks

(1) Assume that you represent Caterpillar. Identify the set of financial data (Column A, B, C, or D) that relates to your company.

(2) Assume that you represent Oracle. Identify the set of financial data (Column A, B, C, or D) that relates to your company.

(3) Assume that you represent Starbucks. Identify the set of financial data (Column A, B, C, or D) that relates to your company.

(4) Assume that you represent Tiffany. Identify the set of financial data (Column A, B, C, or D) that relates to your company.

Hint: In addition to the ratios presented in this chapter, you might also find it useful to com- pute a ratio from the first course of accounting, the gross margin percentage (Gross margin ÷ Sales).

b. Select a representative from each section. Have the representative explain the rationale for the group’s selection. The explanation should include a set of ratios that support the group’s conclusion.

A B C D

Sales $4,249.9 $15,197.3 $ 38,226 $47,011 Cost of goods sold 1,712.7 7,787.5 7,532 33,742 Net income 484.2 2,759.3 9,938 2,102 Inventory 2,362.1 1,306.4 314 9,700 Accounts receivable 195.2 719.0 5,618 15,686 Total assets 5,180.6 12,446.1 110,903 78,497

ATC 13-3 Research Assignment Analyzing Duke Energy’s acquisition of Progressive Energy

In 2012 Duke Energy, a large utility company with its headquarters in North Carolina, completed its $32 billion acquisition of Progress Energy. To get an idea of the size of this deal, in 2011 Duke Energy reported revenues of $14.5 billion. In 2012, with the additional revenue from Prog- ress Energy, its revenues were $19.6 billion. To complete the requirements below you will need to obtain Duke Energy Holding Company’s Form 10-K for 2011, the year before the acquisition, and for 2014, two years after the deal was closed. The Form 10-Ks can be accessed through the “Investors” link on the company’s website, www.duke-energy.com, or through the EDGAR system. Be aware that the Form 10-Ks include separate financial statements for each of Duke Energy’s subsidiary companies, so be sure to use the statements for the consolidated company, Duke Energy Corporation.

Required

a. Compute the following ratios for 2011 and 2014. To make the computations simpler, use end-of- year amounts for total assets and total equity rather than averages. Show your calculations.

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638 Chapter 13

b. Based on the ratios computed in Requirement a, comment on the apparent effects of Duke Energy’s acquisition of Progressive Energy. Assume any significant change in these ratios was the result of the acquisition.

c. Based on this limited analysis, does it appear that the effects of the merger were good or bad for Duke Energy?

Net margin Current ratio Return on investment Debt to assets ratio Return on equity

ATC 13-4 Writing Assignment Identifying companies based on financial statement information

The following ratios are for four companies in different industries. Some of these ratios have been dis- cussed in the textbook and others have not, but their names explain how the ratio was computed. These data are for the companies’ 2013 fiscal years. The four sets of ratios, presented randomly, are as follows:

Company 1 Company 2 Company 3 Company 4

Current assets ÷ Total assets 11% 10% 22% 81% Average days to sell inventory 50 29 43 70 Average days to collect receivables 4 35 8 40 Return on assets 38% 4% 15% 6% Gross profit ÷ Sales 69% 58% 58% 27% Asset turnover 1.9 3.0 19.8 6.4 Sales ÷ Number of full-time employees $41,514 $339,921 $68,965 $522,014

The four companies to which these ratios relate, listed in alphabetical order, are:

Darden Restaurants, Inc., which operated over 2,100 restaurants under 10 different names, including Olive Garden, Red Lobster, and LongHorn Steakhouse. Deere & Company, a company that manufactures farming and heavy construction equipment. Molson Coors Brewing, Inc., a company that produces beer and related products. Weight Watchers International, Inc., a company that provides weight-loss services and products. Its fiscal year-end was December 31, 2013, during which 49 percent of its revenues came from meeting fees, 20 percent came from product sales, and 31 percent came from online services.

Required

Determine which company should be matched with each set of ratios. Write a memorandum explain- ing the rationale for your decisions.

ATC 13-5 Ethical Dilemma Making the ratios look good

J. Talbot is the accounting manager for Kolla Waste Disposal Corporation. Kolla is having its worst financial year since its inception. The company is expected to report a net loss. In the midst of such bad news, Ms. Talbot surprised the company president, Mr. Winston, by suggesting that the company write off approximately 25 percent of its garbage trucks. Mr. Winston responded by noting that the trucks could still be operated for another two or three years. Ms. Talbot replied, “We may use them for two or three more years, but you couldn’t sell them on the street if you had to. Who wants to buy a bunch of old garbage trucks, and besides, it will make next year’s financials so sweet. No one will care about the additional write-off this year. We are already showing a loss. Who will care if we lose a little bit more?”

Required

a. How will the write-off affect the following year’s return on assets ratio? b. How will the write-off affect the asset and income growth percentages? c. Explain how the components of the fraud triangle relate to this case.

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Financial Statement Analysis 639

ATC 13-6 Spreadsheet Assignment Using Excel

Tomkung Corporation’s income statements are presented in the following spreadsheet:

Required

Construct a spreadsheet to conduct horizontal analysis of the income statements for 2019 and 2018.

ATC 13-7 Spreadsheet Assignment Mastering Excel

Refer to the data in ATC 13-6.

Required

Construct a spreadsheet to conduct vertical analysis for both years 2019 and 2018.

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Statement of Cash Flows

LEARNING OBJECTIVES After you have mastered the material in this chapter, you will be able to:

LO 14-1 Prepare the operating activities section of a statement of cash flows using the indirect method.

LO 14-2 Prepare the operating activities section of a statement of cash flows using the direct method.

LO 14-3 Prepare the investing activities section of a statement of cash flows.

LO 14-4 Prepare the financing activities section of a statement of cash flows.

Video lectures and accompanying self-assessment quizzes are available in Connect® for all learning objectives.

CHAPTER 14

CHAPTER OPENING

To make informed investment and credit decisions, financial statement users need information

to help them assess the amounts, timing, and uncertainty of a company’s prospective cash

flows. This chapter explains more about the items reported on the statement of cash flows and

describes a more practical way to prepare the statement than analyzing every entry in the cash

account. As previously shown, the statement of cash flows reports how a company obtained

and spent cash during an accounting period. Sources of cash are cash inflows, and uses are

cash outflows. Cash receipts (inflows) and payments (outflows) are reported as either operat-

ing activities, investing activities, or financing activities.

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The Curious Accountant

Twitter, Inc. began operations in 2006 and began selling its stock to the public on November 7, 2013. It has lost money every year it has been in existence. In 2013 alone its losses were $645 million, and by December  31, 2013, it had total lifetime losses of approximately $995 million.

How could Twitter lose so much money and still be able to pay its bills? (Answer on page 647.) © Zoonar GmbH/Alamy

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642 Chapter 14

AN OVERVIEW OF THE STATEMENT OF CASH FLOWS

The statement of cash flows provides information about cash coming into and going out of a business during an accounting period. Cash flows are classified into one of three cate­ gories: operating activities, investing activities, or financing activities. A separate section also displays any significant noncash investing and financing activities. Descriptions of these categories and how they are presented in the statement of cash flows follow.

Operating Activities Routine cash inflows and outflows resulting from running (operating) a business are reported in the operating activities section of the statement of cash flows. Cash flows reported as operating activities include:

1. Cash receipts from revenues, including interest and dividend revenue. 2. Cash payments for expenses, including interest expense. Recall that dividend payments

are not expenses. Dividend payments are reported in the financing activities section.

Under generally accepted accounting principles, the operat­ ing activities section of the statement of cash flows can be pre­ sented using either the direct or the indirect method. The direct method explicitly (directly) identifies the major sources and uses of cash. To illustrate, assume that during 2016 New South Company earns revenue on account of $500 and collects $400 cash from customers. Further assume the company incurs $390 of expenses on account and pays $350 cash to settle accounts

payable. Exhibit 14.1 shows the operating activities section of the statement of cash flows using the direct method.

In contrast, the indirect method starts with net income as reported on the income state­ ment, followed by the adjustments necessary to convert the accrual­based net income figure to a cash­basis equivalent. To illustrate, begin with New South Company’s income statement based on the above assumptions:

Cash Flows from Operating Activities Net income $ 110 Subtract: Increase in accounts receivable (100) Add: Increase in accounts payable 40 Net cash flow from operating activities $ 50

EXHIBIT 14.2

Operating Activities—Indirect Method

Revenues $ 500 Expenses (390) Net income $ 110

EXHIBIT 14.1

Operating Activities—Direct Method

Cash Flows from Operating Activities Cash receipts from customers $ 400 Cash payments for expenses (350) Net cash flow from operating activities $ 50

Converting the net income of $110 to the net cash flow from operating activities of $50 requires the following adjustments.

1. New South earned $500 of revenue but collected only $400 in cash. The remaining $100 will be collected in the next accounting period. This $100 increase in accounts receivable must be subtracted from net income to determine cash flow because it increased net income but did not increase cash.

2. New South incurred $390 of expense but paid only $350 in cash. The remaining $40 will be paid in the next accounting period. This $40 increase in accounts  payable must

be added back to net income to determine cash flow because it decreased net income but did not use cash.

Exhibit 14.2 shows the operating activities section of the statement of cash flows using the indirect method.

Compare the direct method presented in Exhibit 14.1 with the indirect method presented in Exhibit 14.2. Both methods report $50 of net cash flow from operating activi­ ties. They represent two different approaches to computing the same amount.

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Statement of Cash Flows 643

Because people typically find the direct method easier to understand, the Financial Accounting Standards Board (FASB) recommends it. Most companies, however, use the indirect method. Why? Back when the FASB adopted a requirement for companies to in­ clude a statement of cash flows in their published financial statements, most companies used accounting systems that were compatible with the indirect method. It was therefore easier to prepare the new statement under the indirect method using existing systems than to create new recordkeeping systems compatible with the direct method.

The FASB continues to advocate the direct method and a growing number of companies use it. Since the majority of companies continue to use the indirect method, however, finan­ cial statement users should understand both methods.

CHECK YOURSELF 14.1

Hammer, Inc. had a beginning balance of $22,400 in its Accounts Receivable account. During the accounting period, Hammer earned $234,700 of net income. The ending balance in the Accounts Receivable account was $18,200. Based on this information alone, determine the amount of cash flow from operating activities.

Answer

Account Title Ending Beginning Change

Accounts receivable $18,200 $22,400 $(4,200)

Applicable Rule Cash Flow from Operating Activities Amount

Net Income $234,700 Rule 1 Add: Decrease in accounts receivable        4,200 Cash flow from operating activities $238,900

Investing Activities For a business, long­term assets are investments. Cash flows related to acquiring or disposing of long­term assets are therefore reported in the investing activities section of the statement of cash flows. Cash flows reported as investing activities include:

1. Cash receipts (inflows) from selling property, plant, equipment, or marketable secu­ rities as well as collections from credit instruments such as notes or mortgages receivable.

2. Cash payments (outflows) for purchasing property, plant, equipment, or marketable securities as well as for making loans to borrowers.

Financing Activities Cash flows related to borrowing (short­ or long­term) and stockholders’ equity are reported in the financing activities section of the statement of cash flows. Cash flows reported as financing activities include:

1. Cash receipts (inflows) from borrowing money and issuing stock. 2. Cash payments (outflows) to repay debt, purchase treasury stock, and pay

dividends. © Ryan McVay/Getty Images

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644 Chapter 14

The classification of cash flows is based on the type of activity, not the type of account. For example, buying another company’s common stock is an investing activity, but issuing a company’s own common stock is a financing activity. Receiving dividends from a common stock investment is an operating activity, and paying dividends to a company’s own stockholders is a financing activity. Similarly, loaning money is an investing activity, although borrowing it is a financing activity. Focus on the type of activity rather than the type of account when classifying cash flows as operating, invest­ ing, or financing activities.

Noncash Investing and Financing Activities Companies sometimes undertake significant noncash investing and financing activities such as acquiring a long­term asset in exchange for common stock. Since these types of transactions do not involve exchanging cash they are not reported in the main body of the statement of cash flows. However, because the FASB requires that all material investing and financing activities be disclosed, whether or not they involve exchanging cash, companies must include with the statement of cash flows a separate schedule of any noncash investing and financing activities.

Reporting Format for the Statement of Cash Flows Cash flow categories are reported in the following order: (1) operating activities; (2) invest­ ing activities; and (3) financing activities. In each category, the difference between the in­ flows and outflows is presented as a net cash flow for the category. These net amounts are combined to determine the net change (increase or decrease) in the company’s cash for the period. The net change in cash is combined with the beginning cash balance to deter­ mine the ending cash balance. The ending cash balance on the statement of cash flows is the same as the cash balance reported on the balance sheet. The schedule of noncash investing and financing activities is typically presented at the bottom of the statement of cash flows. Exhibit 14.3 outlines this format.

EXHIBIT 14.3 Format for Statement of Cash Flows

WESTERN COMPANY Statement of Cash Flows

For the Year Ended December 31, 2016

Cash flows from operating activities Net increase (decrease) from operating activities XXX Cash flows from investing activities Net increase (decrease) from investing activities XXX Cash flows from financing activities Net increase (decrease) from financing activities XXX Net increase (decrease) in cash XXX Plus: Beginning cash balance XXX Ending cash balance XXX Schedule of Noncash Investing and Financing Activities List of significant noncash transactions XXX

As indicated in Exhibit 14.4, most companies present the statement of cash flows as the last of the four primary financial statements. However, a sizable number of companies pre­ sent it after the income statement and balance sheet but before the statement of changes in stockholders’ equity. Some companies place the statement of cash flows first, before the other three statements.

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Statement of Cash Flows 645

PREPARING A STATEMENT OF CASH FLOWS

Most of the data needed to construct a statement of cash flows can be obtained from two successive balance sheets and the intervening income statement. Certain information from the long­term asset records is also usually required. To illustrate, refer to the financial state­ ments for New South Company presented in Exhibit 14.5. Notice that cash decreased from $400 at the end of 2016 to $300 at the end of 2017. The statement of cash flows explains what caused this $100 decrease.

EXHIBIT 14.4

Placement of Statement of Cash Flows Relative to Other Financial Statements

After income statement and balance sheet

39% Final statement 54%

First statement 7%

Data Source: AICPA, Accounting Trends and Techniques.

EXHIBIT 14.5 Financial Statements for New South Company

NEW SOUTH COMPANY Balance Sheets

As of December 31

2017 2016 Current assets: Cash $      300 $     400 Accounts receivable 1,000 1,200 Interest receivable 400 300 Inventory 8,900 8,200 Prepaid insurance       1,100      1,400 Total current assets     11,700     11,500 Long-term assets Investment securities 5,100 3,500 Store fixtures 5,400 4,800 Accumulated depreciation (900) (1,200) Land     8,200     6,000 Total long-term assets    17,800     13,100 Total assets $29,500 $24,600 Current liabilities: Accounts payable—Inventory purchases $      800 $  1,100 Salaries payable 1,000 900 Other operating expenses payable 1,500 1,300 Interest payable 300 500 Unearned rent revenue         600      1,600 Total current liabilities      4,200     5,400

continued

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646 Chapter 14

EXHIBIT 14.5 concluded

NEW SOUTH COMPANY Balance Sheets

As of December 31

2017 2016 Long-term liabilities Mortgage payable 2,200 0 Bonds payable      1,000     4,000 Total long-term liabilities     3,200     4,000 Stockholders’ equity Common stock 10,000 8,000 Retained earnings 12,700 7,200 Treasury stock       (600)             0 Total stockholders’ equity    22,100    15,200 Total liabilities and stockholders’ equity $29,500 $24,600

Note 1: No investment securities were sold during 2017. Note 2: During 2017, New South sold store fixtures that had originally cost $1,700. At the time of sale,

accumulated depreciation on the fixtures was $1,300. Note 3: Land was acquired during 2017 by issuing a mortgage note payable. No land sales occurred during 2017.

NEW SOUTH COMPANY Income Statement

For the Year Ended December 31, 2017

Sales revenue $ 20,600  Cost of goods sold    (10,500) Gross margin 10,100  Operating expenses Depreciation expense $ (1,000) Salaries expense (2,700) Insurance expense (1,300) Other operating expenses    (1,400) Total operating expenses      (6,400) Income from sales business 3,700  Other income—Rent revenue       2,400  Operating income 6,100  Nonoperating revenue and expense Interest revenue 700  Interest expense (400) Gain on sale of store fixtures       600  Total nonoperating items          900  Net income $   7,000

PREPARING THE OPERATING ACTIVITIES SECTION OF A STATEMENT OF CASH FLOWS USING THE INDIRECT METHOD

Recall that the indirect approach begins with the amount of net income. Many aspects of accrual accounting, such as recognizing revenues and expenses on account, can cause differ­ ences between the amount of net income reported on a company’s income statement and the amount of net cash flow it reports from operating activities. Most of the differences between

Prepare the operating activities section of a statement of cash flows using the indirect method.

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Statement of Cash Flows 647

First, it should be remembered that

GAAP requires earnings and losses be

computed on an accrual basis. A company can have negative earnings and still have positive cash flows from operating

activities. This was not the case at Twitter. From 2011 through 2013, the company’s cash flows from operating activities

totaled a negative $97 million. Although this is less than the $853 million of cumulative net losses the company incurred

during the same period, negative cash flows do not pay the bills.

In its early years of operations, Twitter, like many new companies, was able to stay in business because of the cash

it raised through financing activities. Obviously, a company cannot operate indefinitely without generating cash from

operating activities. Individuals and institutions who are willing to buy a company’s stock or loan it cash in its early years

will disappear if they do not believe the company will eventually begin earning profits and generating positive cash flows

from operations. Exhibit 14.6 presents Twitter’s statements of cash flows from 2011 through 2013.

Answers to The Curious Accountant

EXHIBIT 14.6

TWITTER, INC. Consolidated Statements of Cash Flows

(in thousands)

Year Ended December 31,

2013 2012 2011

Cash Flows from Operating Activities Net loss $ (645,323) $(79,399) $(128,302) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 110,894  72,506 24,192  Stock-based compensation expense 600,367  25,741 60,384  Provision for bad debt 1,557  1,844 1,828  Deferred income tax benefit (8,902) (1,098) (2,252) Noncash acquisition-related costs 704  1,715 —  Amortization of investment premium and other 3,457  4,102 2,739  Changes in assets and liabilities, net of assets acquired and liabilities assumed from acquisitions: Accounts receivable (112,060) (73,898) (33,023) Prepaid expenses and other assets (12,045) (6,691) (2,597) Accounts payable 7,957  2,931 (918) Accrued and other liabilities      54,792          24,312        7,352  Net cash provided by (used in) operating activities         1,398      (27,935)      (70,597)

Cash flows from investing activities Purchases of property and equipment, net of proceeds from sales (75,744) (50,599) (11,546) Purchases of marketable securities (1,573,489) (542,638) (487,595) Proceeds from maturities of marketable securities 355,270  621,049 178,540  Proceeds from sales of marketable securities 42,816  26,300 19,277  Restricted cash (10,847) (3,143) (4,645) Business combinations, net of cash acquired and purchases of intangible assets (44,072)         (1,526)     (18,906) Net cash provided by (used in) investing activities (1,306,066)      49,443  (324,875)

continued

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648 Chapter 14

EXHIBIT 14.6 concluded

TWITTER, INC. Consolidated Statements of Cash Flows

(in thousands)

Year Ended December 31,

2013 2012 2011

Cash flows from financing activities Net proceeds from issuance of common stock upon initial public offering 2,018,579 — — Taxes paid related to net share settlement of equity awards (14,637) — — Repayments of capital lease obligations (70,445) (39,436) (15,103) Proceeds from issuances of convertible preferred stock, net of issuance costs — — 485,006 Proceeds from exercise of stock options and sales of restricted stock to employees at fair value, net of repurchase         8,679        2,312     10,307 Net cash provided by (used in) financing activities   1,942,176      (37,124)   480,210 Net increase (decrease) in cash and cash equivalents 637,508 (15,616) 84,738 Foreign exchange effect on cash and cash equivalents 174 (52) 5 Cash and cash equivalents at beginning of period    203,328    218,996    134,253 Cash and cash equivalents at end of period $      841,010 $203,328 $218,996

revenue and expense recognition and cash flows are related to changes in the balances of the noncash current assets and current liabilities.

Indirect Method—Reconciliation Approach The following section of this chapter examines the relationships between items reported on the income statement and the related assets and liabilities. Begin by reconciling the noncash current asset and current liability amounts shown on the balance sheets in Exhibit 14.5. Do not include Cash in this analysis. The amount of the change in the cash balance is the result of not only operating activities but also investing and financing activities.

Reconciliation of Accounts Receivable Use the information in Exhibit 14.5 to prepare the following reconciliation of Accounts Receivable. The beginning and ending balances appear on the balance sheets. The increase due to revenue recognized on account is the sales revenue reported on the in­ come statement.

Table 1 Reconciliation of Accounts Receivable*

Beginning balance $ 1,200 Increase due to revenue recognized on account 20,600 Decrease due to cash collections from customers ? = (20,800) Ending balance $ 1,000

$200 Decrease

*Assume all revenue is earned on account.

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To balance Accounts Receivable, the decrease due to cash collections from customers must be $20,800.1

The reconciliation shows that the $200 decrease in the accounts receivable balance occurred because cash collections from customers were $200 more than the amount of revenue recognized on account ($20,800 versus $20,600). Since the amount of cash collected is more than the amount of revenue recognized, we add $200 to the amount of net income to determine net cash flow from operating activities (Reference No. 1 in Exhibit 14.7).

Reconciliation of Interest Receivable The beginning and ending balances appear on the balance sheets in Exhibit 14.5. The increase due to interest revenue recognized on account is the interest revenue reported on the income statement.

$100 Increase

Table 2 Reconciliation of Interest Receivable

Beginning balance $300 Increase due to interest revenue recognized on account 700 Decrease due to cash collections of interest receivable ? = (600) Ending balance $400

To balance Interest Receivable, the decrease due to cash collections of interest receivable must be $600.

The reconciliation shows that the $100 increase in the interest receivable balance occurred because cash collections of interest were $100 less than the interest revenue recognized on account ($600 versus $700). Since the amount of cash collected is less  than the amount of revenue recognized, we subtract the $100 from the amount of net income to determine net cash flow from operating activities (Reference No. 2 in Exhibit 14.7).

Reconciliation of Inventory and Accounts Payable To simplify computing the amount of cash paid for inventory purchases, assume that all inventory purchases are made on account. The computation requires two steps. First, Inventory must be analyzed to determine the amount of inventory purchased. Second, Accounts Payable must be analyzed to determine the amount of cash paid to purchase inventory.

Use the financial statement information in Exhibit 14.5 to prepare the following Inventory reconciliation. The beginning and ending balances appear on the balance sheets. The decrease due to recognizing cost of goods sold is the cost of goods sold reported on the income statement.

$700 Increase

Table 3 Reconciliation of Inventory

Beginning balance $ 8,200 Increase due to inventory purchases ? = 11,200 Decrease due to recognizing cost of goods sold (10,500) Ending balance $ 8,900

To balance Inventory, the increase due to inventory purchases must be $11,200.

1This text uses the simplifying assumption that all sales occur on account.

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Assuming the inventory was purchased on account, the $11,200 of inventory purchases determined above equals the increase due to inventory purchases used in the reconciliation of Accounts Payable below. The beginning and ending balances appear on the balance sheets in Exhibit 14.5.

$300 Decrease

Table 4 Reconciliation of Accounts Payable*

Beginning balance $ 1,100 Increase due to inventory purchases 11,200 Decrease due to cash settlements of accounts payable—Inv. ? = (11,500) Ending balance $ 800

*Assume that Accounts Payable is used for purchases of inventory only and that all inventory purchases are made on account.

$300 Decrease

Table 5 Reconciliation of Prepaid Insurance

Beginning balance $ 1,400 Increase due to the cash purchase of insurance ? = 1,000 Decrease due to recognizing insurance expense (1,300) Ending balance $ 1,100

To balance Accounts Payable, the decrease due to cash settlements of accounts payable— inventory (cash paid to purchase inventory) must be $11,500.

Since the amount of cash paid to purchase inventory is $1,000 more than the amount of cost of goods sold recognized on the income statement ($11,500 versus $10,500), we subtract the $1,000 difference from the amount of net income to determine net cash flow from operating activities. In Exhibit 14.7 the $1,000 subtraction is divided between a $700 increase in inventory (Reference No. 3 in Exhibit 14.7) and a $300 decrease in accounts payable (Reference No. 4 in Exhibit 14.7).

Reconciliation of Prepaid Insurance Use the financial statement information in Exhibit 14.5 to reconcile Prepaid Insurance. The beginning and ending balances appear on the balance sheets. The decrease due to recogniz- ing insurance expense is the insurance expense reported on the income statement.

To balance Prepaid Insurance, the amount of the increase due to the cash purchase of insur- ance must be $1,000.

The reconciliation shows that the $300 decrease in the prepaid insurance balance occurred because cash paid to purchase insurance was $300 less than the amount of  insurance expense recognized ($1,000 versus $1,300). Since the amount of cash paid is less than the amount of expense recognized, we add $300 to the amount of net income to determine the net cash flow from operating activities (Reference No. 5 in Exhibit 14.7).

Reconciliation of Salaries Payable Use the financial statement information in Exhibit 14.5 to reconcile Salaries Payable. The beginning and ending balances appear on the balance sheets. The increase due to recognizing salary expense on account is the salaries expense reported on the income statement.

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$100 Increase

Table 6 Reconciliation of Salaries Payable

Beginning balance $ 900 Increase due to recognizing salary expense on account 2,700 Decrease due to cash settlements of salaries payable ? = (2,600) Ending balance $1,000

Table 7 Reconciliation of Other Operating Expenses Payable

Beginning balance $1,300 Increase due to recognizing other operating expenses on account 1,400 Decrease due to cash settlements of other operating expenses payable ? = (1,200) Ending balance $1,500

$200 Increase

$200 Decrease

Table 8 Reconciliation of Interest Payable

Beginning balance $500 Increase due to recognizing interest expense on account 400 Decrease due to cash settlements of interest payable ? = (600) Ending balance $300

To balance Salaries Payable, the amount of the decrease due to cash settlements of salaries payable (cash paid for salaries expense) must be $2,600. The reconciliation shows that the $100 increase in the salaries payable balance occurred because the cash paid for salary expense is $100 less than the amount of salary expense recognized on account ($2,600 versus $2,700). Since the amount of cash paid is less than the amount of expense recog­ nized, we add $100 to the amount of net income to determine the cash flow from operating activities (Reference No. 6 in Exhibit 14.7).

Reconciliation of Other Operating Expenses Payable Use the financial statement information in Exhibit 14.5 to reconcile Other Operating Expenses Payable. The beginning and ending balances appear on the balance sheets. The increase due to recognizing other operating expenses on account is the other operating expenses amount reported on the income statement.

To balance Other Operating Expenses Payable, the amount of the decrease due to cash set- tlements of other operating expenses payable must be $1,200.

The reconciliation shows that the $200 increase in the other operating expenses pay­ able balance occurred because the cash paid for other operating expenses was $200 less than the amount of other operating expenses recognized on account ($1,200 versus $1,400). Since the amount of cash paid is less than the amount of expense recognized, we add $200 to the amount of net income to determine the net cash flow from operating activities (Reference No. 7 in Exhibit 14.7).

Reconciliation of Interest Payable Use the financial statement information in Exhibit 14.5 to reconcile Interest Payable. The beginning and ending balances appear on the balance sheets. The increase due to recogniz- ing interest expense on account is the interest expense reported on the income statement.

To balance Interest Payable, the amount of the decrease due to cash settlements of interest payable (cash paid for interest expense) must be $600.

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The reconciliation shows that the $200 decrease in the interest payable balance occurred because the amount of cash paid for interest expense is $200 more than the amount of inter- est expense recognized on account ($600 versus $400). Since the amount of cash paid is more than the amount of interest expense recognized, we subtract $200 from the amount of net income to determine the net cash flow from operating activities (Reference No. 8 in Exhibit 14.7).

Reconciliation of Unearned Rent Revenue Use the financial statement information in Exhibit 14.5 to reconcile Unearned Rent Reve­ nue. The beginning and ending balances appear on the balance sheets. The decrease due to recognizing other income—rent revenue is the other income—rent revenue reported on the income statement.

To balance Unearned Rent Revenue, the amount of the increase due to collecting cash in advance of providing rental services must be $1,400.

The reconciliation shows that the $1,000 decrease in the unearned rent revenue balance occurred because the amount of cash collected in advance of providing rental services is $1,000 less than the amount of rent revenue recognized ($1,400 versus $2,400). Since the amount of cash collected is less than the amount of revenue recognized, we subtract $1,000 from the amount of net income to determine the net cash flow from operating activities (Reference No. 9 in Exhibit 14.7).

Noncash Expenses The calculation of accrual­based net income frequently includes noncash expenses such as depreciation expense. Since noncash expenses are deducted in determining net income, they must be added back to the amount of net income when computing net cash flow from operat­ ing activities (Reference No. 10 in Exhibit 14.7).

Gains and Losses When a company retires a long­term asset, the company may receive cash from the sale of the asset being retired. If the asset is sold for more than book value (cost − accumu­ lated depreciation), the gain increases net income; if the asset is sold for less than book value, the loss decreases net income. In either case, the cash inflow is the total amount of cash collected from selling the asset, not the amount of the gain or loss, and this cash inflow is reported in the investing activities section of the statement of cash flows. Since gains increase net income and losses decrease net income, but neither represents the amount of cash received from an asset sale, gains must be subtracted from and losses added back to net income to determine net cash flow from operating activities (Reference No. 11 in Exhibit 14.7).

Indirect Method—Rule-Based Approach The reconciliation process described in the previous section of this chapter leads to a set of rules that can be used to convert accrual­based revenues and expenses to their cash flow equivalents. These rules are summarized in Exhibit 14.8.

Although the rule­based approach offers less insight, it is easy to apply. To illustrate, return to the financial statement data in Exhibit 14.5. The noncash current assets and current

$1,000 Decrease

Table 9 Reconciliation of Unearned Rent Revenue

Beginning balance $ 1,600 Increase due to collecting cash in advance of providing rental services ? = 1,400 Decrease due to recognizing other income—Rent revenue (2,400) Ending balance $ 600G

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Statement of Cash Flows 653

liabilities reported on the balance sheets are summarized in Exhibit 14.9 for your conveni­ ence. The amount of the change in each balance is shown in the Change column.

Refer to the income statement to identify the amounts of net income, noncash expenses, gains, and losses. The income statement for New South Company in Exhibit 14.5 includes three relevant figures: net income of $7,000; depreciation expense of $1,000; and a

EXHIBIT 14.7

Cash Flows from Operating Activities—Indirect Method

Reference No. Cash Flows from Operating Activities

Net income $ 7,000 Adjustments to reconcile net income to net cash flow from operating activities: 1 Decrease in accounts receivable 200 2 Increase in interest receivable (100) 3 Increase in inventory (700) 4 Decrease in accounts payable for inventory purchases (300) 5 Decrease in prepaid insurance 300 6 Increase in salaries payable 100 7 Increase in other operating expenses payable 200 8 Decrease in interest payable (200) 9 Decrease in unearned rent revenue (1,000) 10 Depreciation expense 1,000 11 Gain on sale of store fixtures      (600) Net cash flow from operating activities $ 5,900

EXHIBIT 14.8

Cash Flows from Operating Activities—Indirect Method

Net income XXX Rule 1 Add decreases and subtract increases in noncash current assets. XXX Rule 2 Add increases and subtract decreases in noncash current liabilities. XXX Rule 3 Add noncash expenses (e.g., depreciation). XXX Rule 4 Add losses and subtract gains. XXX Net cash flow from operating activities XXX

EXHIBIT 14.9

Noncash Current Assets and Current Liabilities

Account Title 2017 2016 Change

Accounts receivable $1,000 $1,200 $ (200) Interest receivable 400 300 100 Inventory 8,900 8,200 700 Prepaid insurance 1,100 1,400 (300) Accounts payable—Inventory purchases 800 1,100 (300) Salaries payable 1,000 900 100 Other operating expenses payable 1,500 1,300 200 Interest payable 300 500 (200) Unearned rent revenue 600 1,600 (1,000)

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$600 gain on the sale of store fixtures. Applying the rules in Exhibit 14.8 produces the operating activities section of the statement of cash flows shown in Exhibit 14.10. The applicable rule for each item is referenced in the first column of the exhibit.

The operating activities section of the statements of cash flows shown in Exhibits 14.10 and 14.7 are identical. The rule­based approach is an alternative way to prepare this section when using the indirect method.

EXHIBIT 14.10 Cash Flows from Operating Activities—Indirect Method, Operating Activities

NEW SOUTH COMPANY Statement of Cash Flows

For the Year Ended December 31, 2017

Applicable Rule Cash Flows from Operating Activities

Net income $ 7,000 Adjustments to reconcile net income to net cash flow from operating activities: Rule 1 Decrease in accounts receivable 200 Rule 1 Increase in interest receivable (100) Rule 1 Increase in inventory (700) Rule 2 Decrease in accounts payable for inventory purchases (300) Rule 1 Decrease in prepaid insurance 300 Rule 2 Increase in salaries payable 100 Rule 2 Increase in other operating expenses payable 200 Rule 2 Decrease in interest payable (200) Rule 2 Decrease in unearned rent revenue (1,000) Rule 3 Depreciation expense 1,000 Rule 4 Gain on sale of store fixtures (600) Net cash flow from operating activities $ 5,900

CHECK YOURSELF 14.2

Q Magazine, Inc. reported $369,000 of net income for the month. At the beginning of the month, its Unearned Revenue account had a balance of $78,000. At the end of the month, the account had a balance of $67,000. Based on this information alone, determine the amount of net cash flow from operating activities.

Answer

Account Title Ending Beginning Change

Unearned revenue $67,000 $78,000 $(11,000)

Applicable Rule Cash Flows from Operating Activities Amount

Net income $369,000  Rule 2 Deduct: Decrease in unearned revenue     (11,000) Net cash flow from operating activities $358,000

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PREPARING THE OPERATING ACTIVITIES SECTION OF A STATEMENT OF CASH FLOWS USING THE DIRECT METHOD

The reconciliation tables developed earlier to determine net cash flow from operating activities under the indirect method also disclose the information needed to present the amount of net cash flow from operating activities under the direct method. Remember that the amount of net cash flow from operating activities is the same whether it is presented using the indirect or the direct method.

The direct method shows the specific sources and uses of cash that are associated with operating activities. It does not show adjustments to net income. To illustrate, examine Exhibit 14.11. The information in the reference column identifies the reconciliation table from which the cash flow amounts were drawn. The page number indicates where the recon­ ciliation table is located in this chapter.

Table 3 is not included in Exhibit 14.11 because it does not directly involve a cash flow. Also, noncash expenses, gains, and losses are not used in the determination of net cash flow from operating activities when using the direct method.

CHECK YOURSELF 14.3

The following account balances were drawn from the accounting records of Loeb, Inc.:

Account Title Ending Balance Beginning Balance

Prepaid rent $3,000 $4,200 Interest payable   2,650   2,900

Loeb reported $7,400 of net income during the accounting period. Based on this information alone, determine the amount of net cash flow from operating activities.

Answer Based on Rule 1, the $1,200 decrease ($4,200 − $3,000) in Prepaid Rent (current asset) must be added to net income to determine the amount of net cash flow from operating activities. Rule 2 requires that the $250 decrease ($2,900 − $2,650) in interest Payable (current liability) must be deducted from net income. Accordingly, the cash flow from operating activities is $8,350 ($7,400 + $1,200 − $250). Note that paying interest is defined as an operating activity and should not be confused with dividend payments, which are classified as financing activities.

CHECK YOURSELF 14.4

Arley Company’s income statement reported net income (all amounts are in millions) of $326 for the year. The income statement included depreciation expense of $45 and a net loss on the sale of long-term assets of $22. Based on this information alone, determine the net cash flow from operat- ing activities.

Answer Based on Rule 3 and Rule 4, both the depreciation expense and the loss would have to be added to net income to determine net cash flow from operating activities. Net cash flow from operating activities would be $393 million ($326 + $45 + $22).

Prepare the operating activities section of a statement of cash flows using the direct method.

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EXHIBIT 14.11

Cash Flows from Operating Activities—Direct Method

Reference Cash Flows from Operating Activities

Table 1, page 648 Inflow from customers $ 20,800 Table 2, page 649 Inflow from interest revenue 600 Table 4, page 650 Outflow for inventory purchases (11,500) Table 5, page 650 Outflow to purchase insurance (1,000) Table 6, page 651 Outflow to pay salary expense (2,600) Table 7, page 651 Outflow for other operating expenses (1,200) Table 8, page 651 Outflow pay interest expense (600) Table 9, page 652 Inflow from rent revenue         1,400 Net cash flow from operating activities $ 5,900

Long-Term Asset 2017 2016

Investment securities $5,100 $3,500 Store fixtures 5,400 4,800 Land 8,200 6,000

Reconciliation of Investment Securities

Beginning balance in investment securities $3,500 Increase due to purchase of investment securities ? = 1,600 Decrease due to sale of investment securities 0 Ending balance in investment securities $5,100

PREPARING THE INVESTING ACTIVITIES SECTION OF A STATEMENT OF CASH FLOWS

The direct and indirect methods discussed previously pertain only to the presentation of operating activities. The investing activities section of the statement of cash flows is the same regardless of whether the direct or indirect method is used for operating activities. The information necessary to identify cash inflows and outflows from investing activities is obtained by reconciling changes in a company’s long­term assets. In general: ■ Increases in long­term asset balances suggest cash outflows to purchase assets. ■ Decreases in long­term asset balances suggest cash inflows from selling assets.

It is usually necessary to analyze data from the long­term asset records to determine details about long­term asset purchases and sales. In the New South Company example, these details are presented as notes at the bottom of the balance sheets.

To illustrate, return to the financial statements in Exhibit 14.5. New South Company reports the following three long­term assets on its balance sheets. It is not necessary to reconcile accumulated depreciation since it does not affect cash flow.

Prepare the investing activities section of a statement of cash flows.

LO 14-3

For each long­term asset, reconcile the beginning and ending balances by identifying purchases and sales affecting it. Review the notes for additional relevant information. Begin with investment securities.

Reconciliation of Investment Securities

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Because Note 1 below the balance sheets indicates no investment securities were sold during 2017, the decrease due to sale of investment securities is zero. To balance Investment Securities, the increase due to purchase of investment securities must be $1,600. In the absence of contrary information, assume New South used cash to purchase the investment securities. This cash outflow is reported in the investing activities section of the statement of cash flows in Exhibit 14.12.

Reconciliation of Store Fixtures

Reconciliation of Store Fixtures

Beginning balance in store fixtures $ 4,800 Increase due to purchase of store fixtures ? = 2,300 Decrease due to sale of store fixtures (1,700) Ending balance in store fixtures $ 5,400

Reconciliation of Land

Beginning balance in land $6,000 Increase due to purchase of land ? = 2,200 Decrease due to sale of land 0 Ending balance in land $8,200

Note 2 below the balance sheets indicates that the decrease due to sale of store fixtures is $1,700. What is the cash flow from this sale? The book value of these fixtures was $400 ($1,700 cost − $1,300 accumulated depreciation). Since the income statement reports a $600 gain on the sale of store fixtures, the cash collected from the sale was more than the book value of the store fixtures. Compute the amount of cash collected from the sale of store fixtures as follows:

Cash inflow = Book value + Gain = $400 + $600 = $1,000

The $1,000 cash inflow from the sale of store fixtures is reported in the investing ac­ tivities section of the statement of cash flows in Exhibit 14.12.

To balance Store Fixtures, the increase due to purchase of store fixtures must be $2,300. In the absence of contrary information, assume New South used cash to purchase store fixtures. The cash outflow is reported in the investing activities section of the statement of cash flows in Exhibit 14.12.

Reconciliation of Land

Because Note 3 below the balance sheets indicates no land was sold during 2017, the decrease due to sale of land is zero. To balance Land, the increase due to purchase of land must be $2,200. Since the land was acquired by issuing a mortgage note payable, New South did not use cash for the purchase. This type of transaction is reported in the noncash invest- ing and financing activities section of the statement of cash flows, discussed in more detail later in the chapter. The cash inflows and outflows from investing activities are summarized in Exhibit 14.12.

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PREPARING THE FINANCING ACTIVITIES SECTION OF A STATEMENT OF CASH FLOWS

Because the differences between the direct and the indirect methods of presenting the state­ ment of cash flows pertain only to operating activities, the financing activities section is the same under either approach. The information necessary to identify cash inflows and outflows from financing activities is obtained by reconciling changes in short­term notes payable, long­term liabilities, and stockholders’ equity. In general, ■ Increases in short­term notes payable or long­term debt balances suggest cash inflows

occurred from issuing debt instruments (notes or bonds). ■ Decreases in short­term notes payable or long­term debt balances suggest cash outflows

occurred for payment of debt (notes or bonds).

EXHIBIT 14.12

Cash Flows from Investing Activities

Cash Flows from Investing Activities

Cash outflow to purchase investment securities $(1,600) Cash inflow from the sale of store fixtures 1,000  Cash outflow to purchase store fixtures   (2,300) Net cash flow from investing activities $(2,900)

CHECK YOURSELF 14.5

On January 1, 2016, Wyatt Company had an Equipment balance of $124,000. During 2016, Wyatt pur- chased equipment that cost $50,000. The balance in Equipment on December 31, 2016, was $90,000. The 2016 income statement included a $7,000 loss from the sale of equipment. On the date of sale, accumulated depreciation on the equipment sold was $49,000.

Required

a. Determine the cost of the equipment sold during 2016.

b. Determine the amount of cash flow from the sale of equipment that should be reported in the investing activities section of the 2016 statement of cash flows.

Solution

a.

Reconciliation of Equipment

Beginning balance $124,000 Increase due to the purchase of equipment 50,000 Decrease due to sale of equipment ? = (84,000) Ending balance $ 90,000

To balance Equipment, the decrease due to sale of equipment must be $84,000.

b. The book value of the equipment sold was $35,000 ($84,000 − $49,000 accumulated depreciation). Since Wyatt recognized a loss on the equipment sale, the amount of cash collected from the sale was less than the book value of the equipment. The cash collected from the sale of the equipment was $28,000 ($35,000 book value − $7,000 loss on sale).

Prepare the financing activities section of a statement of cash flows.

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■ Increases in contributed capital (common stock, preferred stock, or paid­in capital) suggest cash inflows occurred from issuing equity instruments.

■ Increases or decreases in treasury stock suggest cash outflows or inflows occurred to purchase or sell a company’s own stock.

■ Decreases in retained earnings from cash dividends suggest cash outflows occurred to pay dividends.

To illustrate, return to the financial statements of the New South Company in Exhibit 14.5. The following long­term liability and stockholders’ equity balances are reported on the New South balance sheets:

© Royalty-Free/Corbis

Account Title 2017 2016

Mortgage payable $  2,200 $ 0 Bonds payable 1,000 4,000 Common stock 10,000 8,000 Retained earnings 12,700 7,200 Treasury stock 600 0

For each account, reconcile the beginning and ending balances by identifying the increases and decreases affecting it. Review the notes for additional relevant information. Begin with the mortgage payable liability.

Reconciliation of Mortgage Payable

Reconciliation of Mortgage Payable

Beginning balance in mortgage payable $        0 Increase due to issuing mortgage payable ? = 2,200 Decrease due to payment of mortgage payable           0 Ending balance in mortgage payable $2,200

Bonds Payable

Beginning balance in bonds payable $4,000 Increase due to issuing bonds payable 0 Decrease due to payment of bonds payable           ? = (3,000) Ending balance in bonds payable $1,000

As previously discussed, Note 3 indicates a mortgage note payable was issued to acquire land. The increase due to issuing mortgage payable is $2,200. Since New South received land, not cash, by issuing the mortgage, the transaction is reported in the noncash investing and financing activities section of the statement of cash flows.

Reconciliation of Bonds Payable

Since there is no indication that New South issued bonds during 2017, assume the increase due to issuing bonds payable is zero. To balance Bonds Payable, the decrease due to payment of bonds payable must be $3,000. The cash outflow is reported in the financing activities section in Exhibit 14.13.

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The increase due to net income comes from the income statement. To balance Retained Earnings, the decrease due to payment of dividends must be $1,500. In the absence of infor­ mation to the contrary, assume the decrease is due to the cash payment of dividends. The cash outflow for payment of dividends is reported in the financing activities section of the statement of cash flows in Exhibit 14.13.

Reconciliation of Treasury Stock

Reconciliation of Treasury Stock

Beginning balance in treasury stock $ 0 Increase due to purchasing treasury stock ? = 600 Decrease due to reissuing treasury stock 0 Ending balance in treasury stock $600

EXHIBIT 14.13

Cash Flows from Financing Activities

Cash Flows from Financing Activities

Cash outflow to reduce bonds payable $(3,000) Cash inflow from issuing common stock 2,000 Cash outflow to pay dividends (1,500) Cash outflow to purchase treasury stock (600) Net cash flow from financing activities $(3,100)

Since there is no indication that New South reissued treasury stock during 2017, the decrease due to reissuing treasury stock is zero. To balance Treasury Stock, the increase due to purchasing treasury stock must be $600. The cash outflow is reported in the financing activities section in Exhibit 14.13.

Exhibits 14.14 and 14.15 illustrate the complete state­ ment of cash flows for New South Company under the two alternative methods. Exhibit 14.14 presents operating activi­ ties using the indirect method. Exhibit 14.15 presents operat­ ing activities using the direct method. The investing and financing activities do not differ between methods. Under either method the combined effects of operating, investing, and financing activities result in a net decrease in cash of $100 for 2017. This $100 decrease is necessarily consistent with the difference between the December 31, 2017, and the December 31, 2016, cash balances shown in the balance sheets in Exhibit 14.5.

Reconciliation of Common Stock

Beginning balance in common stock $ 8,000 Increase due to issuing common stock ? = 2,000 Ending balance in common stock $10,000

Reconciliation of Common Stock

To balance Common Stock, the increase due to issuing common stock has to be $2,000. The cash inflow is reported in the financing activities section in Exhibit 14.13.

Reconciliation of Retained Earnings

Reconciliation of Retained Earnings

Beginning balance in retained earnings $ 7,200 Increase due to net income 7,000 Decrease due to payment of dividends ? = (1,500) Ending balance in retained earnings $12,700

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Statement of Cash Flows 661

EXHIBIT 14.15 Statement of Cash Flows—Direct Method

NEW SOUTH COMPANY Statement of Cash Flows

For the Year Ended December 31, 2017

Cash Flows from Operating Activities Inflow from customers $ 20,800 Inflow from interest revenue 600 Outflow for inventory purchases (11,500) Outflow to purchase insurance (1,000) Outflow to pay salary expense (2,600) Outflow for other operating expenses (1,200) Outflow to pay interest expense (600) Inflow from rent revenue 1,400 Net cash flow from operating activities $5,900

continued

EXHIBIT 14.14 Statement of Cash Flows—Indirect Method

NEW SOUTH COMPANY Statement of Cash Flows

For the Year Ended December 31, 2017

Cash Flows from Operating Activities Net income $ 7,000 Adjustments to reconcile net income to net cash flow from operating activities: Decrease in accounts receivable 200 Increase in interest receivable (100) Increase in inventory (700) Decrease in accounts payable for inventory purchases (300) Decrease in prepaid insurance 300 Increase in salaries payable 100 Increase in other operating expenses payable 200 Decrease in interest payable (200) Decrease in unearned rent revenue (1,000) Depreciation expense 1,000 Gain on sale of store fixtures (600) Net cash flow from operating activities $5,900

Cash Flows from Investing Activities Cash outflow to purchase investment securities (1,600) Cash inflow from the sale of store fixtures 1,000 Cash outflow to purchase store fixtures (2,300) Net cash flow from investing activities (2,900)

Cash Flows from Financing Activities Cash outflow to reduce bonds payable (3,000) Cash inflow from issuing common stock 2,000 Cash outflow to pay dividends (1,500) Cash outflow to purchase treasury stock (600) Net cash flow from financing activities (3,100) Net decrease in cash (100) Plus: Beginning cash balance 400 Ending cash balance $ 300

Schedule of Noncash Investing and Financing Activities Issue mortgage for land $2,200

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EXHIBIT 14.15 concluded

NEW SOUTH COMPANY Statement of Cash Flows

For the Year Ended December 31, 2017

Cash Flows from Investing Activities Cash outflow to purchase investment securities (1,600) Cash inflow from the sale of store fixtures 1,000 Cash outflow to purchase store fixtures (2,300) Net cash flow from investing activities (2,900)

Cash Flows from Financing Activities Cash outflow to reduce bonds payable (3,000) Cash inflow from issuing common stock 2,000 Cash outflow to pay dividends (1,500) Cash outflow to purchase treasury stock (600) Net cash flow from financing activities (3,100) Net decrease in cash (100) Plus: Beginning cash balance 400 Ending cash balance $ 300

Schedule of Noncash Investing and Financing Activities Issue mortgage for land $2,200

CHECK YOURSELF 14.6

On January 1, 2016, Sterling Company had a balance of $250,000 in Bonds Payable. During 2016, Sterling issued bonds with a $75,000 face value. The bonds were issued at face value. The balance in Bonds Payable on December 31, 2016, was $150,000.

Required

a. Determine the cash outflow for repayment of bond liabilities assuming the bonds were retired at face value.

b. Prepare the financing activities section of the 2016 statement of cash flows.

Solution

a.

In order to balance Bonds Payable, the decrease due to payment of bonds payable must be $175,000. In the absence of information to the contrary, assume cash was used to pay the bond liabilities.

b.

Reconciliation of Bonds Payable

Beginning balance $250,000 Increase due to issuing bonds payable 75,000 Decrease due to payment of bonds payable ? = (175,000) Ending balance $150,000

Cash Flows from Financing Activities

Inflow from issuing bond liabilities $ 75,000 Outflow for reduction of bond liabilities (175,000) Net cash flow from financing activities $(100,000)

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PREPARING THE SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES

As mentioned earlier, companies may engage in significant noncash investing and financing activities. For example, New South Company acquired land by issuing a $2,200 mortgage note. Since these types of transactions do not involve exchanging cash, they are not reported in the main body of the statement of cash flows. However, the Financial Accounting Stan­ dards Board (FASB) requires disclosure of all material investing and financing activities whether or not they involve exchanging cash. Companies must therefore include with the statement of cash flows a separate schedule that reports noncash investing and financing activities. See the Schedule of Noncash Investing and Financing Activities at the bottom of Exhibits 14.14 and 14.15 for an example.

CASH FLOW VERSUS NET INCOME IN REAL-WORLD COMPANIES

Why are financial analysts interested in the statement of cash flows? Understanding the cash flows of a business is essential because cash is used to pay the bills. A company, especially one experiencing rapid growth, can be short of cash in spite of earning substantial net in­ come. To illustrate, assume you start a computer sales business. You borrow $2,000 and spend the money to purchase two computers for $1,000 each. You sell one of the computers on account for $1,500. If your loan required a payment at this time, you could not make it. Even though you have net income of $500 ($1,500 sales − $1,000 cost of goods sold), you have no cash until you collect the $1,500 account receivable. A business cannot survive without managing cash flow carefully. It is little wonder that financial analysts are keenly interested in cash flow.

The statement of cash flows frequently provides a picture of business activity that otherwise would be lost in the complexities of accrual accounting. For example, even

How did Johnson & Johnson, Inc. (J&J), acquire $13.3 billion of assets in 2012 without spending cash? Oddly enough, the answer can be found on its statement of cash flows.

The supplemental “noncash transactions” information included at the bottom of J&J’s statement of cash flows reveals that it acquired the assets by exchanging common stock directly for assets. A direct exchange of common stock for assets was responsible for $13.3 billion of the $17.8 billion purchase price of a company called Synthes, Inc. The remaining $4.5 billion was paid with cash.

Had J&J issued $13.3 billion of common stock and then used this cash to pur- chase $13.3 billion of assets, it would have reported two separate cash events in the body of its statement of cash flows. A cash inflow would have been reported in the financing activities section for the issuance of the stock, and a cash outflow would have been reported in the investing activities section for the purchase of the assets. Acquiring large amounts of assets is considered important, even if there is no immediate exchange of cash, so generally accepted accounting principles r equire such events to be reported with the statement of cash flows or disclosed in the notes.

REALITY BYTES

© Bloomberg/Contributor/Getty Images

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though Panasonic Corporation reported a loss of approx­ imately $7.6 billion in 2013 on its income statement, its net cash flow from operating activities was a positive $3.3 billion.

Investors consider cash flow information so important they are willing to pay for it. Even though the FASB prohib- its companies from disclosing cash flow per share in audited financial statements, one prominent stock analysis service, Value Line Investment Survey, sells this information to a significant customer base. Clearly, Value Line’s customers value information about cash flows.

Exhibit 14.16 compares income from operations to cash flows from operating activities for six real­world companies for 2010 through 2013. Several things are ap­ parent from this exhibit.The cash flow from operating ac­ tivities exceeds income from operations for all but three of

the 24 comparisons, and all of these relate to one company, D. R. Horton, a large home­ building company. Cash flows often exceed income because depreciation, a noncash ex­ pense, is usually significant.The most dramatic example of the differences between cash flow and income is AT&T. For the four years shown in Exhibit 14.16, AT&T had cumu­ lative net earnings of $50.5 billion, but its cash flows from operations were $143.6 bil­ lion, almost three times larger. During this period, AT&T’s earnings ranged from a low of $4.2 billion to a high of $20.2 billion, a change of 480 percent, but its cash flow from operating activities ranged from $34.6 billion to $39.2 billion, a change of only 13 per­ cent.The difference between cash flow from operating activities and net income helps explain how some companies can have significant losses over a few years and continue to stay in business and pay their bills.

The exhibit also shows that cash flow from operating activities can be more stable than operating income. Results for Avon Products demonstrate this clearly. Avon reported a loss

© Justin Sullivan/Staff/Getty Images

EXHIBIT 14.16

Net Income versus Cash Flow from Operations (amounts in millions)

2013 2012 2011 2010

AT&T Net income $18,553 $  7,539 $ 4,184 $20,179 Cash flow—operations 34,796 39,176 34,648 34,993

Avon Products Net income (52) (38) 518 609 Cash flow—operations 540 556 656 689

BlackBerry Net income (628) 1,164  3,411 2,457 Cash flow—operations 2,303 2,912  4,009 3,035

Chevron Net income 21,597 26,336  27,008 19,136 Cash flow—operations 35,002 38,812  41,098 31,359

D. R. Horton Net income 463 956  72 245 Cash flow—operations (1,231) (298) 15 709

McDonald’s Net income 5,586 5,465  5,503 4,946 Cash flow—operations 7,121 6,966  7,150 6,342

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in two of the four years presented. However, operating cash flows were not only positive in every year, but they were never lower than $540 million.

What could explain why D. R. Horton had less cash flow from operating activities than operating income in 2012 and 2013? The company was experiencing the kind of growth described earlier for your computer business. Its cash outflows were supporting growth in inventory. After the depressed real estate market that began in 2008, home buying began to increase. As a result, home builders had to add inventory, which in their business includes land, to meet the demand. In 2013 alone, D. R. Horton’s inventory in­ creased by 50 percent, or $2 billion.

The D. R. Horton situation highlights a potential weak­ ness in the format of the statement of cash flows. Some accountants consider it misleading to classify all increases in long­term assets as investing activities and all changes in in­ ventory as affecting cash flow from operating activities. In the case of D. R. Horton, they would argue that the increase in inventory that relates to expanding its business should be classified as an investing activity, just as the cost of a new warehouse is. Although inventory is classified as a current asset and buildings are classified as long­term assets, in reality there is a certain level of inventory a company must permanently maintain to stay in business. The GAAP format of the statement of cash flows penalizes cash flow from operating activities for increases in inventory that are really a permanent investment in assets.

Conversely, the same critics might argue that some pur­ chases of long­term assets are not actually investments but merely replacements of old, existing property, plant, and equipment. In other words, the in- vesting activities section of the statement of cash flows makes no distinction between expen­ ditures that expand the business and those that simply replace old equipment (sometimes called capital maintenance expenditures).

Users of the statement of cash flows must exercise the same care interpreting it as when they use the balance sheet or the income statement. Numbers alone are insufficient. Users must evaluate numbers based on knowledge of the particular business and industry they are analyzing.

Accounting information alone cannot guide a businessperson to a sound decision. Making good business decisions requires an understanding of the business in question, the environmental and economic factors affecting the operation of that business, and the accounting concepts on which the financial statements of that business are based.

This chapter examined in detail only one financial statement, the statement of cash flows. The chapter provided a more comprehensive discussion of how accrual accounting relates to cash­based accounting. Effective use of financial statements requires understanding not only accrual and cash­based accounting systems but also how they relate to each other. That rela­ tionship is why a statement of cash flows can begin with a reconciliation of net income, an accrual measurement, to net cash flow from operating activities, a cash measurement. Finally, this chapter explained how the conventions for classifying cash flows as operating, investing, or financing activities require analysis and understanding to make informed deci­ sions with the financial information.

A Look Back <<

© 2007 Keith Eng

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>> A Look Forward

We sincerely hope this text provided a meaningful learning experience that will serve you well as you progress through your academic training and, ultimately, your career. Good luck and best wishes.

SELF-STUDY REVIEW PROBLEM

The following financial statements pertain to Schlemmer Company:

Income Statement For the Year Ended December 31, 2017

Sales revenue $ 67,300  Cost of goods sold     (24,100) Gross margin 43,200  Depreciation expense       (1,250) Operating income 41,950  Gain on sale of equipment 2,900  Loss on disposal of land          (100) Net income $ 44,750

Balance Sheets As of December 31

2017 2016

Cash $48,400 $ 2,800 Accounts receivable 2,200 1,200 Inventory 5,600 6,000 Equipment 18,000 22,000 Accumulated depreciation—Equip. (13,650) (17,400) Land    17,200    10,400 Total assets $77,750 $25,000 Accounts payable (inventory) $ 5,200 $ 4,200 Long-term debt 5,600 6,400 Common stock 19,400 10,000 Retained earnings   47,550      4,400 Total liabilities and equity $77,750 $25,000

A step-by-step audio-narrated series of slides is available in the Connect library.

Additional Data

1. During 2017 equipment that had originally cost $11,000 was sold. Accumulated depreciation on this equipment was $5,000 at the time of sale.

2. Common stock was issued in exchange for land valued at $9,400 at the time of the exchange.

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Statement of Cash Flows 667

Required

Using the indirect method, prepare in good form a statement of cash flows for the year ended Decem­ ber 31, 2017.

Solution

(1) Add decreases and subtract increases in current asset account balances to net income. (2) Add increases and subtract decreases in current liability account balances to net income. (3) Add noncash expenses (depreciation) to net income. (4) Add losses on the sale of noncurrent assets to net income and subtract gains on the sale of long­

term assets from net income. (5) Information regarding the Equipment account is summarized in the following table:

Equipment Account Information

Beginning balance in equipment $ 22,000 Purchases of equipment (cash outflows) ? = 7,000 Sales of equipment (cash inflows) (11,000) Ending balance in equipment $ 18,000

SCHLEMMER COMPANY Statement of Cash Flows

For the Year Ended December 31, 2017

Cash Flows from Operating Activities Net income $44,750  Add: Decrease in inventory (1) 400  Increase in accounts payable (2) 1,000  Depreciation expense (3) 1,250  Loss on disposal of land (4) 100  Subtract: Increase in accounts receivable (1) (1,000) Gain on sale of equipment (4)   (2,900) Net cash flow from operating activities $43,600 

Cash Flows from Investing Activities Cash inflow from the sale of equipment (5) 8,900  Cash outflow for the purchase of equipment (5) (7,000) Cash inflow from sale of land (6)    2,500  Net cash flow from investing activities 4,400 

Cash Flows from Financing Activities Cash outflow to repay long-term debt (7) (800) Cash outflow to pay dividends (8)    (1,600) Net cash flow from financing activities   (2,400)

Net Increase in Cash 45,600  Plus: Beginning cash balance     2,800  Ending cash balance $48,400 

Schedule of Noncash Investing and Financing Activities Issue of common stock for land (9) $  9,400

To balance the account, equipment costing $7,000 must have been purchased. In the absence of information to the contrary, we assume cash was used to make the purchase.

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668 Chapter 14

Note 1 to the financial statement shows that equipment sold had a book value of $6,000 ($11,000 cost − $5,000 accumulated depreciation). The amount of the cash inflow from this sale is com­ puted as follows:

Cash inflow = Book value + Gain = $6,000 + $2,900 = $8,900

(6) The information regarding the Land account is as follows:

Land Account Information

Beginning balance in land $10,400 Purchases of land (issue of common stock) 9,400 Sales of land (cash inflows)            ? = (2,600) Ending balance in land $17,200

Long-Term Debt Information

Beginning balance in long-term debt $6,400 Issue of long-term debt instruments (cash inflow) 0 Payment of long-term debt (cash outflow)            ? = (800) Ending balance in long-term debt $5,600

Retained Earnings Information

Beginning balance in retained earnings $ 4,400 Net income 44,750 Dividends (cash outflow)             ? = (1,600) Ending balance in retained earnings $47,550

Note 2 indicates that land valued at $9,400 was acquired by issuing common stock. Since there was no cash flow associated with this purchase, the event is shown in the noncash investing and financing activities section of the statement of cash flows.

To balance the account, the cost (book value) of land sold had to be $2,600. Since the income statement shows a $100 loss on the sale of land, the cash collected from the sale is computed as follows:

Cash inflow = Book value − Loss = $2,600 − $100 = $2,500

(7) The information regarding the Long­Term Debt account is as follows:

There is no information in the financial statements that suggests long­term debt was issued. There­ fore, to balance the account, $800 of long­term debt had to be paid off, thereby resulting in a cash outflow.

(8) The information regarding the Retained Earnings account is as follows:

To balance the account, $1,600 of dividends had to be paid, thereby resulting in a cash outflow.

(9) Note 2 states that common stock was issued to acquire land valued at $9,400. This is a noncash investing and financing activity.

Cash inflows 640 Cash outflows 640 Direct method 642

Financing activities 643

Indirect method 642

Investing activities 643 Noncash investing and

financing activities 644

Operating activities 642

KEY TERMS

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Statement of Cash Flows 669

1. What is the purpose of the statement of cash flows?

2. What are the three catego­ ries of cash flows reported on the cash flow statement? Discuss each and give an example of an inflow and an outflow for each category.

3. What are noncash investing and financing activities? Provide an example. How are such transactions shown on the statement of cash flows?

4. Albring Company had a beginning balance in accounts receivable of $12,000 and an ending balance of $14,000. Net income amounted to $110,000. Based on this information alone, deter­ mine the amount of net cash flow from operating activities.

5. Forsyth Company had a beginning balance in utili­ ties payable of $3,300 and an ending balance of $5,200. Net income amounted to $87,000. Based on this information alone, determine the amount of net cash flow from operating activities.

6. Clover Company had a beginning balance in un­ earned revenue of $4,300 and an ending balance of $3,200. Net income amounted to $54,000. Based on this information alone, determine the amount of net cash flow from operating activities.

7. Which of the following activities are financing activities? (a) Payment of accounts

payable. (b) Payment of interest on

bonds payable. (c) Sale of common

stock. (d) Sale of preferred stock

at a premium. (e) Payment of a cash

dividend. 8. Does depreciation

expense affect net cash flow? Explain.

9. If Best Company sold land that cost $4,200 at a $500 gain, how much cash did it collect from the sale of land?

10. If Best Company sold office equipment that originally cost $7,500 and had $7,200 of

accumulated depreciation at a $100 loss, what was the selling price for the office equipment?

11. In which section of the statement of cash flows would the following transactions be reported? (a) The amount of the

change in the bal­ ance of accounts receivable.

(b) Cash purchase of investment securities.

(c) Cash purchase of equipment.

(d) Cash sale of merchandise.

(e) Cash sale of common stock.

(f ) The amount of net income.

(g) Cash proceeds from loan.

(h) Cash payment on bonds payable.

(i) Cash receipt from sale of old equipment.

( j) The amount of the change in the balance of accounts payable.

12. What is the difference between preparing the statement of cash flows

using the direct method and using the indirect method?

13. Which method (direct or indirect) of presenting the statement of cash flows is more intuitively logical? Why?

14. What is the major advan­ tage of using the indirect method to present the statement of cash flows?

15. What is the advantage of using the direct method to present the statement of cash flows?

16. How would Best Company report the following trans­ actions on the statement of cash flows? (a) Purchased new

equipment for $46,000 cash.

(b) Sold old equipment for $8,700 cash. The equipment had a book value of $4,900.

17. Can a company report negative net cash flows from operating activities for the year on the state­ ment of cash flows but still have positive net income on the income statement? Explain.

QUESTIONS

MULTIPLE-CHOICE QUESTIONS

Multiple-choice questions are available in Connect.

All applicable Exercises in Series A are available in Connect.

Exercise 14-1A Use the indirect method to determine cash flows from operating activities

An accountant for Southern Manufacturing Companies (SMC) computed the following information by making comparisons between SMC’s 2016 and 2017 balance sheets. Further information was de­ termined by examining the company’s 2017 income statement.

1. The amount of cash dividends paid to the stockholders. 2. The amount of a decrease in the balance of an Unearned Revenue account. 3. The amount of an increase in the balance of an Inventory account.

LO 14-1

EXERCISES—SERIES A

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670 Chapter 14

4. The amount of an increase in the balance of a Land account. 5. The amount of a decrease in the balance of a Prepaid Rent account. 6. The amount of an increase in the balance of a Treasury Stock account. 7. The amount of an increase in the balance of the Accounts Receivable account. 8. The amount of a loss arising from the sale of land. 9. The amount of an increase in the balance of the Other Operating Expenses Payable account.

10. The amount of a decrease in the balance of the Bonds Payable account. 11. The amount of depreciation expense shown on the income statement.

Required

For each item described above indicate whether the amount should be added to or subtracted from the amount of net income when determining the amount of net cash flow from operating activities using the indirect method. Also identify any items that do not affect net cash flow from operating activities because they are reported as investing or financing activities.

Exercise 14-2A Use the indirect method to determine cash flows from operating activities

Alfonza Incorporated presents its statement of cash flows using the indirect method. The following accounts and corresponding balances were drawn from the company’s 2017 and 2016 year­end balance sheets:

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Account Title 2017 2016

Accounts receivable $16,200 $17,800 Accounts payable   $7,600   $9,100

Account Title 2017 2016

Accounts receivable  $36,000  $37,200 Prepaid rent       2,400       1,800 Interest receivable          600         400 Accounts payable       9,300     10,400 Salaries payable       4,500      5,200 Unearned revenue       3,600      5,400

The 2017 income statement showed net income of $31,600.

Required

a. Prepare the operating activities section of the statement of cash flows. b. Explain why the change in the balance in accounts receivable was added to or subtracted from the

amount of net income when you completed Requirement a. c. Explain why the change in the balance in accounts payable was added to or subtracted from the

amount of net income when you completed Requirement a.

Exercise 14-3A Use the indirect method to determine cash flows from operating activities

Shim Company presents its statement of cash flows using the indirect method. The following accounts and corresponding balances were drawn from Shim’s 2017 and 2016 year­end balance sheets:

LO 14-1

The income statement reported a $1,500 gain on the sale of equipment, an $800 loss on the sale of land, and $3,600 of depreciation expense. Net income for the period was $47,300.

Required

Prepare the operating activities section of the statement of cash flows.

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Statement of Cash Flows 671

Exercise 14-4A Use the direct method to determine cash flows from operating activities

The following accounts and corresponding balances were drawn from Avia Company’s 2017 and 2016 year­end balance sheets:

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Account Title 2017 2016

Unearned revenue $7,600 $6,200 Prepaid rent   2,400   3,600

Account Title 2017 2016

Accounts receivable $35,200 $31,600 Interest receivable     4,200      4,800 Other operating expenses payable    21,000    18,500 Salaries payable      6,500      7,200

Income Statement

Sales $ 530,000 Salaries expense (214,000) Other operating expenses    (175,000) Operating income 141,000 Nonoperating items: Interest revenue       16,500 Net income $ 157,500 

During the year, $46,000 of unearned revenue was recognized as having been earned. Rent expense for 2017 was $18,000.

Required

Based on this information alone, prepare the operating activities section of the statement of cash flows assuming the direct approach is used.

Exercise 14-5A Use the direct method to determine cash flows from operating activities

The following accounts and corresponding balances were drawn from Marinelli Company’s 2017 and 2016 year­end balance sheets:

LO 14-2

Required

a. Use the direct method to compute the amount of cash inflows from operating activities. b. Use the direct method to compute the amount of cash outflows from operating activities.

Exercise 14-6A Direct versus indirect method of determining cash flows from operating activities

Expert Electronics, Inc. (EEI) recognized $3,800 of sales revenue on account and collected $2,100 of cash from accounts receivable. Further, EEI recognized $900 of operating expenses on account and paid $700 cash as partial settlement of accounts payable.

Required

Based on this information alone:

a. Prepare the operating activities section of the statement of cash flows under the direct method. b. Prepare the operating activities section of the statement of cash flows under the indirect method.

LO 14-1, 14-2

The 2017 income statement is shown below:

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672 Chapter 14

Exercise 14-7A The direct versus the indirect method of determining cash flows from operating activities

The following accounts and corresponding balances were drawn from Jogger Company’s 2017 and 2016 year­end balance sheets:

LO 14-1, 14-2

Account Title 2017 2016

Accounts receivable $57,000 $62,000 Prepaid rent       1,100       1,300 Utilities payable        900        750 Other operating expenses payable   21,300   22,400

Income Statement

Sales $268,000  Rent expense (36,000) Utilities expense (18,300) Other operating expenses      (79,100) Net Income $134,600

Account Title 2017 2016

Investment securities $110,000 $116,500 Machinery   486,000    437,000 Land   160,000   100,000

Required

a. Prepare the operating activities section of the statement of cash flows using the direct method. b. Prepare the operating activities section of the statement of cash flows using the indirect method.

Exercise 14-8A Determining cash flow from investing activities

On January 1, 2016, Shelton Company had a balance of $325,000 in its Land account. During 2016, Shelton sold land that had cost $106,500 for $132,000 cash. The balance in the Land account on December 31, 2016, was $285,000.

Required

a. Determine the cash outflow for the purchase of land during 2016. b. Prepare the investing activities section of the 2016 statement of cash flows.

Exercise 14-9A Determining cash flows from investing activities

On January 1, 2016, Bacco Company had a balance of $72,350 in its Delivery Equipment account. During 2016, Bacco purchased delivery equipment that cost $22,100. The balance in the Delivery Equipment account on December 31, 2016, was $69,400. The 2016 income statement reported a gain from the sale of equipment for $5,000. On the date of sale, accumulated depreciation on the equip­ ment sold amounted to $22,000.

Required

a. Determine the original cost of the equipment that was sold during 2016. b. Determine the amount of cash flow from the sale of delivery equipment that should be shown in

the investing activities section of the 2016 statement of cash flows.

Exercise 14-10A Determining cash flows from investing activities

The following accounts and corresponding balances were drawn from Delsey Company’s 2017 and 2016 year­end balance sheets:

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LO 14-3

LO 14-3

The 2017 income statement is shown below:

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Statement of Cash Flows 673

Other information drawn from the accounting records:

1. Delsey incurred a $6,000 loss on the sale of investment securities during 2017. 2. Old machinery with a book value of $8,000 (cost of $36,000 minus accumulated depreciation of

$28,000) was sold. The income statement showed a gain on the sale of machinery of $4,500. 3. Delsey did not sell land during the year.

Required

a. Compute the amount of cash flow associated with the sale of investment securities. b. Compute the amount of cash flow associated with the purchase of machinery. c. Compute the amount of cash flow associated with the sale of machinery. d. Compute the amount of cash flow associated with the purchase of land. e. Prepare the investing activities section of the statement of cash flows.

Exercise 14-11A Determining cash flows from financing activities

On January 1, 2016, DIBA Company had a balance of $450,000 in its Bonds Payable account. During 2016, DIBA issued bonds with a $200,000 face value. There was no premium or discount associated with the bond issue. The balance in the Bonds Payable account on December 31, 2016, was $400,000.

Required

a. Determine the cash outflow for the repayment of bond liabilities assuming that the bonds were retired at face value.

b. Prepare the financing activities section of the 2016 statement of cash flows.

Exercise 14-12A Determining cash flows from financing activities

On January 1, 2016, Hardy Company had a balance of $150,000 in its Common Stock account. During 2016, Hardy paid $20,000 to purchase treasury stock. Treasury stock is accounted for using the cost method. The balance in the Common Stock account on December 31, 2016, was $175,000. Assume that the common stock is no par stock.

Required

a. Determine the cash inflow from the issue of common stock. b. Prepare the financing activities section of the 2016 statement of cash flows.

Exercise 14-13A Determining cash flows from financing activities

The following accounts and corresponding balances were drawn from Dexter Company’s 2017 and 2016 year­end balance sheets:

LO 14-4

LO 14-4

LO 14-4

Account Title 2017 2016

Bonds payable $350,000 $400,000 Common stock   450,000   420,000

Other information drawn from the accounting records:

1. Dividends paid during the period amounted to $50,000. 2. There were no bond liabilities issued during the period.

Required

a. Compute the amount of cash flow associated with the repayment of bond liabilities. b. Compute the amount of cash flow associated with the issue of common stock. c. Prepare the financing activities section of the statement of cash flows.

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674 Chapter 14

PROBLEMS—SERIES A

All applicable Problems in Series A are available in Connect.

Problem 14-14A The direct versus the indirect method to determine cash flow from operating activities

Green Brands, Inc. (GBI) presents its statement of cash flows using the indirect method. The fol­ lowing accounts and corresponding balances were drawn from GBI’s 2017 and 2016 year­end balance sheets:

LO 14-1, 14-2

CHECK FIGURE Net Cash Flow from Operating Activities: $105,200

Account Title 2017 2016

Accounts receivable $48,000 $52,000 Merchandise inventory   78,000   72,000 Prepaid insurance   24,000   32,000 Accounts payable   31,000   28,000 Salaries payable     8,200     7,800 Unearned service revenue     2,400     3,600

Income Statement

Sales $ 720,000  Cost of goods sold   (398,000) Gross margin 322,000  Service revenue 6,000  Insurance expense (36,000) Salaries expense (195,000) Depreciation expense      (12,000) Operating income 85,000  Gain on sale of equipment         4,500  Net income $ 89,500

The 2017 income statement is shown below:

Required

a. Prepare the operating activities section of the statement of cash flows using the direct method. b. Prepare the operating activities section of the statement of cash flows using the indirect method.

Problem 14-15A Determining cash flows from investing activities

The following information was drawn from the year­end balance sheets of Mass Trading Company:

LO 14-3

CHECK FIGURES b. $4,700 c. $10,000

Account Title 2017 2016

Investment securities $ 47,200 $ 42,400 Equipment 246,000  218,000 Buildings 646,000 720,000 Land   95,000   72,000

Additional information regarding transactions occurring during 2017:

1. Investment securities that had cost $6,100 were sold. The 2017 income statement contained a loss on the sale of investment securities of $1,400.

2. Equipment with a cost of $38,000 was purchased.

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Statement of Cash Flows 675

3. The income statement showed a gain on the sale of equipment of $8,000. On the date of sale, accumulated depreciation on the equipment sold amounted to $8,000.

4. A building that had originally cost $210,000 was demolished. 5. Land that had cost $30,000 was sold for $27,000.

Required

a. Determine the amount of cash flow for the purchase of investment securities during 2017. b. Determine the amount of cash flow from the sale of investment securities during 2017. c. Determine the cost of the equipment that was sold during 2017. d. Determine the amount of cash flow from the sale of equipment during 2017. e. Determine the amount of cash flow for the purchase of buildings during 2017. f. Determine the amount of cash flow for the purchase of land during 2017. g. Prepare the investing activities section of the 2017 statement of cash flows.

Problem 14-16A Determining cash flows from financing activities

The following information was drawn from the year­end balance sheets of Fox River, Inc.:

LO 14-4

CHECK FIGURES c. $15,000 e. Net cash flow from financing

activities: ($206,000) outflow Account Title 2017 2016

Bonds payable $600,000 $800,000 Common stock    210,000    180,000 Treasury stock     20,000       5,000 Retained earnings     86,000     75,000

Additional information regarding transactions occurring during 2017:

1. Fox River, Inc. issued $100,000 of bonds during 2017. The bonds were issued at face value. All bonds retired were retired at face value.

2. Common stock did not have a par value. 3. Fox River, Inc. uses the cost method to account for treasury stock. 4. The amount of net income shown on the 2017 income statement was $32,000.

Required

a. Determine the amount of cash flow for the retirement of bonds that should appear on the 2017 statement of cash flows.

b. Determine the amount of cash flow from the issue of common stock that should appear on the 2017 statement of cash flows.

c. Determine the amount of cash flow for the purchase of treasury stock that should appear on the 2017 statement of cash flows.

d. Determine the amount of cash flow for the payment of dividends that should appear on the 2017 statement of cash flows.

e. Prepare the financing activities section of the 2017 statement of cash flows.

Problem 14-17A Preparing a statement of cash flows

The following information can be obtained by examining a company’s balance sheet and income state­ ment information:

a. Increases in current asset account balances, other than cash. b. Decreases in current asset account balances, other than cash. c. Cash outflows to purchase long­term assets. d. Decreases in current liability account balances. e. Cash outflows to repay long­term debt. f. Gains recognized on the sale of long­term assets. g. Noncash expenses (e.g., depreciation). h. Cash outflows to purchase treasury stock.

LO 14-1, 14-3, 14-4

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676 Chapter 14

i. Increases in current liability account balances. j. Cash inflows from the sale of long­term assets. k. Cash inflows from the issue of common stock. l. Cash outflows to pay dividends.

m. Losses incurred from the sale of long­term assets. n. Cash inflows from the issue of long­term debt.

Required

Construct a table like the one shown below. For each item, indicate whether it would be used in the computation of net cash flows from operating, investing, or financing activities. Also, indicate whether the item would be added or subtracted when determining the net cash flow from operating, investing, or financing activities. Assume the indirect method is used to prepare the operating activities section of the statement of cash flows. The first item has been completed as an example.

Item Type of Activity Add or Subtract

a. Operating Subtract

b.

c.

d.

e.

f.

g.

h.

i.

j.

k.

l.

m. n.

Balance Sheets As of December 31

2017 2016 Assets Cash $ 32,500 $ 16,300 Accounts receivable 4,750 2,800 Inventory 11,200 9,800 Equipment 45,000 52,000 Accumulated depreciation—Equipment (17,800) (21,800) Land 28,000 12,000 Total assets $103,650 $ 71,100 Liabilities and equity Accounts payable (inventory) $ 3,750 $ 4,900 Long-term debt 5,800 7,800 Common stock 47,000 25,000 Retained earnings 47,100 33,400 Total liabilities and equity $103,650 $ 71,100

Problem 14-18A Using financial statements to prepare a statements of cash flows— Indirect method

The comparative balance sheets and income statements for Gypsy Company follow:

LO 14-1, 14-3, 14-4

CHECK FIGURES Net Cash Flow from Operating Activities: $32,200 Net Increase in Cash: $16,200

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Statement of Cash Flows 677

Additional Data

1. During 2017, the company sold equipment for $21,500; it had originally cost $36,000. Accumu­ lated depreciation on this equipment was $16,000 at the time of the sale. Also, the company purchased equipment for $29,000 cash.

2. The company sold land that had cost $6,000. This land was sold for $5,900, resulting in the recog­ nition of a $100 loss. Also, common stock was issued in exchange for title to land that was valued at $22,000 at the time of exchange.

3. Paid dividends of $12,400.

Required

Prepare a statement of cash flows using the indirect method.

Problem 14-19A Using financial statements to prepare a statement of cash flows— Indirect method

The comparative balance sheets and an income statement for Raceway Corporation follow:

LO 14-1, 14-3, 14-4

CHECK FIGURES Net Cash Flow from Operating Activities: $45,900 Net decrease in cash: $42,100

Income Statement For the Year Ended December 31, 2017

Sales revenue $ 61,200 Cost of goods sold   (24,500) Gross margin 36,700 Depreciation expense   (12,000) Operating income 24,700 Gain on sale of equipment 1,500 Loss on disposal of land         (100) Net income $ 26,100

Balance Sheets As of December 31

2017 2016 Assets     Cash $ 6,300  $ 48,400      Accounts receivable 10,200  7,260      Merchandise inventory 45,200  56,000      Prepaid rent 700  2,140      Equipment 140,000  144,000      Accumulated depreciation (73,400) (118,000)     Land     116,000     50,000  Total assets $245,000  $189,800  Liabilities     Accounts payable (inventory) $ 37,200  $ 40,000      Salaries payable 12,200  10,600  Stockholders’ equity     Common stock, $50 par value 150,000  120,000      Retained earnings      45,600      19,200  Total liabilities and equity $245,000  $189,800

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678 Chapter 14

Other Information

1. Purchased land for $66,000. 2. Purchased new equipment for $62,000. 3. Sold old equipment that cost $66,000 with accumulated depreciation of $56,000 for $10,000 cash. 4. Issued common stock for $30,000.

Required

Prepare the statement of cash flows for 2017 using the indirect method.

Problem 14-20A Using transaction data to prepare a statement of cash flows— Direct method

York Company engaged in the following transactions for the year 2016. The beginning cash balance was $86,000 and the ending cash balance was $59,100.

1. Sales on account were $548,000. The beginning receivables balance was $128,000 and the ending balance was $90,000.

2. Salaries expense for the period was $232,000. The beginning salaries payable balance was $16,000 and the ending balance was $8,000.

3. Other operating expenses for the period were $236,000. The beginning other operating expenses payable balance was $16,000 and the ending balance was $10,000.

4. Recorded $30,000 of depreciation expense. The beginning and ending balances in the Accumu­ lated Depreciation account were $42,000 and $12,000, respectively.

5. The Equipment account had beginning and ending balances of $44,000 and $56,000 respectively. There were no sales of equipment during the period.

6. The beginning and ending balances in the Notes Payable account were $36,000 and $44,000, re­ spectively. There were no payoffs of notes during the period.

7. There was $4,600 of interest expense reported on the income statement. The beginning and ending balances in the Interest Payable account were $8,400 and $7,500, respectively.

8. The beginning and ending Merchandise Inventory account balances were $22,000 and $29,400, respectively. The company sold merchandise with a cost of $83,600 (cost of goods sold for the period was $83,600). The beginning and ending balances in the Accounts Payable account were $8,000 and $6,400, respectively.

9. The beginning and ending balances in the Notes Receivable account were $60,000 and $100,000, respectively. Notes receivable result from long­term loans made to employees. There were no col­ lections from employees during the period.

10. The beginning and ending balances in the Common Stock account were $120,000 and $160,000, respectively. The increase was caused by the issue of common stock for cash.

11. Land had beginning and ending balances of $24,000 and $14,000, respectively. Land that cost $10,000 was sold for $6,000, resulting in a loss of $4,000.

LO 14-2, 14-3, 14-4

CHECK FIGURE b. Net cash flow from operating

activities: $(900)

Income Statement For the Year Ended December 31, 2017

Sales $ 480,000  Cost of goods sold    (264,000) Gross profit 216,000  Operating expenses     Depreciation expense (11,400)     Rent expense (7,000)     Salaries expense (95,200)     Other operating expenses      (76,000) Net income $ 26,400

G A T E S , D E A N D R A 1 1 2 3 T S

Statement of Cash Flows 679

12. The tax expense for the period was $6,600. The Taxes Payable account had a $2,400 beginning balance and an $2,200 ending balance.

13. The Investments account had beginning and ending balances of $20,000 and $60,000, respec­ tively. The company purchased investments for $50,000 cash during the period, and investments that cost $10,000 were sold for $22,000, resulting in a $12,000 gain.

Required

a. Determine the amount of cash flow for each item and indicate whether the item should appear in the operating, investing, or financing activities section of a statement of cash flows. Also identify any items that do not affect the cash flow statement. Assume York Company uses the direct method for showing net cash flow from operating activities.

b. Prepare a statement of cash flows based on the information you developed in Requirement a.

Problem 14-21A Using financial statements to prepare a statement of cash flows— Direct method

The following financial statements were drawn from the records of Matrix Shoes:

LO 14-2, 14-3, 14-4

CHECK FIGURES Net cash flow from operating activities: $56,200 Net increase in cash: $80,200

Balance Sheets As of December 31

2017 2016 Assets     Cash $  94,300  $  14,100      Accounts receivable 36,000  40,000      Merchandise inventory 72,000  64,000      Notes receivable 0  16,000      Equipment 98,000  170,000      Accumulated depreciation—Equipment (47,800) (94,000)     Land     46,000      30,000  Total assets $298,500  $240,100  Liabilities     Accounts payable $  24,000  $  26,400      Salaries payable 15,000  10,000      Utilities payable 800  1,400      Interest payable 0  1,000      Notes payable (long-term) 0  24,000      Common stock 150,000  110,000      Retained earnings    108,700      67,300  Total liabilities and equity $298,500  $240,100

Income Statement For the Year Ended December 31, 2017

Sales revenue $300,000  Cost of goods sold   (144,000) Gross margin 156,000  Operating expenses     Salaries expense (88,000)     Depreciation expense (9,800)     Utilities expense       (6,400) Operating income 51,800  Nonoperating items     Interest expense (2,400)     Loss on the sale of equipment          (800) Net income $  48,600

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680 Chapter 14

Additional Information

1. Sold equipment costing $72,000 with accumulated depreciation of $56,000 for $15,200 cash. 2. Paid a $7,200 cash dividend to owners.

Required

Analyze the data and prepare a statement of cash flows using the direct method.

The 2017 income statement showed net income of $41,500.

Required

a. Prepare the operating activities section of the statement of cash flows. b. Explain why the change in the balance in accounts receivable was added to or subtracted from the

amount of net income when you completed Requirement a. c. Explain why the change in the balance in accounts payable was added to or subtracted from the

amount of net income when you completed Requirement a.

EXERCISES—SERIES B

Exercise 14-1B Use the indirect method to determine cash flows from operating activities

An accountant for Farve Enterprise Companies (FEC) computed the following information by making comparisons between FEC’s 2017 and 2016 balance sheets. Further information was determined by examining the company’s 2017 income statement.

1. The amount of an increase in the balance of a Prepaid Rent account. 2. The amount of an increase in the balance of a Treasury Stock account. 3. The amount of a decrease in the balance of the Accounts Receivable account. 4. The amount of a gain arising from the sale of land. 5. The amount of an increase in the balance of the Salaries Payable account. 6. The amount of an increase in the balance of the Bonds Payable account. 7. The amount of depreciation expense shown on the income statement. 8. The amount of cash dividends paid to the stockholders. 9. The amount of an increase in the balance of an Unearned Revenue account.

10. The amount of a decrease in the balance of an Inventory account. 11. The amount of a decrease in the balance of a Land account.

Required

For each item described above, indicate whether the amount should be added to or subtracted from the amount of net income when determining the amount of net cash flow from operating activities using the indirect method. Also identify any items that do not affect net cash flow from operating activities because they are reported as investing or financing activities.

Exercise 14-2B Use the indirect method to determine cash flows from operating activities

Napoleon Incorporated presents its statement of cash flows using the indirect method. The following accounts and corresponding balances were drawn from the company’s 2017 and 2016 year­end bal­ ance sheets:

LO 14-1

LO 14-1

Account Title 2017 2016

Accounts receivable $31,400 $28,600 Accounts payable 10,300 9,800

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Statement of Cash Flows 681

Exercise 14-3B Use the indirect method to determine cash flows from operating activities

Pella Company presents its statement of cash flows using the indirect method. The following accounts and corresponding balances were drawn from Pella’s 2017 and 2016 year­end balance sheets:

LO 14-1

Account Title 2017 2016

Accounts receivable   $24,000  $21,000 Prepaid rent         1,650       1,900 Interest receivable           900       1,200 Accounts payable      10,200      8,500 Salaries payable        2,700      2,900 Unearned revenue       2,000       1,800

Account Title 2017 2016

Unearned revenue $4,500 $6,000 Prepaid rent   5,200   3,600

Account Title 2017 2016

Accounts receivable $62,000 $56,000 Interest receivable      8,000      6,000 Other operating expenses payable    26,000    29,000 Salaries payable     12,000      9,000

Income Statement

Sales $ 650,000 Salaries expense (420,000) Other operating expenses     (110,000) Operating income 120,000  Nonoperating items: Interest revenue       15,000  Net income $ 135,000 

The income statement reported a $700 loss on the sale of equipment, a $900 gain on the sale of land, and $2,500 of depreciation expense. Net income for the period was $36,500.

Required

Prepare the operating activities section of the statement of cash flows.

Exercise 14-4B Use the direct method to determine cash flows from operating activities

The following accounts and corresponding balances were drawn from Osprey Company’s 2017 and 2016 year­end balance sheets:

LO 14-2

During the year, $84,000 of unearned revenue was recognized as having been earned. Rent expense for 2017 was $24,000.

Required

Based on this information alone, prepare the operating activities section of the statement of cash flows assuming the direct approach is used.

Exercise 14-5B Use the direct method to determine cash flows from operating activities

The following accounts and corresponding balances were drawn from Pixi Company’s 2017 and 2016 year­end balance sheets:

LO 14-2

The 2017 income statement is shown below:

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682 Chapter 14

Required

a. Use the direct method to compute the amount of cash inflows from operating activities. b. Use the direct method to compute the amount of cash outflows from operating activities.

Exercise 14-6B Direct versus indirect method of determining cash flows from operating activities

Ragg Shop, Inc. (RSI) recognized $3,800 of sales revenue on account and collected $2,950 of cash from accounts receivable. Further, RSI recognized $1,200 of operating expenses on account and paid $900 cash as partial settlement of accounts payable.

Required

Based on this information alone:

a. Prepare the operating activities section of the statement of cash flows under the direct method. b. Prepare the operating activities section of the statement of cash flows under the indirect method.

Exercise 14-7B The direct versus the indirect method of determining cash flows from operating activities

The following accounts and corresponding balances were drawn from Geneses Company’s 2017 and 2016 year­end balance sheets:

LO 14-1, 14-2

LO 14-1, 14-2

Account Title 2017 2016

Accounts receivable $65,000 $72,000 Prepaid rent       1,400      1,950 Utilities payable      3,200     3,800 Other operating expenses payable    27,000    31,500

Income Statement

Sales $420,000  Rent expense (52,000) Utilities expense (45,300) Other operating expenses   (195,000) Net Income $ 127,700

Required

a. Prepare the operating activities section of the statement of cash flows using the direct method. b. Prepare the operating activities section of the statement of cash flows using the indirect method.

Exercise 14-8B Determining cash flow from investing activities

On January 1, 2016, Poole Company had a balance of $178,000 in its Land account. During 2016, Poole sold land that had cost $71,000 for $95,000 cash. The balance in the Land account on December 31, 2016, was $210,000.

Required

a. Determine the cash outflow for the purchase of land during 2016. b. Prepare the investing activities section of the 2016 statement of cash flows.

LO 14-3

The 2017 income statement is shown below:

G A T E S , D E A N D R A 1 1 2 3 T S

Statement of Cash Flows 683

Exercise 14-9B Determining cash flow from investing activities

On January 1, 2016, Sanita Company had a balance of $76,300 in its Office Equipment account. Dur­ ing 2016, Sanita purchased office equipment that cost $30,300. The balance in the Office Equipment account on December 31, 2016, was $75,400. The 2016 income statement contained a gain from the sale of equipment of $6,000. On the date of sale, accumulated depreciation on the equipment sold amounted to $14,400.

Required

a. Determine the cost of the equipment that was sold during 2016. b. Determine the amount of cash flow from the sale of office equipment that should be shown in the

investing activities section of the 2016 statement of cash flows.

Exercise 14-10B Determining cash flows from investing activities

The following accounts and corresponding balances were drawn from Teva Company’s 2017 and 2016 year­end balance sheets:

LO 14-3

LO 14-3

Account Title 2017 2016

Investment securities $102,000 $110,000 Machinery    480,000    465,000 Land       75,000      95,000

Other information drawn from the accounting records:

1. Teva incurred a $3,000 loss on the sale of investment securities during 2017. 2. Old machinery with a book value of $8,000 (cost of $34,000 minus accumulated depreciation of

$26,000) was sold. The income statement showed a gain on the sale of machinery of $7,500. 3. Teva incurred a loss of $4,000 on the sale of land in 2017.

Required

a. Compute the amount of cash flow associated with the sale of investment securities. b. Compute the amount of cash flow associated with the purchase of machinery. c. Compute the amount of cash flow associated with the sale of machinery. d. Compute the amount of cash flow associated with the sale of land. e. Prepare the investing activities section of the statement of cash flows.

Exercise 14-11B Determining cash flows from financing activities

On January 1, 2016, Van Company had a balance of $800,000 in its Bonds Payable account. During 2016, Van issued bonds with a $300,000 face value. There was no premium or discount associated with the bond issue. The balance in the Bonds Payable account on December 31, 2016, was $600,000.

Required

a. Determine the cash outflow for the repayment of bond liabilities assuming that the bonds were retired at face value.

b. Prepare the financing activities section of the 2016 statement of cash flows.

Exercise 14-12B Determining cash flows from financing activities

On January 1, 2016, Milam Company had a balance of $300,000 in its Common Stock account. Dur­ ing 2016, Milam paid $18,000 to purchase treasury stock. Treasury stock is accounted for using the cost method. The balance in the Common Stock account on December 31, 2016, was $350,000. As­ sume that the common stock is no par stock.

Required

a. Determine the cash inflow from the issue of common stock. b. Prepare the financing activities section of the 2016 statement of cash flows.

LO 14-4

LO 14-4

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684 Chapter 14

Exercise 14-13B Determining cash flows from financing activities

The following accounts and corresponding balances were drawn from Cushing Company’s 2017 and 2016 year­end balance sheets:

LO 14-4

Account Title 2017 2016

Bonds payable $200,000 $150,000 Common stock   650,000   400,000

Account Title 2017 2016

Accounts receivable $31,000 $36,000 Merchandise inventory   70,000   65,000 Prepaid insurance   25,000   24,000 Accounts payable    18,000   20,000 Salaries payable    5,100     4,500 Unearned service revenue    10,200     9,500

Income Statement

Sales $ 495,000  Cost of goods sold     (215,000) Gross margin 280,000  Service revenue 20,000  Insurance expense (42,000) Salaries expense (122,000) Depreciation expense       (12,000) Operating income 124,000  Gain on sale of equipment          1,500  Net income $ 125,500

Other information drawn from the accounting records:

1. Dividends paid during the period amounted to $50,000. 2. There were no bond liabilities repaid during the period.

Required

a. Compute the amount of cash flow associated with the issue of bond liabilities. b. Compute the amount of cash flow associated with the issue of common stock. c. Prepare the financing activities section of the statement of cash flows.

PROBLEMS—SERIES B

Problem 14-14B The direct versus the indirect method of determining cash flows from operating activities

The following accounts and corresponding balances were drawn from Crimson Sports, Inc.’s 2017 and 2016 year­end balance sheets:

LO 14-1, 14-2

Required

a. Prepare the operating activities section of the statement of cash flows using the direct method. b. Prepare the operating activities section of the statement of cash flows using the indirect method.

The 2017 income statement is shown below:

G A T E S , D E A N D R A 1 1 2 3 T S

Statement of Cash Flows 685

Problem 14-15B Determining cash flows from investing activities

The following information was drawn from the year­end balance sheets of Vigotti Company:

LO 14-3

Account Title 2017 2016

Investment securities $ 51,000 $ 60,000 Equipment   310,000    275,000 Buildings   980,000     950,000 Land      135,000       110,000 

Additional information regarding transactions occurring during 2017:

1. Investment securities that had cost $11,300 were sold. The 2017 income statement contained a loss on the sale of investment securities of $800.

2. Equipment with a cost of $80,000 was purchased. 3. The income statement showed a gain on the sale of equipment of $9,500. On the date of sale,

accumulated depreciation on the equipment sold amounted to $38,000. 4. A building that had originally cost $90,000 was demolished. 5. Land that had cost $20,000 was sold for $15,000.

Required

a. Determine the amount of cash flow for the purchase of investment securities during 2017. b. Determine the amount of cash flow from the sale of investment securities during 2017. c. Determine the cost of the equipment that was sold during 2017. d. Determine the amount of cash flow from the sale of equipment during 2017. e. Determine the amount of cash flow for the purchase of buildings during 2017. f. Determine the amount of cash flow for the purchase of land during 2017. g. Prepare the investing activities section of the 2017 statement of cash flows.

Problem 14-16B Determining cash flows from financing activities

The following information was drawn from the year­end balance sheets of Long’s Wholesale, Inc.:

LO 14-4

Account Title 2017 2016

Bonds payable $400,000 $600,000 Common stock    190,000    150,000 Treasury stock     20,000      15,000 Retained earnings     96,000     80,000

Additional information regarding transactions occurring during 2017:

1. Long’s Wholesale, Inc. issued $90,000 of bonds during 2017. The bonds were issued at face value. All bonds retired were retired at face value.

2. Common stock did not have a par value. 3. Long’s Wholesale, Inc. uses the cost method to account for treasury stock. Long’s Wholesale, Inc.

did not resell any treasury stock in 2017. 4. The amount of net income shown on the 2017 income statement was $49,000.

Required

a. Determine the amount of cash flow for the retirement of bonds that should appear on the 2017 statement of cash flows.

b. Determine the amount of cash flow from the issue of common stock that should appear on the 2017 statement of cash flows.

G A T E S , D E A N D R A 1 1 2 3 T S

686 Chapter 14

c. Determine the amount of cash flow for the purchase of treasury stock that should appear on the 2017 statement of cash flows.

d. Determine the amount of cash flow for the payment of dividends that should appear on the 2017 statement of cash flows.

e. Prepare the financing activities section of the 2017 statement of cash flows.

Problem 14-17B Preparing a statement of cash flows

The following information can be obtained by examining a company’s balance sheet and income state­ ment information:

a. Increases in current asset account balances, other than cash. b. Cash outflows to purchase noncurrent assets. c. Decreases in current liability account balances. d. Noncash expenses (e.g., depreciation). e. Cash outflows to purchase treasury stock. f. Gains recognized on the sale of noncurrent assets. g. Cash outflows to pay dividends. h. Cash inflows from the issue of common stock. i. Cash inflows from the sale of noncurrent assets. j. Increases in current liability account balances. k. Cash inflows from the issue of noncurrent debt. l. Losses incurred from the sale of noncurrent assets.

m. Decreases in current asset account balances, other than cash. n. Cash outflows to repay noncurrent debt.

Required

Construct a table like the one shown below. For each item, indicate whether it would be used in the computation of net cash flows from operating, investing, or financing activities. Also, indi­ cate whether the item would be added or subtracted when determining the net cash flow from operating, investing, or financing activities. Assume the indirect method is used to prepare the operating activities section of the statement of cash flows. The first item has been completed as an example.

LO 14-1, 14-3, 14-4

Item Type of Activity Add or Subtract

a. Operating Subtract

b.

c.

d.

e.

f.

g.

h.

i.

j.

k.

l.

m.

n.

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Problem 14-18B Using financial statements to prepare a statement of cash flows— Indirect method

The following financial statements were drawn from the records of Culinary Products Co.:

LO 14-1, 14-3, 14-4

Balance Sheets As of December 31

2017 2016 Assets     Cash $24,200  $ 2,800      Accounts receivable 2,000  1,200      Inventory 6,400  6,000      Equipment 19,000  42,000      Accumulated depreciation—Equipment (9,000) (17,400)     Land    18,400      10,400  Total assets $61,000  $ 45,000  Liabilities and equity     Accounts payable (inventory) $ 2,600  $ 4,200      Long-term debt 2,800  6,400      Common stock 22,000  10,000      Retained earnings   33,600     24,400  Total liabilities and equity $61,000  $ 45,000

Income Statement For the Year Ended December 31, 2017

Sales revenue $ 35,700  Cost of goods sold     (14,150) Gross margin 21,550  Depreciation expense     (3,600) Operating income 17,950  Gain on sale of equipment 500  Loss on disposal of land           (50) Net income $ 18,400 

Additional Data

1. During 2017, the company sold equipment for $18,500; it had originally cost $30,000. Accumulated depreciation on this equipment was $12,000 at the time of the sale. Also, the com­ pany purchased equipment for $7,000 cash.

2. The company sold land that had cost $4,000. This land was sold for $3,950, resulting in the recog­ nition of a $50 loss. Also, common stock was issued in exchange for title to land that was valued at $12,000 at the time of exchange.

3. Paid dividends of $9,200.

Required

Prepare a statement of cash flows using the indirect method.

Problem 14-19B Using financial statements to prepare a statement of cash flows— Indirect method

The comparative balance sheets and an income statement for Wang Beauty Products, Inc. are shown on the next page.

LO 14-1, 14-3, 14-4

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Balance Sheets As of December 31

2017 2016 Assets     Cash $ 68,800  $ 40,600      Accounts receivable 30,000  22,000      Merchandise inventory 160,000  176,000      Prepaid rent 2,400  4,800      Equipment 256,000  288,000      Accumulated depreciation (146,800) (236,000)     Land     192,000      80,000  Total assets $ 562,400  $ 375,400  Liabilities     Accounts payable (inventory) $ 67,000  $   76,000      Salaries payable 28,000  24,000  Stockholders’ equity     Common stock, $50 par value 250,000  200,000      Retained earnings     217,400      75,400  Total liabilities and equity $ 562,400  $ 375,400

Income Statement For the Year Ended December 31, 2017

Sales $1,500,000 Cost of goods sold      (797,200) Gross profit 702,800  Operating expenses     Depreciation expense (22,800)     Rent expense (24,000)     Salaries expense (256,000)     Other operating expenses     (258,000) Net income $ 142,000

Other Information

1. Purchased land for $112,000. 2. Purchased new equipment for $100,000. 3. Sold old equipment that cost $132,000 with accumulated depreciation of $112,000 for $20,000 cash. 4. Issued common stock for $50,000.

Required

Prepare the statement of cash flows for 2017 using the indirect method.

Problem 14-20B Using transaction data to prepare a statement of cash flows— Direct method

The Electric Company engaged in the following transactions during 2017. The beginning cash balance was $43,000 and the ending cash balance was $48,600.

1. Sales on account were $274,000. The beginning receivables balance was $86,000 and the ending balance was $74,000.

2. Salaries expense was $115,000. The beginning salaries payable balance was $9,600 and the ending balance was $7,500.

3. Other operating expenses were $118,000. The beginning Other Operating Expenses Payable balance was $8,500 and the ending balance was $6,000.

4. Recorded $25,000 of depreciation expense. The beginning and ending balances in the Accumu­ lated Depreciation account were $18,000 and $43,000, respectively.

LO 14-2, 14-3, 14-4

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5. The Equipment account had beginning and ending balances of $28,000 and $42,000, respectively. There were no sales of equipment during the period.

6. The beginning and ending balances in the Notes Payable account were $38,000 and $32,000, respectively. There were no notes payable issued during the period.

7. There was $4,600 of interest expense reported on the income statement. The beginning and ending balances in the Interest Payable account were $6,400 and $6,200, respectively.

8. The beginning and ending Merchandise Inventory account balances were $26,000 and $32,500, respectively. The company sold merchandise with a cost of $119,000. The beginning and ending balances in the Accounts Payable account were $10,000 and $12,500, respectively.

9. The beginning and ending balances in the Notes Receivable account were $80,000 and $20,000, respectively. Notes receivable result from long­term loans made to creditors. There were no loans made to creditors during the period.

10. The beginning and ending balances in the Common Stock account were $140,000 and $190,000, respectively. The increase was caused by the issue of common stock for cash.

11. Land had beginning and ending balances of $48,000 and $28,000, respectively. Land that cost $20,000 was sold for $16,000, resulting in a loss of $4,000.

12. The tax expense for the period was $6,600. The Tax Payable account had a $3,200 beginning balance and a $2,800 ending balance.

13. The Investments account had beginning and ending balances of $10,000 and $30,000, respec­ tively. The company purchased investments for $40,000 cash during the period, and investments that cost $20,000 were sold for $26,000, resulting in a $6,000 gain.

Required

a. Determine the amount of cash flow for each item and indicate whether the item should appear in the operating, investing, or financing activities section of a statement of cash flows. Also identify any items that do not affect the cash flow statement. Assume The Electric Company uses the di­ rect method for showing net cash flow from operating activities.

b. Prepare a statement of cash flows based on the information you developed in Requirement a.

Problem 14-21B Using financial statements to prepare a statement of cash flows— Direct method

The following financial statements were drawn from the records of Boston Materials, Inc.:

LO 14-2, 14-3, 14-4

Balance Sheets As of December 31

2017 2016 Assets     Cash $  99,700  $  25,400      Accounts receivable 72,000  60,000      Inventory 86,000  75,000      Notes receivable (long-term) 0  24,000      Equipment 104,000  152,000      Accumulated depreciation—Equipment (67,500) (75,000)     Land     60,000      45,000  Total assets $354,200 $306,400  Liabilities and equity     Accounts payable $  35,300  $  36,200      Salaries payable 18,200  15,500      Utilities payable 1,400  2,800      Interest payable 600  1,200      Notes payable (long-term) 0  36,000      Common stock 120,000  100,000      Retained earnings     178,700      114,700  Total liabilities and equity $354,200  $306,400

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Additional Information

1. Sold equipment costing $48,000 with accumulated depreciation of $26,000 for $23,500 cash. 2. Paid a $50,000 cash dividend to owners.

Required

Analyze the data and prepare a statement of cash flows using the direct method.

Income Statement For the Year Ended December 31, 2017

Sales revenue $ 450,000  Cost of goods sold    (212,000) Gross margin 238,000  Operating expenses     Salaries expense (96,000)     Depreciation expense (18,500)     Utilities expense        (7,500) Operating income 116,000  Nonoperating items     Interest expense (3,500)     Gain on sale of equipment          1,500  Net income $ 114,000

ANALYZE, THINK, COMMUNICATE

ATC 14-1 Real-World Case Following the cash

Tesla Motors Company, Inc. began operations in 2003 but did not begin selling its stock to the pub­ lic until June 28, 2010. It has lost money every year it has been in existence, and by December 31, 2013, it had total lifetime losses of approximately $1.1 billion. The company makes the Tesla Model S, and it supplies electric car components to Daimler and Toyota. Tesla’s statements of cash flows for 2011, 2012, and 2013 follow.

TESLA MOTORS, INC. Consolidated Statements of Cash Flows

(in thousands)

For the Years Ended December 31

2013 2012 2011 Cash flows from operating activities: Net loss $ (74,014) $(396,213) $(254,411) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 106,083  28,825 16,919 Stock-based compensation  80,737 50,145 29,419 Amortization of discount on convertible debt 9,143 — — Inventory write-downs 8,918 4,929 1,828 Write-off of Department of Energy (DOE) loan origination costs 5,558 — — Change in fair value of DOE warrant liabilities (10,692) 1,854 2,750

continued

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For the Years Ended December 31

2013 2012 2011

Other noncash operating activities 3,611 1,560 233 Foreign currency transaction gain 3,655 — — Change in operating assets and liabilities Account receivables (21,917) (17,303) (2,829) Inventories and operating lease vehicles (463,270) (194,726) (13,638) Prepaid expenses and other current assets (17,466) 1,121 (248) Other assets  (342) (482) (288) Accounts payable (243) 187,821 19,891 Accrued liabilities 66,567 9,603 10,620 Deferred revenue    268,153 (526) (1,927) Customer deposits 24,243 47,056 61,006 Resale value guarantee 236,299 — — Other long-term liabilities     32,971      10,255         2,641 Net cash provided by (used in) operating activities   257,994  (266,081)  (128,034)

Cash flows from investing activities: Purchases of property and equipment excluding capital leases  (264,224) (239,228) (184,226) Withdrawals out of our dedicated DOE account, net   14,752 8,620 50,121 (Increase) decrease in other restricted cash 55 (1,330) (3,201) Purchase of marketable securities — (14,992) (64,952) Maturities of short-term marketable securities             —      40,000     40,000 Net cash provided by investing activities  (249,417)  (206,930)  (162,258)

Cash flows from financing activities: Proceeds from convertible debt 660,000 — — Proceeds from issuance of common stock in public offering 360,000 221,496 172,410 Proceeds from issuance of warrants 120,318 — — Proceeds from exercise of stock options and other stock issuances 95,307 24,885 10,525 Proceeds from issuance of common stock in private placement 55,000 — 59,058 Principal payments on DOE loans (452,337) (12,710) — Purchase of convertible note hedges (177,540) — — Common stock and convertible debt issuance costs (16,901) — — Principal payments on capital leases and other debt (8,425) (2,832) (416) Proceeds from DOE loans              —   188,796   204,423 Net cash provided by financing activities   635,422   419,635   446,000 Net increase (decrease) in cash and cash equivalents 643,999 (53,376) 155,708 Cash and cash equivalents at beginning of period   201,890   255,266      99,558 Cash and cash equivalents at end of period $ 845,889 $ 201,890 $ 255,266

Required

a. As this chapter explained, many companies that report net losses on their earnings statements re­ port positive cash flows from operating activities. How do Tesla’s net incomes compare to its cash flows from operating activities?

b. Based only on the information in the statements of cash flows, does Tesla appear to be growing the capacity of its business? Explain.

c. In 2013 Tesla paid off $452.3 million on Department of Energy (DOE) loans and $8.4 million of capital leases and other debt. Where did it get the funds to repay this debt?

d. All things considered, based on the information in its statements of cash flows, does Tesla’s cash position appear to be improving or deteriorating?

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ATC 14-2 Group Assignment Preparing a statement of cash flows

The following financial statements and information are available for Blythe Industries, Inc.:

Balance Sheets As of December 31

2017 2016 Assets     Cash $ 160,200 $ 120,600     Accounts receivable 103,200 85,000     Inventory 186,400 171,800     Marketable securities (available for sale) 284,000 220,000     Equipment 650,000 490,000     Accumulated depreciation (310,000) (240,000)     Land        80,000    120,000 Total assets $1,153,800 $ 967,400 Liabilities and equity Liabilities     Accounts payable (inventory) $ 36,400 $ 66,200     Notes payable—Long-term 230,000 250,000     Bonds payable    200,000    100,000  Total liabilities      466,400     416,200  Stockholders’ equity     Common stock, no par 240,000 200,000      Preferred stock, $50 par 110,000 100,000      Paid-in capital in excess of par—Preferred stock       34,400      26,800      Total paid-In capital 384,400 326,800      Retained earnings 333,000 264,400      Less: Treasury stock      (30,000)     (40,000) Total stockholders’ equity     687,400     551,200  Total liabilities and stockholders’ equity $1,153,800 $ 967,400

Income Statement For the Year Ended December 31, 2017

Sales revenue $1,050,000  Cost of goods sold     (766,500) Gross profit 283,500  Operating expenses     Supplies expense $20,400     Salaries expense 92,000     Depreciation expense   90,000 Total operating expenses     (202,400) Operating income 81,100  Nonoperating items     Interest expense (16,000)     Gain from the sale of marketable securities 30,000      Gain from the sale of land and equipment         12,000  Net income $      107,100

Additional Information 1. Sold land that cost $40,000 for $44,000. 2. Sold equipment that cost $30,000 and had accumulated depreciation of $20,000 for $18,000. 3. Purchased new equipment for $190,000.

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4. Sold marketable securities that were classified as available­for­sale and that cost $40,000 for $70,000.

5. Purchased new marketable securities, classified as available­for­sale, for $104,000. 6. Paid $20,000 on the principal of the long­term note. 7. Paid off a $100,000 bond issue and issued new bonds for $200,000. 8. Sold 100 shares of treasury stock at its cost. 9. Issued some new common stock.

10. Issued some new $50 par preferred stock. 11. Paid dividends. (Note: The only transactions to affect retained earnings were net income and

dividends.)

Required

Organize the class into three sections and divide each section into groups of three to five students. Assign each section of groups an activity section of the statement of cash flows (operating activities, investing activities, or financing activities).

Group Task

Prepare your assigned portion of the statement of cash flows. Have a representative of your section put your activity section of the statement of cash flows on the board. As each section adds its information on the board, the full statement of cash flows will be presented.

Class Discussion

Have the class finish the statement of cash flows by computing the net change in cash. Also have the class answer the following questions:

a. What is the cost per share of the treasury stock? b. What was the issue price per share of the preferred stock? c. What was the book value of the equipment sold?

ATC 14-3 Business Applications Case Identifying different presentation formats

In Statement of Financial Accounting Standards No. 95, the Financial Accounting Standards Board (FASB) recommended but did not require that companies use the direct method. In Appendix B, Para­ graphs 106–121, the FASB discussed its reasons for this recommendation.

Required

Obtain a copy of Standard No. 95 and read Appendix B Paragraphs 106–121. Write a brief response summarizing the issues that the FASB considered and its specific reaction to those issues. Your re­ sponse should draw heavily on paragraphs 119–121.

ATC 14-4 Writing Assignment Explaining discrepancies between cash flow and operating income

The following selected information was drawn from the records of Fleming Company:

Assets 2016 2017

Accounts receivable $  400,000 $  840,200  Merchandise inventory 720,000 1,480,000  Equipment 1,484,000 1,861,200  Accumulated depreciation (312,000) (402,400)

Fleming is experiencing cash flow problems. Despite the fact that it reported significant increases in operating income, operating activities produced a net cash outflow. Recent financial forecasts predict that Fleming will have insufficient cash to pay its current liabilities within three months.

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Required

Write an explanation of Fleming’s cash shortage. Include a recommendation to remedy the problem.

ATC 14-5 Ethical Dilemma Would I lie to you, baby?

Andy and Jean Crocket are involved in divorce proceedings. When discussing a property settlement, Andy told Jean that he should take over their investment in an apartment complex because she would be unable to absorb the loss that the apartments are generating. Jean was somewhat distrustful and asked Andy to support his contention. He produced the following income statement, which was supported by a CPA’s unqualified opinion that the statement was prepared in accordance with gener­ ally accepted accounting principles.

CROCKET APARTMENTS Income Statement

For the Year Ended December 31, 2016

Rent revenue $580,000  Less: Expenses     Depreciation expense $280,000     Interest expense 184,000     Operating expense 88,000     Management fees     56,000     Total expenses  (608,000) Net loss $ (28,000)

Account Title 2015 2016

Rent receivable $40,000 $44,000 Interest payable    12,000    18,000 Accounts payable (oper. exp.)     6,000     4,000

All revenue is earned on account. Interest and operating expenses are incurred on account. Management fees are paid in cash. The following accounts and balances were drawn from the 2015 and 2016 year­end balance sheets:

Jean is reluctant to give up the apartments but feels that she must do so because her present salary is only $40,000 per year. She says that if she takes the apartments, the $28,000 loss would absorb a significant portion of her salary, leaving her only $12,000 with which to support herself. She tells you that while the figures seem to support her husband’s arguments, she believes that she is failing to see something. She knows that she and her husband collected a $20,000 distribution from the business on December 1, 2016. Also, $150,000 cash was paid in 2016 to reduce the prin­ cipal balance on a mortgage that was taken out to finance the purchase of the apartments two years ago. Finally, $24,000 cash was paid during 2016 to purchase a computer system used in the busi­ ness. She wonders, “If the apartments are losing money, where is my husband getting all the cash to make these payments?”

Required

a. Prepare a statement of cash flows for the 2016 accounting period. b. Compare the cash flow statement prepared in Requirement a with the income statement and

provide Jean Crocket with recommendations. c. Comment on the value of an unqualified audit opinion when using financial statements for

decision­making purposes.

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ATC 14-6 Research Assignment Analyzing cash flow information

In 2013 and 2012 Sears Holding Corporation reported net losses and negative cash flows from op­ erating activities. Using the company’s Form 10­K for the fiscal year ended February 1, 2014 (2013), complete the requirements below. The Form 10­K can be found on the company’s website, where it is called the Annual Report. It can also be obtained using the EDGAR system following the instructions in Appendix A.

Required

a. Determine Sears’ net incomes and cash flow from operating activities for 2012 and 2013. b. How was Sears able to pay its bills given that it has such large, negative net cash flows from

operating activities in 2012 and 2013? Provide a separate answer for each year.

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