Libby 4ce Solutions Manual - Ch05

Chapter 5
Reporting and Interpreting Cash Flows

Revised: December 11, 2010
ANSWERS TO QUESTIONS
1. The income statement reports revenues earned and expenses incurred during a period
of time. It is prepared on an accrual basis. The statement of financial position reports
the assets, liabilities, and equity of a business at a point in time. The statement of cash
flows reports cash receipts and cash payments of a business, during a specific period of
time, from three broad categories of business activities: operating, investing, and
financing.
2. The statement of cash flows reports cash receipts and cash payments from three broad
categories of business activities: operating, investing, and financing. While the income
statement reports operating activities, it reports them on the accrual basis: revenues
when earned, and expenses when incurred, regardless of the timing of the cash received
or paid. In contrast, the statement of cash flows reports the cash flows arising from
operating activities. The statement of financial position reports assets, liabilities, and
equity at a point in time. The statement of cash flows and related schedules indirectly
report changes in the statement of financial position accounts by reporting the
operating, investing, and financing activities which caused changes in the statement of
financial position accounts from one period to the next. In this way, the statement of
cash flows reports information to link together the financial statements from one
period to the next, by explaining the changes in cash and other statement of financial
position accounts, while summarizing the information into operating, investing, and
financing activities.
3. Cash equivalents are short-term, highly liquid investments that are purchased within
three months of the maturity date. The statement of cash flows does not separately
report the details of purchases and sales of cash equivalents because these transactions
affect only the composition of total cash and cash equivalents, not the total amount. The
statement of cash flows reports the change in total cash and cash equivalents from one
period to the next.
4. The major categories of business activities reported on the statement of cash flows are
operating, investing, and financing activities. Operating activities of a business arise
from the production and sale of goods and/or services. Investing activities arise from
acquiring and disposing of long-term productive assets and long-term investments.
Financing activities arise from transactions with investors and creditors.
5. Cash inflows from operating activities include cash sales, collections on trade receivabes
and notes receivable arising from sales, dividends on investments, and interest on loans
and investments. Cash outflows from operating activities include payments to suppliers
and employees, and payments for operating expenses, taxes, and interest.
Financial Accounting, 4ce, Libby, Libby, Short, Kanaan, Gowing © 2011 McGraw-Hill Ryerson Limited. All rights reserved.
5-1
6. Depreciation expense is added to profit to adjust for the effects of a non-cash expense
that was deducted in determining profit. It does not involve an inflow of cash.
7. Cash expenditures for purchases and salaries are not reported on the statement of cash
flows under the indirect method because that method does not report cash inflows and
outflows for each operating activity. Rather, it reports profit which includes a major
portion of these expenditures. The profit figure is then adjusted for non-cash
components of revenues and expenses.
8. The $50,000 increase in inventory must be used in the statement of cash flows
calculations because it increases the outflow of cash depending on the amount paid to
suppliers during the period. It is therefore subtracted from profit as a reconciling item
with cash flows from operating activities.
9. The two methods of reporting cash flows from operating activities are the direct
method and the indirect method. The direct method reports the gross amounts of cash
receipts and cash payments related to the operations of the business. The indirect
method reports the net amount of cash provided or used by operating activities, by
reporting the adjustments to profit for the net effects of non-cash revenues and
expenses, and changes in accruals and deferrals. The two approaches differ in the way
they report cash flows from operating activities, but net cash provided by operating
activities, is the same amount.
10. Cash inflows from investing activities include cash received from sale of operational
assets, sale of investments, maturity value of bond investments, and principal
collections on notes receivable that are not related to operations. Cash outflows from
investing activities include cash payments to purchase operational assets and
investments, and to make loans.
11. Cash inflows from financing activities include cash received from shareholders
(issuance of shares), and non-trade creditors. Cash outflows from financing activities
include cash payments for dividends, the purchase of the company’s own shares, and
principal payments on borrowing.
12. Non-cash investing and financing activities are activities that would normally be
classified as investing or financing activities, except no cash was received or paid.
Examples of non-cash investing and financing include the purchase of assets by issuing
shares or bonds, the repayment of loans using non-cash assets, and the conversion of
bonds into shares. Non-cash investing and financing activities are not reported in the
statement of cash flows, because there was no cash received or cash paid; however, the
activities are disclosed in a note or a separate schedule.
13. The company used cash for operating activities and for investing activities. Cash from
investors – shareholders and or long-term creditors – is used to finance both operating
and financing activities. This reflects a cash flow pattern for a company that is in a start
up or growth stage.
5-2
Authors' Recommended Solution Time
(Time in minutes)
Alternate Cases and

Exercises Problems Problems Projects
No. Time No. Time No. Time No. Time
1 10 E 1 25 M 1 25 M 1 20 M
2 15 E 2 45 M 2 30 M 2 15 M
3 15 E 3 25 M 3 50 M 3 25 M
4 15 M 4 50 M 4 60 D 4 30 M
5 20 E 5 60 D 5 40 D 5 30 M
6 20 E 6 55 D 6 45 D
7 10 E 7 30 D
8 15 M 8 30 M
9 25 M 9 35 D
10 20 E 10 *
11 25 E
12 20 E
13 15 M
14 10 E
15 15 E
E = Easy M = Moderate D = Difficult
* Due to the nature of these cases and projects, it is very difficult to estimate the amount of
time students will need to complete the assignment. As with any open-ended project, it is
possible for students to devote a large amount of time to these assignments. While students
often benefit from the extra effort, we find that some become frustrated by the perceived
difficulty of the task. You can reduce student frustration and anxiety by making your
expectations clear. For example, when our goal is to sharpen research skills, we devote class
time discussing research strategies. When we want the students to focus on a real
accounting issue, we offer suggestions about possible companies or industries.
EXERCISES
E5–1
1. – I Plant and equipment

Cash
2. NE Inventory
Trade payables
5-3
3. + O Cash
Trade receivables
4. NE Salaries expense
Accrued salaries payable
5. – O Interest expense
Cash
6. – F Short-term debt
Cash
7. – O Prepaid rent
Cash
8. + I Cash
Plant and equipment
9. – O Trade payables
Cash
10. – F Retained earnings

Cash
5-4
E5–2
1. – O Income tax expense

Cash
2. + F Cash
Common shares
3. – O Prepaid rent
Cash
4. NE Expense
Prepayment
5. – I Plant and equipment

Cash
6. + F Cash
Long-term debt
7. + O Cash
Trade receivables
8. NE Inventory
Trade payables
9. – O Salary expense
Cash
10. NE Plant and equipment

Note payable
E5–3
While depreciation is indeed added to profit to compute cash flow from operating activities,
the new controller's idea will not work. If depreciation expense is increased, profit will
decrease by exactly the same amount. When depreciation is added to the new profit amount,
the sum will be exactly the same as the amount that was computed before depreciation was
increased. The only way to increase cash flow from operation is to increase cash revenues,
decrease cash expenses (other than depreciation), or improve the efficiency of operations
(such as collecting receivables more quickly or operating with less inventory).
5-5
E5–4
Req. 1
Cash flows from operating activities — indirect method

Net loss............................................................................................................................................. $ (6,000)
Add (deduct) items not affecting cash:
Depreciation expense................................................................................................................ 7,300
Decrease in trade receivables ............................................................................................... 12,000
Increase in salaries payable.................................................................................................... 9,000
Decrease in unearned service revenue ........................................................................... (4,000)
Net cash provided by operating activities............................................................................... $18,300
Req. 2
The reasons that caused Kane to report a net loss but positive cash flow are: (1)
depreciation expense, and (2) changes in non-cash working capital items. Depreciation
expense, along with decreased working capital requirements (current assets - current
liabilities), turned the net loss into positive operating cash flow. The reasons for the
difference between profit and cash flow are important because they help the financial
analyst to determine if the trends are sustainable or whether they represent one-time
events.
5-6
E5–5
Req. 1
Cash flows from operating activities—indirect method

Net loss............................................................................................................................................ $(74,070)
Depreciation and amortization expense...................................................................... 60,567
Decrease in receivables........................................................................................................ 13,815
Decrease in inventories........................................................................................................ 4,500
Increase in prepayments..................................................................................................... (2,207)
Increase in trade payables.................................................................................................. 5,842
Increase in accrued liabilities............................................................................................ 8,744
Increase in income taxes payable.................................................................................... 4,935
Cash flows from operating activities......................................................................... $22,126
Note: The reduction of long-term debt and additions to equipment do not affect cash flows
from operating activities.
Req. 2
The reasons that caused Coolbrands to report a net loss but positive cash flow are: (1)
depreciation and amortization expense, and (2) changes in non-cash working capital items.
The large depreciation and depreciation expense, offset partially by increased working
capital requirements, turned Sizzler’s net loss into positive operating cash flow. The
reasons for the difference between profit and cash flow are important because they help the
financial analyst to determine if the trends are sustainable or whether they represent one-
time events.
E5–6
Account Change
Receivables Increase
Inventories Increase
Payables Increase
Other current assets Increase
E5–7
Account Change
Trade receivables Increase
Inventories Decrease
Trade payables Increase
Income taxes payable Decrease
5-7
E5–8
Req. 1
Cash flows from operating activities—indirect method

Profit.................................................................................................................................................. $5,142
Depreciation and amortization......................................................................................... 1,543
Decrease in trade receivable............................................................................................... 549
Decrease in inventories......................................................................................................... 345
Decrease in prepayments..................................................................................................... 68
Increase in trade payables................................................................................................... 718
Decrease in taxes payable..................................................................................................... (180)
Decrease in other current liabilities................................................................................ (367)
Cash flows from operating activities......................................................................... $7,818
Note: The cash dividend paid and repurchase of shares are not related to operating activities
and do not affect cash flows from operating activities. The decrease in other current
liabilities was not explained in the PepsiCo annual report, so its proper inclusion in this
computation is a judgment call. If it was not related to operations, it should not be included
in the previous computation. In reality, PepsiCo included the decrease on its statement of
cash flows.
Req. 2
Quality of earnings ratio = Cash flow from operations = $7,818 =1.52

Profit $5,142
Req. 3
The main reasons the quality of earnings ratio was significantly greater than one are the
large non-cash depreciation charges ($1,543) which reduced profit and the net increase in
accruals ($1,133) during the period.
5-8
E5–9
The investing and financing sections of the statement of cash flows for Pan American Silver
Corp.:
Cash flows from investing activities:

Purchase of property, plant and equipment................................ $(243,800)
Sale of short-term investments......................................................... 62,779
Net cash flows from investing activities................................ $(181,021)
Note: The short-term investments could be considered cash

equivalents depending on the nature of these investments. If so,
changes in these investments would not be listed under
Investing Activities.
Cash flows from financing activities:

Proceeds from issuance of shares..................................................... $ 50,843
Payment of dividends............................................................................. (2,626)
Net cash flows from financing activities................................ 48,217
E5–10
Req. 1
The investing and financing sections of the statement of cash flows for Sobeys Inc.:

Purchase of property, plant and equipment................................ $(431.0 )
Sale of discontinued operations........................................................ 78.0
Net cash flows from investing activities................................ $(353.0)

Proceeds from issuance of shares..................................................... 129.1
Repayment on long term debt............................................................ (307.7 )
Payment of dividends............................................................................. ( 46.1 )
Net cash flows from financing activities................................ (224.7)
Req. 2
Sobeys Inc.'s management is using the cash proceeds from sale of discontinued operations
for two purposes. First, it is using the funds to finance the Company’s investment in
property, plant and equipment. Second, some of the funds are being used to pay long-term
debt. The debt may have been related to the assets sold with the discontinued operations.
5-9
E5–11
Req. 1
Capital acquisitions ratio = Cash flow from operations

Cash paid for plant and equipment
Total 2006 to 2008 = $122.4 = 0.81

$150.6
Req. 2
The capital acquisitions ratio measures the company's ability to finance plant and
equipment purchases from operations. The ratio of 0.81 indicates that 19% of the investing
activities were financed using external sources or existing cash.
Req. 3
During 2008, Boston Beer Co. may have borrowed money to pay for its purchases of plant
and equipment.
E5–12
Req. 1
Both of these transactions are considered non-cash investing and financing activities, and
are not reported on the statement of cash flows. The transactions must be disclosed in a
separate schedule or in the notes. The information disclosed in the separate schedule would
state:
a. Equipment valued at $26,000 was acquired in exchange for a $15,000, 12%, two-year
note, and common shares with a market value of $11,000.
b. A machine valued at $8,700 was acquired by exchanging land with a book value of
$8,700.
Req. 2
equipment purchases from operations. Since neither of these transactions enters the
numerator or denominator of the ratio, they would have no effect. Many analysts believe
that these transactions represent important capital acquisitions, and thus should be
included in the denominator of the ratio to indicate what portion of all (not just cash)
acquisitions are being financed from operations. (In this case transaction b would not have
any effect as the acquisition of assets is financed through the sale of other assets.)
5-10
E5–13
F 1. Dividends paid
O 2. Income taxes paid
O 3. Interest received
N/A _ 4. Profit
I _ 5. Payments for property, plant, and equipment
O _ 6. Payments in the course of operations
F _ 7. Proceeds from ordinary share issues
I _ 8. Proceeds from the sale of property, plant, and equipment
O _ 9. Receipts from customers
F _ 10. Repayment of loans
E5–14
Comparison of Statement of cash flows direct and indirect reporting

Cash flows Cash flow from operations
(and related changes) Direct Indirect
1. Revenues from customers X
2. Increase or decrease in Trade receivables X
3. Payments to suppliers X
4. Increase or decrease in Inventory X
5. Increase or decrease in Trade payables X
6. Payments to employees X
7. Increase or decrease in Wages payable X
8. Depreciation expense X
The direct method reports cash flows from operating activities individually for each major
revenue and expense. In contrast, the indirect method reports a reconciliation of profit to
cash flow from operating activities. The two methods report the investing and financing
activities in exactly the same way.
E5–15
Cash flows from operating activities—direct method

Collections from customers ($80,000 – $4,000) $76,000
Payments to:
Suppliers ($50,000 – $8,000) $42,000
Employees ($11,000 – $500) 10,500 (52,500)
Net cash provided by operating activities $23,500
5-11
PROBLEMS
P5–1
Req. 1
FRANK CORPORATION
Statement of Cash Flows
For the Year Ended December 31, 2011
Cash flows from operating activities:

Profit..................................................................................................................................................
$42,000
Depreciation expense............................................................................................................... 9,200
Increase in trade receivables ($17,000 – $12,000).................................................... (5,000)
Decrease in inventory ($60,000 – $52,000).................................................................. 8,000
Decrease in trade payables ($10,000 – $7,000).......................................................... (3,000)
Decrease in wages payable ($1,000 – $800)................................................................. (200)
Increase in income tax payable ($5,000 – $3,000)..................................................... 2,000
Net cash flow from operating activities.................................................................... $53,000
Sale of machinery 11,000
............................................................................................................................................
Purchase of machinery* (9,000)
............................................................................................................................................
Purchase of investments (5,000)
............................................................................................................................................
Net cash flow from investing activities (3,000)
.....................................................................................................................................
Borrowing on long-term note 15,000
............................................................................................................................................
Payment of cash dividend (10,000)
............................................................................................................................................
Net cash inflow from financing activities 5,000
.....................................................................................................................................
Net increase in cash during 2011.............................................................................. 55,000
Cash, beginning of 2011................................................................................................. 21,000
Cash, end of 2011.............................................................................................................. $76,000
*Note that the $41,000 non-cash portion of the purchase and the related financing are not
reported in the statement. They are reported separately in the note.
Additional Cash Flow Information
During 2011, the company also purchased machinery for $50,000, which was partially
financed with a four-year $41,000 note payable to the dealer.
5-12
Income taxes paid were $9,800**.
Interest paid was $12,200.
**Income taxes paid = Income tax expense – Increase in income taxes payable.
5-13
P5–1 (continued)
Req. 2
Quality of earnings ratio = Cash flow from operations = $53,000 = 1.26

Profit $42,000
The quality of earnings ratio measures the portion of income that was generated
in cash. The ratio is greater than 1 primarily because of the large non-cash depreciation
expense that reduced profit but did not affect cash.
Capital acquisitions ratio = Cash flow from operations = $53,000 = 5.89

Cash paid for plant and equipment $9,000
equipment purchases from operations without the need to issue shares, borrow from
creditors, or to sell long-lived assets. The company paid $9,000 to purchase machinery but
generated $53,000 in cash from operations, resulting is a relatively high ratio. In this
particular case, the company received $11,000 for selling older machinery for a net cash
inflow of $2,000. Hence, cash from operations was not needed to cover the $9,000
expenditure.
5-14
P5–2
Req. 1
MIKOS INC.

Profit..................................................................................................................................................
$105,000
Depreciation expense ($33,000 + 4,000)..................................................................... 37,000
Increase in trade receivables.............................................................................................. (42,000)
Increase in inventory.............................................................................................................. (14,000)
Decrease in prepayments..................................................................................................... 2,000
Decrease in trade payables.................................................................................................. (23,000)
Increase in income tax payable.......................................................................................... 5,000
Increase in accrued liabilities............................................................................................. 10,000
Net cash flow from operating activities.................................................................. $80,000
Sale of land...................................................................................................... 25,000
Purchase of equipment............................................................................. (166,000)
Sale of equipment (note 1)...................................................................... 32,000
Net cash flow used for investing activities............................................................ (109,000)
Repayment of long-term note (note 2)........................................ (10,000)
Issuance of common shares ($140,000 – 30,000).................. 110,000
Payment of cash dividends ($105,000 – 51,000).................... (54,000)
Net cash inflow from financing activities............................. 46,000
Net increase in cash and short-term investments (note 3).......... 17,000
Cash and short-term investments, beginning of year...................... 37,000
Cash and short-term investments, end of year................................... $54,000
Note 1:
Increase in building and equipment, net = acquisitions - disposals - depreciation expense
$101,000 = 166,000 - disposals - 33,000
Disposals at book value = $32,000
Note 2:
The conversion of long-term notes to shares is a non-cash transaction that is reported
separately in a note.
Note 3:
Since short-term investments will mature in February 2013, they are considered cash
equivalents.
5-15
P5–2 (continued)
Req. 2
The statement of cash flows shows that the company generated $80,000 from operations. It
used $166,000 to invest in equipment and disposed of land and old equipment for a total of
$57,000. The cash flow from operations was not sufficient to pay for the net investment in
equipment. To help pay for the new equipment, the company issued shares to investors for a
total $110,000 in cash. The cash inflow helped the company pay $54,000 in dividends.
Mikos Inc. is a profitable business as evidenced by the reported profit, and net cash flow
from operations. Given this expansion and the payment of dividends, the company’s free
cash flow is negative (= $80,000 – 109,000 – 54,000 = –$83,000). It seems that the company
does not have financial flexibility. It is unlikely that the company will increase its long-term
assets significantly in the next few years, so it will not require significant amounts of cash for
investing activities. A successful expansion of operations that leads to positive cash flow
from operations will help the company repay any loans.
In addition to analyzing the statement of cash flows, the bank loan officer is likely to
consider the company’s future plans and a projection of future cash flows before deciding on
lending the company the requested amount. The bank officer may also be concerned that the
company paid out just over 50% of its income in dividends.
Req. 3
Both the statement of financial position and income statement provide useful information
about the financial condition and profitability of the company. But neither statement shows
how much cash the company was able to generate from its operations, which is vital if the
company is to continue to operate for the long run. The statement of cash flows shows how
the company manages its inflows and outflows of cash, so that it has enough cash to pay its
bills, finance its growth and keep borrowing under control. Furthermore, the statement of
cash flows provides information about the financing and investing activities that is not
available in the income statement.
5-16
P5–3
Req. 1
BETA COMPANY
Cash Flows from Operating Activities
Indirect Method

Profit............................................................................................................... $ (0)
Adjustments to reconcile profit to net cash provided by
Operating activities:
Depreciation expense............................................................................ $2,000
Decrease in trade receivables............................................................ 70
Increase in merchandise inventory................................................ (22)
Decrease in prepaid rent...................................................................... 5
Increase in prepaid insurance........................................................... (9)
Increase in trade payables................................................................... 30
Increase in salaries payable................................................................ 9
Decrease in rent payable...................................................................... (4)
Total adjustments................................................................................... 2,079
Net cash provided by operating activities............................. $2,079
Req. 2
As an analyst, I would prefer to see the cash flows reported under the direct method
because the cash inflows and outflows related to the operating activities during the
accounting period are clearly identified. In addition, I would like to see a reconciliation of
the profit amount and the net cash flows from operating activities. This reconciliation helps
me in analyzing the quality of earnings ratio.
Req. 3
As an accountant, I can prepare the cash flows from operating activities using either of the
two methods. The direct method provides a clearer understanding of the sources and uses
of the cash generated from (or used for) operating activities, and the indirect method shows
the causes for the difference between profit and cash flows from operating activities.
5-17
P5–4
Req. 1
MCGREGOR CORP.

Profit..................................................................................................................................................
$140,000
Depreciation expense ............................................................................................................ 4,000
Gain on sale of equipment ................................................................................................... (3,000)
Increase in inventory.............................................................................................................. (8,000)
Increase in prepayments...................................................................................................... (4,000)
Increase in trade payables................................................................................................... 2,000
Decrease in income tax payable........................................................................................ (3,000)
Decrease in wages payable.................................................................................................. (15,000)
Purchase of equipment (note 1)........................................................... (43,000)
Sale of equipment........................................................................................ 9,000
Issuance of long-term note................................................................ 17,000
Issuance of common shares............................................................... 6,000
Net cash inflow used for financing activities...................... (54,000)
Net increase in cash.......................................................................................... 12,000
Cash balance, January 1, 2012..................................................................... 4,000
Cash balance, December 31, 2012............................................................. $16,000
Note 1:
Beg. Bal., Equipment ($24,000) + Purchases (X) – Cost of equipment sold ($7,000)
= End. Bal. ($60,000) → Purchases = $43,000
Note 2:
Beg. Bal., Retained earnings ($1,000) + Profit ($140,000) – Dividends declared (X)
= End. Bal. ($64,000) → Dividends declared = $77,000.
The full amount of dividends was paid during the year.
5-18
P5–4 (continued)
Req. 2
a.

Profit $140,000
The quality of earnings ratio measures the portion of income that was generated in cash.
This ratio helps establish whether there are significant differences between profit and
operating cash flows. In this case, operating cash flows represent only about 70% of profit.
The difference between the two amounts is due primarily to sales that have not been
collected and payment to suppliers of goods and services a larger amount than the amount
of expenses recognized during the year.
b.

The capital acquisitions ratio reflects the company's ability to finance the acquisition of
property, plant and equipment from operating cash flows. In this case cash from operations
was more than twice the amount of cash paid for capital acquisitions.
c. Free cash flow = Cash flow from operations – Dividends paid – Capital expenditures
= $100,000 – $77,000 – $43,000 = – $20,000.
Free cash flow represents the amount of cash that is available for additional capital
expenditures, investments in other companies, and mergers and acquisitions, without the
need for external financing. In this case, the cash from operations is not sufficient to pay for
dividends and for capital expenditures.
5-19
P5–5
Req.1
a.
Trade receivables, beginning $ 27,000
+ Sales revenue 762,000
– Cash collections from customers ( X ) [X = $749,000]
= Trade receivables, ending $ 40,000
b. The computation of the cash paid to suppliers is a two-step process. First, we need to
compute the amount of merchandise purchases, and then determine how much was paid to
suppliers.
Merchandise inventory, beginning $ 20,000
+ Merchandise purchases X [X = $418,000]
– Cost of sales (410,000)
= Merchandise inventory, ending $ 28,000
Trade payables, beginning $ 8,000

+ Merchandise purchases 418,000
[Y = $416,000]
– Cash payments to suppliers ( Y )
= Trade payables, ending $ 10,000
c. The computation of the cash paid for general expenses requires analysis of the changes
in two accounts: Prepayments and Accrued liabilities as follows:
Cash paid for general

expenses = General expenses $24,000
+ Prepayments, end of year (paid during the year) 9,000
– Prepayments, beginning of year (paid previously) (5,000)
+ Accrued liabilities, beginning of year (paid during the year) 0
– Accrued liabilities, end of year (not paid yet) 0
$28,000
Since the statement of financial position does not include Accrued liabilities, we included
zeros in the general computation above.
5-20
P5–5 (continued)
Req. 2
MCGREGOR CORP.

Collections from customers....................................................................................................
$749,000
Cash payments:
To suppliers ...............................................................................................................................
(416,000)
To employees ($122,000 + $15,000 – 0) ..................................................................... (137,000)
For general expenses..............................................................................................................
(28,000)
For interest..................................................................................................................................
(5,000)
For income taxes ($60,000 + $5,000 – $2,000)......................................................... (63,000)
Purchase of equipment (note 1)........................................................... (43,000)
Sale of equipment........................................................................................ 9,000
Issuance of long-term note................................................................ 17,000
Issuance of common shares............................................................... 6,000
Net cash inflow used for financing activities...................... (54,000)
Net increase in cash.......................................................................................... 12,000
Note 1:
Beginning balance, Equipment ($24,000) + Purchases (X) – Cost of equipment sold ($7,000)
= Ending balance ($60,000) → Purchases = $43,000
Note 2:
Beginning balance, Retained earnings ($1,000) + Profit ($140,000) – Dividends declared (X)
= Ending balance ($64,000) → Dividends declared = $77,000.
The full amount of dividends was paid during the year.
Req. 3
The statement of cash flows summarizes the cash inflows and outflows during the year.
Such information is not available on the statement of financial position or on the income
statement. The statement of financial position shows the beginning and ending balances of
Cash, but it does not provide details about the types of activities that caused the change in
Cash. The income statement reports a summary of the operating activities during the year in
terms of revenues and expenses, but revenues usually differ from cash receipts and
expenses differ from cash payments.
5-21
P5–6
Req. 1
FRANK CORPORATION

Collections from customers ($400,000 + 12,000 – 17,000)................................... $395,000
Cash payments:
To suppliers (note 1)..............................................................................................................
(263,000)
To employees ($51,000 + $1,000 – 800) ..................................................................... (51,200)
For rent.........................................................................................................................................
(5,800)
For interest..................................................................................................................................
(12,200)
For income taxes ($11,800 + $3,000 – $5,000)......................................................... (9,800)
Sale of machinery .................................................................................................... 11,000
Purchase of machinery*........................................................................................ (9,000)
Purchase of investments ...................................................................................... (5,000)
Net cash flow from investing activities................................................... (3,000)
Borrowing on long-term note............................................................................ 15,000
Payment of cash dividend.................................................................................... (10,000)
Net cash inflow from financing activities............................................... 5,000
Net increase in cash during 2011.............................................................................. 55,000
Cash, beginning of 2011................................................................................................. 21,000
Cash, end of 2011.............................................................................................................. $76,000
Note 1:
Beginning balance, Inventory ($60,000) + Purchases (X) – Cost of sales ($268,000)
= Ending balance, Inventory ($52,000)  Purchases = $260,000
Beginning balance, Trade payables ($10,000) + Purchases ($260,000) – Payments (X)

= Ending balance, Trade payables ($7,000)  Payments = $263,000
Req. 2
The direct method of computing cash flow from operations requires that each account
related to operating activities be analyzed in order to compute the cash receipts and
payments during the period. The direct method appears to be more difficult to use than the
indirect method because of the mechanistic way of adjusting profit (or loss) for the changes
in the balances of current accounts (other than cash and cash equivalents). It is more
cumbersome than the indirect method. However, a good understanding of the bookkeeping
system allows students to compute the cash flows from operating activities under the direct
method as well as when using the indirect method.
5-22
P5–6 (continued)
Req. 3
The information presented using the direct method is easy to understand because it consists
of a listing of cash receipts from customers and cash payments to suppliers, employees, and
other providers of services. On the other hand, the indirect method allows the statement
user to identify the main sources of differences between profit (loss) and net cash flow from
operations. One of the issues that often arise with the indirect method is the misconception
that depreciation is a source of cash – this may have to be explained to non-accountants.
5-23
ALTERNATE PROBLEMS
AP5–1
Req. 1
STONEWALL COMPANY

Profit ($4,000 + 5,000).......................................................................... $ 9,000
Add (deduct) to reconcile profit to net cash flow
provided by operating activities:
Depreciation expense............................................................................. 4,000
Increase in trade receivables ............................................................. (18,000)
Increase in inventory.............................................................................. (15,000)
Increase in trade payables ................................................................... 10,000
Increase in accrued expenses payable............................................ 21,000
Net cash inflow from operating activities.............................. $11,000
Purchase of machinery........................................................................... (29,000)
Issuance of share capital....................................................................... 54,000
Borrowing on short-term note.......................................................... 15,000
Payment of cash dividend ($5,000 – 2,000)................................ (3,000)
Net cash inflow from financing activities............................... 66,000
Net increase in cash during 2004.............................................................. 48,000
Cash, beginning of year................................................................................... –0–
Cash, end of year................................................................................................ $48,000
During 2012, the company also exchanged plant machinery with a book value of $2,000 for
office machines with a market value of $2,000.
Req. 2

Profit $9,000
The cash generated from operations is different from profit because of non-cash expenses
such as depreciation and changes to non-cash working capital accounts that result from the
accrual basis of accounting.
5-24
AP5–1 (continued)

The capital acquisitions ratio measures the company's ability to finance purchases of
property, plant and equipment from operating cash flows. The company paid $29,000 to
purchase machinery but generated only $11,000 from operations. Financing of this
acquisition was also provided by selling shares.
AP5–2
Req. 1
PAN AMERICAN SILVER CORP.

For the Quarter Ended June 30, 2009

Profit .............................................................................................................. $11,297
Depreciation and depreciation expense...................................... 21,856
Gain on sale of assets............................................................................ (2,479)
Decrease in trade receivables .......................................................... 12,281
Increase in inventories......................................................................... (178)
Increase in prepayments..................................................................... (2)
Decrease in trade payables ............................................................... (3,730)
Increase in accrued liabilities........................................................... 13,721
Decrease in income taxes payable.................................................. (3,827)
Req. 2
The reconciliation between profit and net cash flows from operating activities under the
direct method helps the investor or analyst in identifying the items that caused the
difference between profit and net cash flows. This reconciliation is also useful in analyzing
the quality of earnings ratio.
5-25
AP5–3
Req. 1
MUSICAL INSTRUMENTS LTD.

Profit..................................................................................................................................................
$3,000
Depreciation expense ............................................................................................................ 6,600
Loss on sale of furniture ...................................................................................................... 300
Gain on sale of investment .................................................................................................. (200)
Decrease in inventories......................................................................................................... 10,000
Increase in trade payables................................................................................................... 1,950
Net cash flow used for operating activities........................................................... $(1,200)
Sale of furniture (note 1) 100
............................................................................................................................................
Purchase of furniture (note 2)..... (17,500)
Sale of investments ($500 change in balance + $200 gain) 700
Bank loan 5,000
............................................................................................................................................
Issuance of mortgage notes................................................................................ 14,000
Issuance of common shares 1,000
............................................................................................................................................
Payment of cash dividends ($6,000 + $300) (6,300)
............................................................................................................................................
Net cash inflow from financing activities 13,700
....................................................................................................................................
Net increase in cash and cash equivalents........................................................... (4,200)
Cash and cash equivalents, Jan. 1, 2011 ($1,700 + $4,000) ........................ 5,700
Cash and cash equivalents, Dec. 31, 2011 ($500 + $1,000)......................... $1,500
Note 1:
Loss on sale (–$300) = Cash received (X) – Book value of furniture sold ($1,000 – $600)
Cash received = $100
Note 2:
Cost of furniture, January 1, 2011 $13,000
+ Purchases during the year X
– Cost of furniture sold (1,000)
= Cost of furniture, December 31, 2011 $29,500
5-26
Purchases (X) = $17,500
5-27
AP5–3 (continued)
Req. 2
a.
Quality of earnings ratio = Cash flow from operations = $(1,200) = –0.40

Profit $3,000
The quality of earnings ratio measures the portion of income that was generated
in cash. This ratio helps establish whether there are significant differences between profit
and operating cash flows. In this case, the large increase in Trade receivables, which reflects
sales on account, reduced the amount of cash from operations.
b.
Capital acquisitions ratio = Cash flow from operations = $(1,200) = –0.069

The capital acquisitions ratio reflects the company's ability to finance the acquisition of
property, plant and equipment from operating cash flows. In this case, the company is
unable to finance the purchase of furniture from operating cash flows.
c. Free cash flow = Cash flow from operations – Dividends paid – Capital expenditures
= – $1,200 – $6,300 – $17,500 = – $25,000.
Free cash flow represents the amount of cash that is available for additional capital
expenditures, investments in other companies, and mergers and acquisitions, without the
need for external financing. In this case, the operating activities did not generate positive
cash flows.
Req. 3
As a professional accountant, I need to ensure that the proposed change is justified based on
the available evidence. It should be consistent with GAAP. The proposed change would be
acceptable if the original estimate of the useful life of these assets was understated or if
regular maintenance or improvements increased the assets’ useful life. However, if the
proposed change is to improve the company’s financial performance without valid
justification, I would point out to Mr. Cheng that such a change is not appropriate. It should
be noted that the proposed change would increase income but not affect cash flow.
5-28
AP5–4
Req.1
a.
Trade receivables, beginning $ 5,300
+ Sales revenue 245,000
– Cash collections from customers (X) [X = $222,150]
= Trade receivables, ending $ 28,150
b. The computation of the cash paid to suppliers is a two-step process. First, we need to
compute the amount of merchandise purchases, and then determine how much was paid to
suppliers.
Inventories, beginning $ 15,000
+ Merchandise purchases X [X = $150,000]
– Cost of sales (160,000)
= Inventories, ending $ 5,000
Trade payables, beginning $ 6,550

+ Merchandise purchases 150,000
[Y = $148,050]
– Cash payments to suppliers (Y)
= Trade payables, ending $ 8,500
c. Loss on sale = Cash received – Book value of furniture sold

–$300 = X – ($1,000 – $600) → Cash received = $100
d. Gain on sale = Cash received – Book value of investment sold

$200 = X – $500 → Cash received = $700
5-29
AP5–4 (continued)
Req. 2
MUSICAL INSTRUMENTS LTD.

Collections from customers ...................................................................................................
$222,150
Cash payments:
To suppliers................................................................................................................................
(148,050)
For selling and general expenses...................................................................................... (71,900)
For interest..................................................................................................................................
(2,400)
For income taxes .....................................................................................................................
(1,000)
Net cash flow used for operating activities........................................................... $(1,200)
Sale of furniture (note 1) .................................................................................. 100
Purchase of furniture (note 2)..... (17,500)
Sale of investments ($500 change in balance + $200 gain) 700
Bank loan................................................................................................................... 5,000
Issuance of mortgage notes................................................................................ 14,000
Issuance of common shares.............................................................................. 1,000
Payment of cash dividends ($6,000 + $300)............................................ (6,300)
Net cash inflow from financing activities............................................ 13,700
Net increase in cash and cash equivalents........................................................... (4,200)
Cash and cash equivalents, Jan. 1, 2011 ($1,700 + $4,000) ........................ 5,700
Cash and cash equivalents, Dec. 31, 2011 ($500 + $1,000)......................... $1,500
5-30
AP5–4 (continued)
Req. 3
The statement of cash flows focuses attention on a firm’s ability to generate cash internally,
its management of current assets and current liabilities, and the details of its investments, as
well as external financing. It is designed to help both managers and analysts answer
important cash-related questions as to whether the company has (1) adequately managed
its trade receivables, inventory, and other current assets, (2) made the necessary
investments in new productive capacity, (3) generated enough cash flow internally to
finance necessary investments or relied on external financing, and (4) changed the
proportion of debt and equity in its capital structure.
The statement of cash flows summarizes the cash inflows and outflows during the year,
which are not reported on either the statement of financial position or the income
statement. Both the statement of financial position and income statement provide useful
information about the financial condition and profitability of the company. But neither
statement shows how much cash the company was able to generate from its operations,
which is vital if the company is to continue to operate for the long run. The statement of
cash flows prepared for MIL shows that operations resulted in a net outflow of $1,200. The
statement of cash flows shows how the company manages its inflows and outflows of cash,
so that it has enough cash to pay its bills, finance its growth and keep borrowing under
control. Furthermore, the statement of cash flows provides information about the financing
and investing activities that is not available in the income statement. MIL used $16,700 in
investing activities – primarily through the acquisition of furniture. The outflows for
operations and investing activities were covered by financing activities ($13,700) and cash
on hand at the start of the year ($5,700).
5-31
AP5–5
Req. 1
STONEWALL COMPANY

Collections from customers ($80,000 – $18,000)....................................................... $62,000
Cash payments:
To suppliers ($35,000 + $15,000 – $10,000)............................................................. (40,000)
For other expenses ($32,000 – $21,000)...................................................................... (11,000)
Purchase of machinery........................................................................... (29,000)
Issuance of share capital....................................................................... 54,000
Borrowing on short-term note.......................................................... 15,000
Payment of cash dividend..................................................................... (3,000)
Net cash inflow from financing activities............................... 66,000
Net increase in cash during 2011.............................................................. 48,000
Cash, beginning of year................................................................................... –0–
Cash, end of year................................................................................................ $48,000
During 2011, the company also exchanged plant machinery with a book value of $2,000 for
office machines with a market value of $2,000.
Req. 2
The direct method of computing cash flow from operations requires that each account
related to operating activities be analyzed in order to compute the cash receipts and
payments during the period. On the surface, the direct method appears to be more difficult
to use than the indirect method because of the mechanistic way of adjusting profit (or loss)
for the changes in the balances of current accounts (other than cash and cash equivalents).
However, a good understanding of the bookkeeping system allows students to compute the
cash flows from operating activities under the direct method as easily as using the indirect
method.
Req. 3
The information presented using the direct method is easy to understand because it consists
of a listing of cash receipts from customers and cash payments to suppliers, employees, and
other providers of services. On the other hand, the indirect method allows the statement
user to identify the main sources of differences between profit (loss) and net cash flow from
operations.
5-32
CASES AND PROJECTS
FINDING AND INTERPRETING ACCOUNTING INFORMATION
CP5–1
Req. 1
The company uses the indirect method.
Req. 2
Nestlé paid CHF 3,207,000 for income taxes during the year as disclosed in Note 22.6 to the
Company’s financial statements, Additional information on cash flows.
Req. 3
Depreciation of property, plant and equipment was added back to profit in the
determination of cash flow from operations because it is a non-cash item. It is deducted in
the determination of profit and to remove the impact it is added back and the net impact on
cash flow from operations is nil.
Req. 4
Free cash flow is determined as follows (in thousands):
Cash flows from operating activities CHF 10,763

Less: Dividends (4,573 )
Less: Capital expenditures, net ($4,869 – 122) (4,747 )
Free cash flow $1,443
Req. 5
Yes, the company paid cash dividends of CHF 4,573,000 during fiscal year 2008 and CHF
4,004,000 during fiscal year 2007. These amounts are disclosed in the Financing Activities
section of the statement of cash flows.
5-33
CP5–2
Req. 1
The three largest adjustments to reconcile profit to net cash provided by operating activities
are:
(a) Depreciation, amortization and impairment (£244) is added to profit in the

reconciliation because it is a non-cash expense, which does not cause a cash outflow
when it is recorded.
(b) Interest paid (£165) is subtracted as it is a cash outflow and not included in the
calculation of profit from operations.
(c) Income taxes paid (£153) is subtracted as it is a cash outflow and not included in the
calculation of profit from operations.
Req. 2
Cadbury’s major uses of cash over the past two years have been repayment of borrowings
and purchase of property, plant and equipment and software. The major sources of cash for
these activities have been new borrowings.
Req. 3
Cadbury’s free cash flow at the end of fiscal year 2008 is determined as follows (in
thousands):
Cash flows from operating activities £469

Less: Dividends (295)
Less: Capital expenditures (500-18) (482)
Free cash flow £(308)
Cadbury has little financial flexibility. The free cash flow is negative. More was used to pay
dividends and purchase assets than was generated by operations. This cannot continue
indefinitely.
5-34
CP5–3
Req. 1
Quality of earnings ratio = Cash flow from operations / Profit
Cadbury: £489 / £366 = 1.34
Nestlé: €10,763 / €19,051 = 0.56
The increase in sales should result in higher profits and a higher amount of cash flows from
operations over time if the company maintains its existing credit policy. However, the
timing of cash receipts from customers and cash payments to suppliers affects the cash
flows from operations and may not lead necessarily to an increase in operating cash flows
that corresponds to the increase in sales.
Nestlé has a sales growth rate of 2.2% [calculated as (€109,908 – €107,552) / €107,552],
compared to Cadbury’s sales growth rate of 14.6% [calculated as [(£5,384 – £4,699) /
£4,699]. Cadbury has a higher sales growth than Nestlé, and also a higher quality of earnings
ratio because of a significant gain on sale of businesses that increased profit for the year.
Req. 2

Cash paid for property, plant and equipment
Cadbury: £489 / £500 = 0.98
Nestlé: €10,763 / €4,869 = 2.21
Nestlé has a much higher capital acquisitions ratio than does Cadbury. The ratio for
Cadbury is almost 1.0, indicating that the Company relies on cash flows from operating
activities to finance the acquisition of operational assets. Nestlé also relies on cash flows
from its operations to finance the acquisition of property, plant and equipment.
5-35
FINANCIAL REPORTING AND ANALYSIS CASES
CP5–4
Req. 1
Depreciation (amortization) is never a source of cash. It is an allocation of the cost of long-

term assets that are typically purchased and paid for in previous years. Depreciation
expense is deducted from revenue in the computation of profit. Since it is a non-cash
expense, it is added back to profit in computing cash flow from operations. The net result is
that it has no impact on cash flow.
Req. 2
Note 22.2 shows a deduction of €83 relating to trade receivables in computing the net
decrease/(increase) in working capital. Given that a deduction reflects an increase in
working capital, then trade receivables increased during the year, which means that the
cash collected from customers was lower than sales revenue during the year.
Req. 3
Profit represents the difference between revenues and expenses whereas cash flow from
operations reflects the difference between cash receipts and cash payments. When revenues
increase from one year to the next, one would normally expect an increase in cash receipts.
Similarly, changes in expenses over time would normally be accompanied by corresponding
changes in cash payments. However, we have learned that revenues during a given period
may not equal cash receipts, and expenses may not equal cash payments. For this reason,
one should not expect that a change in profit would cause an equal change in cash flow from
operations.
The change in non-cash balances, shown in note 22.2, was a source of funds in 2009 of
€2,442 versus a use of funds of €1,787 in 2008. Note 22.1 shows that non-cash items, such
as depreciation, caused an increase in profit in 2008, but they reduced profit by €3,478 in
2009.
Req. 4
Nestlé expanded during 2009 but contracted during 2008. The statement of cash flows
shows that it spent €5,399 on investing activities in 2009 whereas in 2008 it had net cash
inflows from investing of €4,699. This included €10,999 in proceeds from the sale of
businesses. The company paid for this expansion from the cash flow generated from
operations.
5-36
CP5–4 (continued)
Req. 5
Quality of earnings ratio = Cash flow from operations / Profit

2009: £17,934 / £11,793 = 1.52
2008: £10,763 / £19,051 = 0.56

2009: £17,934 / (£4,641 – 111) = 3.96

2008: £10,763 / (£4,869 – 122) = 2.27
Free cash flow = Cash flow from operations – capital expenditures – cash dividends
2009: £17,934 – 4,530 – 5,047 = £8,357

2008: £10,763 – 4,747 – 4,573 = £1,443
Cadbury’s quality of earnings, capital acquisitions ratio and free cash flow all increased in
2009.
CP5–5
Note: RIM reports its financial statements in thousands of U.S. dollars.
Req. 1
The statement of cash flows shows that an amount of $480,610 is deducted from profit in
computing cash flow from operations, indicating that this amount was not received in cash
from customers yet. Therefore, trade receivables increased during fiscal year 2010.
RIM’s trade receivables increased also in both fiscal years 2009 and 2008. Over the three
fiscal years, trade receivables increased by $2,019,179 ($480,610 + 936,514 + 602,055).
Req. 2
The change in inventory is added to profit in computing cash flow from operations. This
indicates that inventory decreased during fiscal year 2010, which may not have resulted in
cash outflows. However, we need to examine the change in trade payables as well to get the
full effect of inventory changes on cash flows.
5-37
CP5–5 (continued)
Req. 3
Net income (profit) represents the difference between revenues and expenses whereas cash
flow from operations reflects the difference between cash receipts and cash payments. We
have learned that revenues during a given period may not equal cash receipts, and expenses
may not equal cash payments. Analysis of the various items that reconcile profit to cash
flow from operations for fiscal year 2008 shows that RIM delayed payments due to
suppliers of goods and services (as evidenced by the increase in Accounts payable, Accrued
liabilities and Income tax payable) and these delayed payments more than offset the sales
that were not collected from customers (as indicated by the increase in Accounts
receivable). These and other non-cash components of profit, such as amortization, resulted
in an addition to net income to reconcile it to cash flow from operations. The opposite
occurred during fiscal year 2009 whereby the increase in Accounts receivable was greater
than the changes that affected other working capital accounts. The end result is that the net
income for 2009 was reduced by approximately $440 million to reconcile it to cash flow
from operations.
Req. 4
RIM financed its expansion during fiscal year 2008 from the cash it generated from
operations. In 2009, financing was provided primarily from cash generated from operations
and use of cash resources available at the start of the year.
Req. 5
Both the statement of financial position and income statement provide useful information
about the financial condition and profitability of the company. But neither statement shows
how much cash the company was able to generate from its operations, which is vital if the
company is to continue to operate for the long run. The statement of cash flows shows how
the company manages its inflows and outflows of cash, so that it has enough cash to pay its
debts, finance its growth and keep borrowing under control. Furthermore, the statement of
cash flows provides information about the financing and investing activities that is not
available in the income statement.
5-38
CP5–6
Req. 1
Depreciation and amortization expenses are not sources of cash. They are allocations of the
cost of long-term assets that are typically purchased and paid for in previous years.
Depreciation and amortization expenses are deducted from revenue in the computation of
profit. Since they are non-cash expenses they are added back to profit in computing cash
flow from operations. This reverses the effect of deducting it from revenues in the
computation of profit.
Req. 2
The change in inventory, $110.2 million is added to net earnings (profit) in computing cash
flow from operations. This indicates that inventory decreased during 2009, which may not
have resulted in cash outflows. However, we need to examine the change in accounts
payable as well to get the full effect of inventory changes on cash flows.
Req. 3
The non-cash working capital items increased by $183.8 million in 2007, decreased by
$41.7 million in 2008, and then increased by $129.0 million in 2009. The change in 2007
was largely a result of a decrease in inventories partially offset by a reduction in payables. In
2008 the change was largely a result of an increase in receivables and in 2009 the change
was a result of a decrease in receivables and inventories offset by a decrease in payables.
Req. 4

2007: $351.4 / ($63.7 – 27.0) = 9.57

2008: $208.2 / ($88.8 – 7.7) = 2.57
2009: $293.5 / ($77.3 – 10.0) = 4.36
2007: $351.4 – 36.7 – 0 = $314.7

2008: $208.2 – 81.1 – 0 = $127.1
2009: $293.5 – 67.3 – 0 = $226.2
Celestica's ability to generate funds from its operations declined from 2007 to 2008 but
improved again in 2009.
5-39
CP5–6 (continued)
Req. 5
The operating cash flows declined in 2008 but increased again in the following year. In all
three years, Celestica had negative cash flows from financing activities, primarily from
repurchase of notes in 2009. It reported a large loss in 2008 because of the economic
downturn, but returned to profitability in 2009. It had less cash at December 31, 2009 than
at December 31, 2007, but it appears that it has a lower amount of debt by the end of 2009.
Overall it appears that Celestica is less risky at December 31, 2009. An examination of the
company’s statement of financial position would show how the company’s financial position
changed between 2007 and 2009.
Req. 6
In all three years, the company had positive cash from operations and used this cash for
investment purposes and to reduce its debts. This is typically indicative of a mature,
successful firm. In this case this is tempered by the fact that the company had losses in 2007
and 2008. It returned to profitability in 2009. It had a difficult year in 2008 but has gotten
back on track in 2009.
Req. 7
This question could not be answered because the company’s annual report was not
available at the time of preparing the solution.
Req. 8
As a potential investor, I would be interested in learning about Celestica’s projected demand

for its products and services, and its products compared to those of competing companies. I
would also be interested in the company’s plans for using its cash resources which are close
to $1 billion at December 31, 2009. Will the company use them to expand its operations, to
reduce its debt, or both?
5-40
CP5–7
Req. 1
Depreciation is not a source of cash. It is an allocation of the cost of long-term assets that
are typically purchased and paid for in previous years. Depreciation expense is deducted
from revenue in the computation of profit. Since it is a non-cash expense, it is added back to
profit in computing cash flow from operations.
Req. 2
The statement of cash flows shows that trade receivables increased by €7,613 during 2009.
This amount was not collected from customers during that year. Therefore, the amount of
cash collected from customers in 2009 is €2,934,352 (€2,941,965 – €7,613).
Req. 3
The increase in trade payables during fiscal year 2009 is added to profit in the computation
of cash from operating activities. This indicates that Ryanair delayed payment of amounts
due to trade suppliers, which resulted in more cash at year end.
Req. 4
Ryanair spent €1,188,993, €692,310 and €388,334 on investing activities in fiscal years
2007, 2008 and 2009, respectively. The company’s operating cash flows in 2008 and 2009
were sufficient to cover the expenditures on investing activities. However, cash flows from
operations were not sufficient in 2007 to cover the full amount of expenditures on investing
activities. The shortfall was covered by proceeds from long-term borrowings.
Req. 5
Quality of earnings ratio = Cash flow from operations

Profit
2009: €413,134 / €(180,437) = –2.29

2008: €703,902 / €438,927 = 1.60
2007: €900,836 / €451,037 = 2.00
Ryanair’s quality of earnings ratio is greater than 1 in absolute terms. The Company’s profits
deteriorated over time because of the economic recession, and its cash flows from
operations also decreased significantly during the same period, but its operating cash flows
have exceeded its profits (loss) in all three years.
5-41
CP5–7 (continued)

2009: €413,134 / (€702,017 – 314,205) = 1.07

2008: €703,902 / (€937,115 – 150,042) = 0.89
2007: €900,836 / (€525,956 – 495) = 1.71
The ratios indicate that Ryanair generated sufficient cash from operations to pay for its
property, plant and equipment in 2007 and 2009, but not in 2008. Ryanair should take
advantage of the renewal of its fleet and increase its revenues and collections from
customers in the future.
2009: €413,134 + €387,812 – 0 = €25,322

2008: €703,902 – €787,073 – 0 = –€83,171
2007: €900,836 – €525,461 – 0 = €375,375
Ryanair’s free cash flow is positive in 2007 and 2009, but it was negative in 2008. Although
Ryanair did not pay dividends in the three years, its cash flows from operations were not
sufficient to pay for the renewal of its fleet of aircraft in 2008. The sale of used property,
plant and equipment helped in making up for the shortfall of cash from operations.
Req. 6
As a potential investor in Ryanair I would like more information on the reason for the
decrease in profit from 2008 to 2009, and whether the Company expects to return to
profitability in 2010. I would also be interested in seeing the statement of financial position
to assess the Company’s financial condition and the extent of its dependence on creditors to
finance its assets.
5-42
CP5–8
Note: the amounts reported below are in Australian dollars, the currency used by Foster’s.
Req. 1
The direct method reports cash receipts from customers and cash payments to suppliers of
goods, employees, and other providers of services during the accounting period. As such,
the reported information is relatively easy to understand. In contrast, the indirect method
does not provide such details, but it shows a reconciliation of profit to cash flows from
operations. This allows the statement user to identify the main sources of differences
between profit (loss) and net cash flow from operations. This also helps the statement
reader in assessing the quality of the company’s income. One advantage of the indirect
method is it is used by a majority of Canadian companies, which makes comparisons easier.
Overall as an investor I would prefer the indirect method.
(Note to instructor – either preference would be acceptable as long as it is properly supported.)
Req. 2
The reconciliation between profit (profit for the year) and cash flows from operations
shows the change in receivables resulted in the addition of $169.6 million to profit. This
means that Forster’s collected $169.6 million in addition to the year’s sales. The receipts
from customers, $7,532.1 million, include therefore $169.6 million that is not related to the
sales for 2009. Accordingly, the sales for 2009 are $7,362.5 million ($7.532.1 – $169.6).
Req. 3
If Foster’s paid for all its inventory purchases during 2009, then the balance of Trade
payables would not change between the beginning and end of the year. However, Trade
payables decreased by $21.0 million, as reported in the reconciliation of profit to cash flows
from operations. This indicates that Foster’s did pay suppliers more than the cost of
purchases during 2009.
5-43
CP5–8 (continued)
Req. 4
Quality of earnings ratio = Cash flow from operations

Profit
2009: $884.9 / $442.7 = 2.00

2008: $669.9 / $117.5 = 5.70
The quality of earnings ratio measures the portion of profit that was generated in cash. This
ratio helps establish whether there are significant differences between profit and operating
cash flows. In 2008, the difference between profit and cash flow from operations is caused
by many items as reported in the reconciliation schedule, including a recoverable amount
write down of $702.9 million. A similar situation occurred in 2009 in the amount of $274.6
million. There were also significant changes in non-cash working capital items in both years.
Req. 5
The indirect method shows a reconciliation of profit to cash flow from operating activities.
As indicated above, this allows the statement user to identify the main sources of the
difference between profit and net cash flow from operations, which helps in analyzing the
quality of the company’s income.
5-44
CRITICAL THINKING CASES
CP5–9
Date: (today’s date)

To: Supervising Analyst
From: (your name)
Re: Evaluation of Carlyle Golf, Inc.’s Planned Expansion
While many companies experience losses and negative cash flows during the early years of
their operations, the cash situation for Carlyle Golf is a major concern. The company has
announced plans to increase inventory by $2 million but there is no obvious source to
finance the acquisition of this inventory. The statement of cash flows shows that the
company has to make cash deposits with its suppliers. It is unlikely that these suppliers will
be a major source of financing for Carlyle's inventory. The company obviously does not have
enough cash on hand to finance its expansion of inventory.
The planned expansion of inventory has additional implications. The company must have
plans to expand its sales volume. There is no information in the company's report
concerning whether this expansion will require additional expenditures, such as increased
advertising or hiring new sales people. In any case, the expansion will most likely require an
increase in trade receivables. Most companies underestimate the amount of resources that
must be tied up in inventory and trade receivables when they expand sales volume.
Carlyle should seek additional capital to support an increased level of operations. Without
this extra capital, it is unlikely that Carlyle can continue in business.
FINANCIAL REPORTING AND ANALYSIS TEAM PROJECT
CP5–10
The solution to this case will depend on the company and/or accounting period selected for
analysis.
5-45
Appendix 5C
Spreadsheet Approach – Statement of Cash Flows
Revised, January 30, 2011
EXERCISES
E–1
Req. 1
Spreadsheet to Prepare Statement of Cash Flows, Indirect Method
Balances Analysis of change Balances
Item 12/31/2011 Debit Credit 12/31/2012
Cash....................................................................... 16,500 l 5,300 11,200
Non-cash accounts:
Trade receivables........................................... 22,000 22,000
Merchandise inventory............................... 68,000 h 7,000 75,000
Long-term investments.............................. d 15,000 15,000
Property and equipment............................ 114,500 b 20,000 i 21,000 113,500
Total................................................................... 221,000 236,700
Accumulated depreciation........................ 32,000 i 19,000 c 7,000 20,000
Trade payables................................................. 17,000 e 3,000 14,000
Wages payable................................................. 2,500 f 1,000 1,500
Income taxes payable................................... 3,000 g 1,500 4,500
Bonds payable.................................................. 54,000 54,000
Share capital...................................................... 100,000 j 6,000
b 20,000 126,000
Retained earnings.......................................... 12,500 k 12,000 a 16,200 16,700
Total................................................................... 221,000 77,000 77,000 236,700
Statement of Cash Flows Inflows Outflows

Conversion of profit to cash flow
from operating activities:
Profit a 16,200
Adjustments to reconcile profit to net
Cash provided by operating activities:
Depreciation expense c 7,000
Increase in inventory h 7,000
Decrease in trade payables e 3,000
Decrease in wages payable f 1,000
Increase in income taxes payable g 1,500 $13,700
Purchase of long-term investment d 15,000
Sale of operational assets i 2,000 (13,000)
Sale of share capital j 6,000
Dividends paid k 12,000 (6,000)
Net increase (decrease) in cash l 5,300 ($5,300)
5-46
b. This amount is not reported in the Statement of Cash Flows as it is a non-cash transaction.
5-47
E–1 (continued)
Req. 2

Profit $16,200
The ratio is below 1 because the cash payments for operations exceeded the amount of
expenses reported on the income statement.
Capital acquisitions ratio = Cash flow from operations = $13,700 = –6.85

Cash paid for property and equipment $(2,000)
The capital acquisitions ratio measures the company's ability to finance property and
equipment purchases from operations. The company did not purchase property and
equipment for cash during the year. However, it sold an old machine at $2,000. The ratio is
negative in this particular case and not particularly meaningful.
Req. 3
The company generated cash from its operations during the year, which it used to purchase
a long-term investment. It also sold shares for $6,000 and paid a sizable amount of
dividends, thereby reducing its cash balance it had at the start of the year.
5-48
E–2
Req. 1
Spreadsheet to Prepare Statement of Cash Flows, Direct Method
Balances Analysis of change Balances

Item 12/31/2011 Debit Credit 12/31/2012
Income statement items
Sales.............................................................. 140,000 a 140,000
Cost of sales............................................... 59,000 b 59,000
Depreciation expense........................... 7,000 q 7,000
Wages expense......................................... 28,000 e 28,000
Income taxes expense........................... 9,000 g 9,000
Interest expense...................................... 5,000 i 5,000
Other expenses........................................ 15,800 j 15,800
Statement of Financial Position
items
Cash............................................................... 16,500 p 5,300 11,200
Non-cash accounts:
Trade receivables................................... 22,000 22,000
Merchandise inventory........................ 68,000 c 7,000 75,000
Long-term investments....................... k 15,000 15,000
Property and equipment..................... 114,500 m 20,000 l 21,000 113,500
Total............................................................ 221,000 236,700
Accumulated depreciation................. 32,000 l 19,000 q 7,000 20,000
Trade payables......................................... 17,000 d 3,000 14,000
Wages payable.......................................... 2,500 f 1,000 1,500
Income taxes payable............................ 3,000 h 1,500 4,500
Bonds payable.......................................... 54,000 54,000
n 6,000
Share capital.............................................. 100,000 m 20,000 126,000
Retained earnings................................... 12,500 o 12,000 16,200 16,700
Total............................................................ 221,000 77,000 77,000 236,700
m. This amount is not reported in the Statement of Cash Flows as it is a non-cash transaction.
q. This amount is not reported on the Statement of Cash Flows as it is a non-cash item.
5-49
E–2 (continued)
Statement of Cash Flows Inflows Outflows

Conversion of profit to cash flow
from operating activities:
Collections from customers
Sales a 140,000 * 140,000
Payments:
To suppliers
Cost of sales b 59,000
+ Increase in inventory c 7,000
+ Decrease in trade payables d 3,000 (69,000)
To employees
Wages expense e 28,000
+ Decrease in wages payable f 1,000 (29,000)
For income taxes
Income taxes expense g 9,000
– Increase is income taxes payable h (1,500) (7,500)
For interest
Interest expense i 5,000 ** (5,000)
For other operating expenses j 15,800 *** (15,800)
13,700
Purchase of long-term investment k 15,000
Sale of operational assets l 2,000 (13,000)
Sale of share capital n 6,000
Dividends paid o 12,000 (6,000)
Net increase (decrease) in cash p 5,300 ($5,300)
*This amount is adjusted for changes (+ decrease /– increase) in Trade receivables, if any.
**This amount is adjusted for changes (+ decrease /– increase) in Interest payable, if any.
***This amount is adjusted for changes (+ decrease /– increase) in Prepaid expenses and Accrued
liabilities, if any.
Req. 2
The indirect method required adjusting the profit for non-cash items that are included in
the computation of profit. The computations in the spreadsheet suggest that the indirect
method is simpler than the direct method for preparing the operating activities sections of
the Statement of Cash Flows. Therefore as the accountant preparing the statement I would
prefer the indirect approach. However, if I was explaining the statement to a non-
accountant I might prefer the direct approach.
5-50
PROBLEMS
P–1
Req.1
HUNTER COMPANY
Statement of Cash Flows Spreadsheet
Analysis of Changes
12-31-2010 Debit Credit 12-31-2011
Statement of Financial Position
Cash 18,000 26,000 (k) 44,000
Trade receivables 29,000 2,000 (b) 27,000
Merchandise inventory 36,000 6,000 (c) 30,000
Property, plant & equipment (net) 72,000 9,000 (g) 6,000 (e) 75,000
Total 155,000 176,000
Trade payables 22,000 3,000 (d) 25,000
Wages payable 1,000 200 (f) 800
Notes payable, long-term 48,000 10,000 (h) 38,000
Share capital 60,000 20,000 (i) 80,000
Retained earnings 24,000 3,800 (j) 12,000 (a) 32,200
Total 155,000 49,000 49,000 176,000
Statement of Cash Flows – Indirect Method
Inflow Outflow
Profit 12,000 (a)
Adjustments to reconcile net loss to net
cash provided by operating activities:
Depreciation expense 6,000 (e)
Decrease in Trade receivables 2,000 (b)
Decrease in Merchandise inventory 6,000 (c)
Increase in Trade payables 3,000 (d)
Decrease in Wages payable 200 (f) 28,800
Cash payment to purchase property, plant and
equipment 9,000 (g) (9,000)
Payments on long-term note 10,000 (h)
Issuance of shares 20,000 (i)
Payments for cash dividends 3,800 (j) 6,200
Increase (decrease) in cash during the year 26,000 (k) 26,000
Totals 49,000 49,000
Cash balance, Jan. 1 18,000
Cash balance, Dec. 31 44,000
5-51
P–1 (continued)
Req. 2
HUNTER COMPANY

Profit.................................................................................................................. $12,000
Adjustments to reconcile profit to net cash
provided by operating activities:
Depreciation expense............................................................................ $ 6,000
Decrease in Trade receivables........................................................... 2,000
Decrease in Merchandise inventory............................................... 6,000
Increase in Trade payables................................................................. 3,000
Decrease in Wages payable................................................................. (200)
Total adjustments..................................................................................... 16,800
Net cash provided by operating activities............................. 28,800
Purchase of property, plant and equipment................................ (9,000)
Payments on long-term note............................................................... (10,000)
Issuance of shares..................................................................................... 20,000
Payments of cash dividends................................................................. (3,800)
Net cash provided by financing activities.............................. 6,200
Net increase in cash during the year........................................................ 26,000
Req. 3
There were no non-cash investing and financing activities during 2011.
Req. 4
The company generated $28,800 in cash from operations. It used $9,000 to purchase
equipment that will help the company in improving or expanding its operations. The
remaining amount is added to the cash balance along with the net cash flow provided by
issuing additional shares. The company has a sizeable amount of cash that can be used for
expansion of its operations or to pay some of its debts.
5-52
ALTERNATE PROBLEMS
AP–1
Req. 1
CHOO-FOO COMPANY
Statement of Cash Flows Spreadsheet
Analysis of Changes
Balance Sheet 12-31-2011 Debit Credit 12-31-2012
Cash 21,000 1,400 (l) 22,400
Trade receivables 18,000 3,000 (b) 21,000
Inventory 35,000 3,000 (g) 32,000
Prepaid insurance 2,400 1,000 (d) 1,400
Long-term investments 12,500 3,200 (i) 9,300
Property, plant and equipment (net) 31,100 33,000 (m) 4,500 (c) 59,600
Patent 2,000 500 (c) 1,500
Total 122,000 147,200
Trade payables 27,000 12,000 (h) 15,000

Wages payable 4,000 3,000 (e) 1,000
Income tax payable 2,000 200 (f) 2,200
Note payable, long-term 20,000 10,000 (j) 10,000
Share capital 53,000 33,000 (m) 86,000
Retained earnings 16,000 8,500 (k) 25,500 (a) 33,000
Total 122,000 70,900 70,900 147,200
m is a noncash transaction and is not included in the Statement of Cash Flows. Supplemental
disclosure is required.
5-53
AP–1 (continued)
Statement of Cash Flows - Indirect Method

Inflow Outflow
DR CR
Profit 25,500 (a)
Adjustment to reconcile profit to net cash
flow provided by operating activities:
Depreciation expense 5,000 (c)
Increase in Trade receivables 3,000 (b)
Decrease in inventory 3,000 (g)
Decrease in prepaid insurance 1,000 (d)
Decrease in Trade payables 12,000 (h)
Decrease in wages payable 3,000 (e)
Increase in income tax payable 200 (f) 16,700

Sale of long-term investments 3,200 (i) 3,200

Payments on long-term note 10,000 (j)
Payments of cash dividends 8,500 (k) ( 18,500)
Increase in cash during the year 1,400 (l) 1,400

Totals 37,900 37,900
Cash balance, January 1, 2012 21,000
Cash balance, December 31, 2012 22,400
(a) Profit = $150,000 – ($62,000 + $5,000 + $2,000 + $48,500 + $7,000 = $25,500

(k) Beginning RE, $16,000 + profit, $25,500 – dividends = Ending RE, $33,000;
Dividends = $16,000 + $25,500 – $33,000 = $8,500
5-54
AP–1 (continued)
Req. 2
CHOO-FOO COMPANY

Profit.............................................................................................................................. $25,500
Adjustments to reconcile profit to net cash provided by operating
activities:
Depreciation of property, plant and equipment............................. 4,500
Patent amortization...................................................................................... 500
Increase in trade receivables.................................................................... $ (3,000)
Decrease in inventory.................................................................................. 3,000
Decrease in prepaid insurance................................................................ 1,000
Decrease in trade payables........................................................................ (12,000)
Decrease in wages payable........................................................................ (3,000)
Increase in income tax payable............................................................... 200
Total adjustments.......................................................................................... (8,800)
Net cash provided by operating activities................................... $16,700
Sale of long-term investments.................................................................. 3,200
Payments on long-term note..................................................................... $(10,000)
Payments of cash dividends....................................................................... (8,500)
Net cash used by financing activities............................................. (18,500)
Net increase in cash during the year.............................................................. 1,400
Cash balance, January 1, 2012........................................................................... 21,000
Cash balance, December 31, 2012................................................................... $22,400
Req. 3
Schedule of Non-cash
Investing and Financing Activities
The company issued common shares with a market value of $33,000 in exchange for
machinery.
Req. 4
The company generated $16,700 in cash from operations. It used all of it to reduce its long-
term debt and pay dividends to shareholders. The company is in a healthy financial position
and has a sufficient amount of cash resources for expansion of its business as implied by the
purchase of new machinery.
5-55

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Chapter 5

Reporting and Interpreting Cash Flows

Alternate Cases and

E = Easy M = Moderate D = Difficult

1. – I Plant and equipment

10. – F Retained earnings

1. – O Income tax expense

5. – I Plant and equipment

10. NE Plant and equipment

Cash flows from operating activities — indirect method

Cash flows from operating activities—indirect method

Cash flows from operating activities—indirect method

Quality of earnings ratio = Cash flow from operations = $7,818 =1.52

Cash flows from investing activities:

Note: The short-term investments could be considered cash

Cash flows from financing activities:

Cash flows from investing activities:

Cash flows from financing activities:

Capital acquisitions ratio = Cash flow from operations

Total 2006 to 2008 = $122.4 = 0.81

Comparison of Statement of cash flows direct and indirect reporting

Cash flows from operating activities—direct method

Cash flows from operating activities:

Additional Cash Flow Information

Quality of earnings ratio = Cash flow from operations = $53,000 = 1.26

Capital acquisitions ratio = Cash flow from operations = $53,000 = 5.89

Cash flows from operating activities:

Cash flows from operating activities:

Cash flows from operating activities:

Quality of earnings ratio = Cash flow from operations = $100,000 = 0.71

Capital acquisitions ratio = Cash flow from operations = $100,000 = 2.33

Trade payables, beginning $ 8,000

Cash paid for general

Cash flows from operating activities:

Cash flows from operating activities:

Beginning balance, Trade payables ($10,000) + Purchases ($260,000) – Payments (X)

Cash flows from operating activities:

Additional Cash Flow Information

Quality of earnings ratio = Cash flow from operations = $11,000 = 1.22

Capital acquisitions ratio = Cash flow from operations = $11,000 = 0.38

PAN AMERICAN SILVER CORP.

Cash flows from operating activities:

Cash flows from operating activities:

Quality of earnings ratio = Cash flow from operations = $(1,200) = –0.40

Capital acquisitions ratio = Cash flow from operations = $(1,200) = –0.069

Trade payables, beginning $ 6,550

c. Loss on sale = Cash received – Book value of furniture sold

d. Gain on sale = Cash received – Book value of investment sold

Cash flows from operating activities:

Cash flows from operating activities:

FINDING AND INTERPRETING ACCOUNTING INFORMATION

The company uses the indirect method.

Free cash flow is determined as follows (in thousands):

Cash flows from operating activities CHF 10,763

(a) Depreciation, amortization and impairment (£244) is added to profit in the

Cash flows from operating activities £469

Quality of earnings ratio = Cash flow from operations / Profit

Cadbury: £489 / £366 = 1.34

Nestlé: €10,763 / €19,051 = 0.56

Capital acquisitions ratio = Cash flow from operations

Cadbury: £489 / £500 = 0.98

Nestlé: €10,763 / €4,869 = 2.21