Decision Case 12-4 Dividend Decision and the Statement of Cash Flows—Direct Method

Bailey Corp. just completed the most profitable year in its 25-year history. Reported earnings

of $1,020,000 on sales of $8,000,000 resulted in a very healthy profit margin of 12.75%. Each

year before releasing the financial statements, the board of directors meets to decide on the

amount of dividends to declare for the year. For each of the past nine years, the company has

declared a dividend of $1 per share of common stock, which has been paid on January 15 of

the following year.

Presented here are the income statement for the year and the comparative balance sheets as

of the end of the last two years.

Additional information follows

  2014 Dec
Sales revenue 8,000,000
Cost of goods sold 4,500,000
Gross profit 3,500,000
Operating expenses 1,450,000
Income before interest and taxes 2,050,000
Interest expense 350,000
Income before taxes 1,700,000
Income tax expense (40%) 680,000
Net income 1,020,000

  2014 2013
Cash 480,000 450,000
Accounts receivable 250,000 200,000
Inventory 750,000 600,000
Prepayments 60,000 75,000
Total current assets 1,540,000 1,325,000
Land 3,255,000 2,200,000
Plant and equipment 4,200,000 2,500,000
Accumulated depreciation (1,250,000) (1,000,000)
Long-term investments 500,000 900,000
Patents 650,000 750,000
Total long-term assets 7,355,000 5,350,000
Total assets 8,895,000 6,675,000
Accounts payable 350,000 280,000
Other accrued liabilities 285,000 225,000
Income taxes payable 170,000 100,000
Dividends payable - 200,000
Notes payable due within next year 200,000 -
Total current liabilities 1,005,000 805,000
Long-term notes payable 300,000 500,000
Bonds payable 2,200,000 1,500,000
Total long-term liabilities 2,500,000 2,000,000
 Common stock, $10 par 2,500,000 2,000,000
Retained earnings 2,890,000 1,870,000
Total stockholders' equity 5,390,000 3,870,000
Total liabilities and stockholders' equity 8,895,000 6,675,000

Additional information follows:

a. All sales are on account, as are all purchases.

b. Land was purchased through the issuance of bonds. Additional land (beyond the amount purchased through
the issuance of bonds) was purchased for cash.

c. New plant and equipment were acquired during the year for cash. No plant assets were retired during the year.
Depreciation expense is included in operating expenses.

d. Long-term investments were sold for cash during the year.

e. No new patents were acquired, and none were disposed of during the year. Amortization expense is included
in operating expenses.

f. Notes payable due within the next year represents the amount reclassified from long term to short term.

g. Fifty thousand shares of common stock were issued during the year at par value. As Bailey’s controller, you
have been asked to recommend to the board whether to declare a dividend this year and, if so, whether the
precedent of paying a $1-per-share dividend can be maintained. The president is eager to keep the dividend at $1
in view of the successful year just completed. He is also concerned, however, about the effect of a dividend on
the company’s cash position. He is particularly concerned about the large amount of notes payable that comes
due next year. He further notes the aggressive growth pattern in recent years, as evidenced this year by large
increases in land and plant and equipment.

Required

1. Using the format in Exhibit 12-11, convert the income statement from an accrual basis to a cash basis.

2. Prepare a statement of cash flows using the direct method in the Operating Activities section.

3. What do you recommend to the board of directors concerning the declaration of a cash dividend? Should the
$1-per-share dividend be declared? Should a smaller amount be declared?

Should no dividend be declared? Support your answer with any necessary computations. From a cash flow
perspective, include in your response your concerns about the following year.