chapter 06 - answer

MANAGEMENT ACCOUNTING - Solutions Manual

CHAPTER 6

CASH FLOW ANALYSIS

I. Questions

1. Purposes of the Statement of Cash Flows

a. To predict future cash flowsb. To evaluate management decisionsc. To determine the ability to pay dividends to shareholders and

interest and principal to creditorsd. To show the relationship of net income to changes in the

business’s cash.

2. Comparative balance sheets present the financial position of the enterprise at two points in time. The income statement for the period between the two balance sheets describes how the income-producing activities affected the financial position. Because cash flows from operating activities may differ substantially from net income, and because numerous other financing and investing activities have an impact on financial position, the statement of cash flows is necessary. The statement emphasizes changes in the cash balances that result from changes in assets, liabilities and equity accounts caused by operating, investing and financing activities.

3. The most important source of cash for many successful companies is from operating activities. A large positive operating cash flow is a good sign because it means funds have been internally generated with no fixed obligations or commitment to return such to anybody.

4. It is possible for cash to decrease during a year when income is high because cash may be used not only for operating activities but also for investing and financing activities.

5. Transactions involving accounts payable are not considered to be financing activities because such transactions are used to obtain goods and services rather than to obtain cash. Furthermore, purchases of goods and services relate to a company’s day-to-day operating activities.

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Chapter 6 Cash Flow Analysis

6. The loss is added back to net income to avoid double counting since the entire proceeds from the sale (net book value minus loss on sale) will appear as a cash inflow from investing activities.

7. Three categories of transactions that may result in increases in cash are

a. Operating activitiesb. Investing activities (e.g., sale of investments or other assets).c. Financing activities (e.g., borrowing or sale of shares).

These activities are sources of cash when cash is increased as a result of the particular activity.

8. Three categories of transactions that may result in decreases in cash are

a. Operating activitiesb. Investing activities (e.g., purchase of investments or other assets).c. Financing activities (e.g., repayment of debt or retirement of shares).

These activities are uses of cash when cash is decreased as a result of the particular activity.

9. Noncash transactions do not provide or consume cash even though they may result in significant changes in financial position. Examples are the issuance of share capital for plant assets and the conversion of debt or preference shares into ordinary shares. Such transactions are not presented in the body of the statement of cash flows but rather disclosed in a separate schedule as financing or investing activities.

10. While net loss is usually associated with a decrease in cash, it may be a source of cash if noncash expenses are greater than the amount of the net loss. For example, if a net loss of P100,000 included amortization and depreciation of P125,000 and no noncash revenues existed, cash provided by operating activities would be P25,000, computed as follows:

Net loss P(100,000)Add: Expenses not requiring cash – depreciation

and amortization 125,000Net cash provided by operating activities P 25,000

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Cash Flow Analysis Chapter 6

11. The change in cash is the difference between cash at the beginning and end of the accounting period. The net amount of cash provided by or used in operating, investing and financing activities must equal this change in cash. For example, if cash increased by P150,000 during the year, total sources from operating, investing, and financing activities must exceed total uses by P150,000. Also, if cash decreased by P25,000 during the year, total uses of cash must exceed total sources by P25,000.

12. (a) The use of cash does not occur until the cash dividend is actually paid in the next period. The declaration of the dividend does affect financial position, however, and should be disclosed as a noncash financing activity in a separate schedule accompanying the statement of cash flows.

(b) Because the dividend was declared and paid in the same accounting period, it appears in the statement of cash flows as a cash decrease in the financing activities category.

13. Disagree. The refunding of 10% debt by the 8% debt represents a significant financing activity, even though the net impact of the exchange on the balance sheet or on the amount of cash is not material. The issuance of 8% bonds and the retirement of 10% bonds should be reported as noncash financing transactions in a schedule accompanying the statement of cash flows.

14. The net income figure includes P150,000 as an expense. Only P112,500 of this amount resulted in a decrease in cash, because P37,500 represents an increase in the deferred income tax liability account. In determining cash provided by operating activities, the amount of income tax paid is P112,500 (direct method). Alternatively, under the indirect method, P37,500 must be added to net income to determine cash flows from operating activities.

15. The loss is omitted when listing expenses requiring cash payment (direct approach) or added back to net income (indirect approach) in determining cash provided by operating activities. This eliminates the impact of the transaction from cash provided by operating activities. Then, the proceeds from the sale are included as a source of cash in the investing activities category of the statement of cash flows. Any tax effects of the transaction are included in the tax expense figure and remain a part of cash flows from operating activities.

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16. (1) Operating activities: Transactions that affect current assets, current liabilities, or net income.

(2) Investing activities: Transactions that involve the acquisition or disposition of noncurrent assets.

(3) Financing activities: Transactions (other than the payment of interest) involving borrowing from creditors, and any transactions (involving the owners of a company.

17. Interest is included as an operating activity since it is part of net income. Financing activities are narrowly defined to include only the principal amount borrowed or repaid.

18. Since the entire proceeds from a sale of an asset (including any gain) appear as a cash inflow from investing activities, the gain must be deducted from net income to avoid double counting.

19. The direct method reconstructs the income statement on a cash basis by restating revenues and expenses in terms of cash inflows and outflows. The indirect method starts with net income and adjusts it to a cash basis to determine the cash provided by operating activities.

20. An increase in the Accounts Receivable account must be deducted from net income under the indirect method because this is an increase in a noncash asset.

21. A decrease in the Accounts Payable account must be added to cost of goods sold under the direct method. The cost of goods sold is increased by the amount of the decrease in accounts payable. Because the cost of goods sold is increased, the net cash flow provided by operating activities is decreased. The effect of a decrease in a liability is a decrease in cash.

22. A sale of equipment for cash would be classified as an investing activity. Any transaction involving the acquisition or disposition of noncurrent assets is classified as an investing activity.

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II. Exercises

Exercise 1

Net income...............................................................................................................P84,000Adjustments to convert net income to a cash basis:

Depreciation charges for the year.........................................................................P50,000Increase in accounts receivable............................................................................(60,000)Increase in inventory............................................................................................(77,000)Decrease in prepaid expenses...............................................................................2,000Increase in accounts payable................................................................................30,000Decrease in accrued liabilities..............................................................................(4,000)Increase in deferred income taxes......................................................................... 6,000 (53,000)

Net cash provided by operating activities.................................................................P31,000

Exercise 2

Sales..............................................................................................P1,000,000Adjustments to a cash basis:

Less increase in accounts receivable....................................... – 60,000 P940,000

Cost of goods sold.........................................................................580,000Adjustments to a cash basis:

Plus increase in inventory.......................................................+ 77,000Less increase in accounts payable........................................... – 30,000 627,000

Selling and administrative expenses...............................................300,000Adjustments to a cash basis:

Less decrease in prepaid expenses...........................................– 2,000Plus decrease in accrued liabilities..........................................+ 4,000Less depreciation charges....................................................... – 50,000 252,000

Income taxes..................................................................................36,000Adjustments to a cash basis:

Less increase in deferred income taxes.................................... – 6,000 30,000

Net cash provided by operating activities.......................................P 31,000

Note that the P31,000 agrees with the cash provided by operating activities figure under the indirect method in the previous exercise.

Exercise 3

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Item Amount Add DeductAccounts Receivable.......................................P70,000 decrease XAccrued Interest Receivable............................P6,000 increase XInventory........................................................P110,000 increase XPrepaid Expenses............................................P3,000 decrease XAccounts Payable...........................................P40,000 decrease XAccrued Liabilities..........................................P9,000 increase XDeferred Income Taxes Liability.....................P15,000 increase XSale of equipment...........................................P8,000 gain XSale of long-term investments.........................P12,000 loss X

Exercise 4

Requirement (1)

Net income............................................................................................. P75Adjustments to convert net income to a cash basis:

Depreciation charges...........................................................................P40Decrease in accounts receivable...........................................................10Increase in inventory...........................................................................(30)Decrease in prepaid expenses..............................................................5Increase in accounts payable................................................................20Decrease in accrued liabilities..............................................................(10)Increase in taxes payable.....................................................................10Increase in deferred taxes....................................................................5Loss on sale of long-term investments.................................................5Gain on sale of land............................................................................(40) 15

Net cash provided by operating activities................................................ P90

Requirement (2)

Swan CompanyStatement of Cash Flows

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Operating activities:Net cash provided by operating activities (see above).......................................P 90

Investing activities:Proceeds from sale of long-term investments....................................................P 45Proceeds from sale of land................................................................................70Additions to long-term investments..................................................................(20)Additions to plant & equipment........................................................................(150)Net cash used for investing activities................................................................(55)

Financing activities:Decrease in bonds payable................................................................................(20)Increase in ordinary shares...............................................................................40Cash dividends................................................................................................. (35 )Net cash used by financing activities................................................................ (15 )

Net increase in cash (net cash flow)..................................................................20Cash balance, beginning................................................................................... 100 Cash balance, ending........................................................................................P120

While not a requirement, a worksheet may be helpful.

Change

Source or

Use?

Cash Flow Effect

Adjust-ments

Adjusted Effect Classification

Assets (except cash and cash equivalents)Current assets:

Accounts receivable...............................................–10 Source +10 +10 OperatingInventory................................................................+30 Use –30 –30 OperatingPrepaid expenses..................................................–5 Source +5 +5 Operating

Noncurrent assets:Long-term investments...........................................–30 Source +30 –50 –20 Investing

Plant and equipment..............................................+150 Use–

150 –150 InvestingLand......................................................................–30 Source +30 –30 0 Investing

Liabilities, Contra assets, and Shareholders’ EquityContra assets:

Accumulated depreciation......................................+40 Source +40 +40 OperatingCurrent liabilities:

Accounts payable...................................................+20 Source +20 +20 OperatingAccrued liabilities...................................................–10 Use –10 –10 OperatingTaxes payable........................................................+10 Source +10 +10 Operating

Noncurrent liabilities:Bonds payable.......................................................–20 Use –20 –20 Financing

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Deferred income taxes...........................................+5 Source +5 +5 OperatingShareholders’ equity:

Ordinary shares.....................................................+40 Source +40 +40 FinancingRetained earnings:

Net income.......................................................+75 Source +75 +75 OperatingDividends..........................................................–35 Use –35 –35 Financing

Additional entriesProceeds from sale of investments.............................. +45 +45 InvestingLoss on sale of investments........................................ +5 +5 OperatingProceeds from sale of land.......................................... +70 +70 InvestingGain on sale of land.................................................... –40 –40 OperatingTotal +20 0 +20

Exercise 5

Sales........................................................................................P600Adjustments to a cash basis:

Decrease in accounts receivable........................................ +10 P610Cost of goods sold...................................................................250

Adjustments to a cash basis:Increase in inventory........................................................+30Increase in accounts payable............................................. –20 260

Selling and administrative expenses.........................................280Adjustments to a cash basis:

Decrease in prepaid expenses........................................... –5Decrease in accrued liabilities...........................................+10Depreciation charges........................................................ –40 245

Income taxes........................................................................... 30Adjustments to a cash basis:

Increase in taxes payable..................................................–10Increase in deferred taxes................................................. –5 15

Net cash provided by operating activities................................. P 90 Exercise 6

Requirements (1) and (2)

Stephenie CompanyStatement of Cash Flows

For the Year Ended December 31, 2008

Operating activities:Net income..........................................................................................P 56Adjustments to convert net income to cash basis:

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Depreciation charges....................................................................25Increase in accounts receivable.....................................................(80)Decrease in inventory...................................................................35Increase in prepaid expenses.........................................................(2)Increase in accounts payable.........................................................75Decrease in accrued liabilities.......................................................(10)Gain on sale of investments..........................................................(5)Loss on sale of equipment............................................................2Increase in deferred income taxes.................................................. 8 48

Net cash provided by operating activities............................................. 104

Investing activities:Proceeds from sale of long-term investments........................................12Proceeds from sale of equipment..........................................................18Additions to plant and equipment.........................................................(110)Net cash used for investing activities.................................................... (80)

Financing activities:Increase in bonds payable.....................................................................25Decrease in ordinary shares..................................................................(40)Cash dividends.................................................................................... (16 )Net cash used for financing activities................................................... (31 )

Net decrease in cash............................................................................. (7)Cash balance, January 1, 2008.............................................................. 11 Cash balance, December 31, 2008........................................................P 4

While not a requirement, a worksheet may be helpful.

Change

Source or

Use?

Cash Flow Effect

Adjust-ments

Adjusted Effect

Classi-fication

Assets (except cash and cash equivalents)Current assets:

Accounts receivable...............................................+80 Use –80 –80 OperatingInventory................................................................–35 Source +35 +35 OperatingPrepaid expenses..................................................+2 Use –2 –2 Operating

Noncurrent assets:Plant and equipment..............................................+80 Use –80 –30 –110 InvestingLong-term investments...........................................–7 Source +7 –7 0 Investing

Liabilities, Contra assets, and Shareholders’ EquityContra assets:

Accumulated depreciation......................................+15 Source +15 +10 +25 Operating

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Current liabilities:Accounts payable...................................................+75 Source +75 +75 OperatingAccrued liabilities...................................................–10 Use –10 –10 Operating

Noncurrent liabilities:Bonds payable.......................................................+25 Source +25 +25 FinancingDeferred income taxes...........................................+8 Source +8 +8 Operating

Shareholders’ equity:Ordinary shares.....................................................–40 Use –40 –40 FinancingRetained earnings:

Net income.......................................................+56 Source +56 +56 OperatingDividends..........................................................–16 Use –16 –16 Financing

Additional entriesProceeds from sale of equipment................................ +18 +18 InvestingLoss on sale of equipment........................................... +2 +2 OperatingProceeds from sale of long-term

investments............................................................ +12 +12 InvestingGain on sale of long-term investments......................... –5 –5 Operating

Total –7 0 –7

II. Problems

Problem 1

Transaction Operating Investing Financing Source Use1. Short-term investment

securities were purchased...................................

X X

2. Equipment was purchased...................................

X X

3. Accounts payable increased...................................

X X

4. Deferred taxes decreased...................................

X X

5. Long-term bonds were

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issued...................................

X X

6. Ordinary shares were sold...................................

X X

7. Interest was paid to long-term creditors...................................

X X

8. A long-term mortgage was entirely paid off...................................

X X

9. A cash dividend was declared and paid...................................

X X

10. Inventories decreased... X X11. Accounts receivable

increased....................................

X X

12. Depreciation charges totaled P200,000 for the year....................................

X X

Problem 2 (Analysis of Cash Flow Transactions)

Requirement (a)

The eight items should be presented in the statement of cash flows as follows:1. Net income is the basis for the calculation of cash flows from operating

activities by starting with that number and adjusting for noncash revenue and expense transactions (indirect method) or by computing by the direct method the positive cash flows from revenues, less the negative cash flows from expenses. The cash flows from the transaction giving rise to the extraordinary loss is reclassified as an investing activity.

2. The acquisition of intangibles is a negative cash flow from investing activities. The amortization is a noncash expense in determining cash flows from operating activities.

3. The payment of a cash dividend is a negative cash flow that is presented in the financing activities section of the statement.

4. The purchase of treasury share is a negative cash flow in the financing activities section of the statement.

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5. The depreciation expense recognized during the year is a noncash expense in determining cash flows from operating activities.

6. The conversion of convertible bonds into ordinary shares is a noncash financing activity that requires disclosure in a separate schedule.

7. The changes in plant asset accounts – land, equipment, and building – represent activities whose cash flow effects are presented in the investing activities section of the statement.

8. The increase in working capital also represents the change in cash because all other current assets and current liabilities remained constant. The net of all cash flows from operating, investing and financing activities must reconcile with the change in cash in the statement of cash flows.

Requirement (b)

1. Net cash provided by operating activities

Net income P145,000Noncash expense adjustments:

Depreciation expense 46,250Amortization expense 6,000

Reclassification of extraordinary loss 15,000P212,250

2. Net cash used in investing activities

Purchase of intangible assets P (34,000)Purchase of land (130,000)Purchase of equipment (60,000)Purchase of building (100,000)Sale of land 165,000

P(159,000)3. Net cash used in financing activities

Purchase of treasury shares P(31,000)Payment of dividends (12,500)

P(43,500)

Computations:

Depreciation expenseChange in accumulated depreciation account P35,000Accumulated depreciation on fully depreciated

assets disposed 11,250

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P46,250

Purchase of landChange in land account P (50,000)Cost of land sold in condemnation proceedings 180,000

P130,000

Problem 3 (Cash Flow from Operating Activities)

Cash received from customers:Total revenues P185,000Less: Note receivable (15,000) P170,000

Cash disbursed for expenses:Total expenses (P173,000 + P4,200) P177,200Less: Income taxes deferred (1,260)

Depreciation (25,000)Amortization (7,000) (143,940)

Net cash provided by operating activities P 26,060

Problem 4 (Cash Flow from Operating Activities)

Cash received from customers (1) P5,237,000Cash paid for expenses:

Cost of goods sold P3,150,000Selling 246,000Salaries and wages (2) 394,400Interest (3) 65,200Miscellaneous operating 5,000Incomes taxes (4) 335,000 4,195,600

Net cash provided by operating activities P1,041,400Computations:

1. Revenue from sales P5,432,000Less: Note receivable (120,000)

Land (75,000)P5,237,000

2. Salaries and wages expense P 400,000Less: Increase in accrued salaries and wages

(P45,600 – P40,000) (5,600)P 394,400

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3. Interest expense P 72,000Less: Discount amortization (6,800)

P 65,200

4. Income tax expense P 445,000Less: Deferred portion (110,000)

P 335,000

Problem 5 (Statement of Cash Flows Preparation – Indirect)

Green Tea CompanyStatement of Cash Flows


Cash flows from operating activities Net income* P8,500Adjustments to reconcile net income to net

cash flows provided by operating activities:

Depreciation 1,000Amortization of intangibles 1,000Increase in current assets (6,000)Increase in current liabilities 3,000

Net cash provided by operating activities P7,500

Cash flows from financing activitiesDividends paid (1,500)Retirement of long-term liabilities (1,000)

Net cash used in financing activities (2,500)Net increase in cash P 5,000Cash, January 1, 2005 10,000Cash, December 31, 2005 P15,000

Problem 6 (Cash Flow Statement Preparation – Direct)

Requirement (a)

* Increase in retained earnings (P20,000 – P13,000) P7,000 Dividends declared 1,500 Net income P8,500

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Hundred Acre CompanyStatement of Cash Flows


Cash flows from operating activities Cash received from customers P74,000Cash paid for expense 67,000

Net cash provided by operating activities P7,000Cash flow from investing activities

Sale of equipment 9,500Sale of investments 15,000Acquisition of equipment (53,000)

Net cash used in investing activities (28,500)Cash flows from financing activities

Sale of ordinary shares 40,000Payment of cash dividends (8,500)

Net cash used in financing activities 31,500Net increase in cash P10,000Cash, January 1, 2005 20,000Cash, December 31, 2005 P30,000

Reconciliation of net income to net cash provided by operating activities:Net income P15,000Adjustments to reconcile net income to net

cash provided by operating activities:Depreciation expense 24,500*

Amortization expense 1,000Increase in accounts receivable (33,000)Decrease in accrued expenses (500)

Net cash provided by operating activities P 7,000

Computations:

Cash received from customers:Revenues P107,000Deduct: Increase in accounts receivable

(P78,000 – P45,000) 33,000

* Net increase during 2005 (P33,600 – P27,100) P 6,500 Accumulated depreciation on assets sold 18,000 Depreciation expense for 2005 P24,500

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P 74,000Cash paid for expenses:

Expenses P 92,000Add: Decrease in accrued expenses

(P7,500 – P7,000) 500Deduct: Depreciation expense

(P33,600 – P27,100 + P18,000) (24,500) Amortization (1,000)

P 67,000Cash from sale of equipment:

Cost P 27,500Deduct: Accumulated depreciation (18,000)Cash received on sale at book value P 9,500

Cash paid to acquire equipment:Increase in property, plant and equipment

(P118,100 – P92,600) P 25,500Cost of machinery sold 27,500

P 53,000Cash received on sale of shares:

Increase in ordinary shares amount (P100,000 – P75,000) P 25,000

Increase in additional paid-in capital account(P55,000 – P40,000) 15,000

P 40,000Cash dividends:

Increase in retained earnings (P21,000 – P14,500) P 6,500Net income (P107,000 – P92,000) (15,000)

P 8,500

Requirement (b)

The reconciliation of net income to net cash provided by or used in operating activities is required to be disclosed in order to show more clearly the relationship and emphasize the differences between the two. Users of financial statements are often not as aware of the accrual concepts, which determine net income, as are preparers of those statements. The reconciliation of net income to net cash flows from operating activities clearly demonstrates that the two are different and details those events and transactions that account for the difference.

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Problem 7 (Interpretation of Cash Flow Statement)

Requirement (a)

The two companies are similar in the following respects:

1. Overall size.2. Industry in which they operate.3. Current ratio (2.4 to 1).4. Overall peso amounts of cash provided and used:

Range, 2002-2005Cash Provided Cash Used

Ebony Company P125,000 – P168,000 P115,000 – P170,000Ivory Company P135,000 – P160,000 P125,000 – P165,000

5. Net increase in working capital is identical for each year, 2002 – 2005.

Requirement (b)

The two companies are dissimilar in the makeup of the sources of cash, as indicated in the following analysis:

Sources of Cash in Percentages2002 2003 2004 2005

Ebony

Ivory

Ebony

Ivory

Ebony

Ivory

Ebony

Ivory

Cash provided:Operations 80 37 77 21 70 (38) 76 7Long-term debt 8 56 -- 10 -- 44 9 --Share capital -- -- 16 52 -- 63 -- 56Asset disposition 12 7 7 17 30 31 15 37

100 100 100 100 100 100 100 100

Ebony Company has relied much more heavily on operations to provide cash and to a very limited extent on debt and equity financing and asset disposition. On the other hand, Ivory Company has not been able to provide cash from operations and has been required to rely on the alternatives of debt and equity financing and asset disposition.

Requirement (c)

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Ebony Company is in a considerably stronger position (as determined by the data given) and thus should be considered the better investment and credit risk. The following points are significant:

1. Ebony Company has provided 70%-80% of its cash via operating activities, supplementing with other means to maintain a current ratio at the industry average. Ebony has not had to rely consistently on any alternative source of funding.

2. Ivory Company has apparently been forced to rely continuously on debt financing except in 2005, perhaps because of the inability to obtain such financing. The year 2004 is particularly weak for Ivory, with operations resulting in a P60,000 reduction in cash. The ability of Ivory to sustain its present financial position (i.e., current ratio, etc.) is questionable in light of its history.

III. Multiple Choice Questions

1. D 4. D 7. C 10. B2. C 5. B 8. B 11. A3. D 6. D 9. A 12. D

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chapter 06 - answer

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