ENMG602 – Introduction to Financial Engineering

Week 6 – Assignment 3
Submitted by: Issam Tamer, Antoine Araman, Ziad Chahla

1. The indirect method for constructing cash flow statements states that, to calculate cash flow from

operations, net income must be adjusted by adding back non-cash expenses. Depreciation is

considered an expense that doesn't involve a cash outflow. Given that net income decreases due to

depreciation expenses, adding back depreciation expenses to net income is required to determine

the initial income value without depreciation. This explains why the 197,118$ for depreciation

expenses was added back to net income in the statement of cash flows.

2. The table below shows that changes in accounts receivable, work-in-progress, and prepaid expenses

between the year 1999 and 2000 are equivalent to the corresponding adjustments in the cash flow

statement for year 2000. However, this is not always the case because if a company acquires

another business, sells a major division, or reclassifies certain financial assets, then this will affect

how assets and liabilities will be recorded, and therefore lead to variations between the numbers

reported on the balance and the adjustments on the cash flow statement.

Balance on December Balance on December Change

31, 2000 31, 1999
Accounts receivable 221,363$ 97,600$ 123,763$

Work-in-progress 0 70,581$ (70,581$)

Prepaid expenses 144,767$ 93,201$ 51,563$

3. The change in prepaid expenses between 1999 and 2000 corresponds to an increase of 51,563$.

Prepaid expenses are considered as current assets and therefore, according to the indirect method

for constructing cash flow statements, they must be subtracted from net income. In the cash flow

statement, since an increase in current assets must be subtracted from income, then will lead to a

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 decrease in net income, and therefore an increase of 51,563$ in prepaid expenses in the balance

sheet corresponds to a decrease of 51,563$ in the cash flow statement, which is recorded on the

cash flow statement as (51,563$) for year 2000.

4. Similar to what was done for the depreciation adjustment, and since the Stock Based Compensation

is an expense that did not consume any cash during that year, it has been added back to the net

income to calculate the cash flow from operating activities.

A journal entry reflecting this is as shown hereafter:

Compensation expense………………………………….359,173

Additional paid in capital………………………………….359,173

5. As shown under the current liabilities section of the balance sheets for the fiscal years of 1999 and

2000, the deferred revenue account was 60,020$ and 180,143$ respectively for the years 2000 and

1999. As such, the deferred revenue account balance decreased by 120,123$ where this decrease is

reflected through the following journal entry (It is worth mentioning that even though the revenue

was recognized, the cash flow associated with the revenue was already collected in a previous

period):

Deferred Revenue……………………………….120,123

Revenue……………………………………………….120,123

As for fiscal year 1999, and the opposite is true since more cash was collected than revenue

recognized.

6. The transaction for the exchange product and service revenue and exchange advertising can be

explained through the following excerpt:

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 “On August 1, 1997, the Company entered into an agreement to exchange services with a British

Columbia television station (BCTV). The Company provided Web site development and monthly

maintenance services in exchange for daily television advertising. The Company recognized the

revenues and advertising expenses from the barter transaction at the fair value of the advertising

received.”

No adjustment was shown in the cash flow statement because the revenue might have been exactly

equal to the expense and neither entailed a cash flow which would have led them to cancel each

other out. A better representation would have been to show the subtraction of the related revenue

and the addition of the expense in two different lines in the cash flow from operations section.

If the company engaged in such barter transactions in 2000, and since such transactions require to

be reported differently for that year, they likely would not have reported the related transactions in

the fiscal year 2000 statements as no historical track record could have been used to rely on.

7. As indicated in the consolidated statements of cash flows, Blue Zone reported a net loss for the

years 1998, 1999, and 2000, which amounted to $28,457, $1,422,310, and $3,843,767, respectively.

As for the cash flow from operating activities, it decreased between 1998 and 2000, with cash inflow

of $61,694 for the year 1998 and cash outflows of $807,311 and $3,600,177 for the years 1999 and

2000, respectively. Blue Zone reported cash outflow from financing activities for the year 1998 and

cash inflows for the years 1999 and 2000. The financing cash inflow decreased between 1999 and

2000. Regarding the cash flows from investing, they were negative and decreased between the

years 1998 and 2000. The cash flow statements reflect that that Blue Zone Inc. was not performing

well during 1998 and 2000. The consecutive net losses, declining operating cash flows, and negative

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 trends in financing and investing activities suggest that the company was facing financial challenges

and may have been struggling to meet its financial obligations and generate positive returns.

8.

Fixed assets Accumulated depreciation

(Beginning balance) (Beginning balance)
544,263$ 118,667$
(Increases) 610,419$ (Decreases) 8,453$ (Decreases) 8,453$ (Increases) 197,118$
(Ending balance) (Ending balance)
1,146,229$ 307,332$

The consolidated statement of cash flows indicates that Blue Zone, Inc purchased fixed assets for

610,419$. The corresponding journal entry is as follows:

Fixed assets…………………………………………………………610,419$

Cash…………………………………………………………………….610,419$

The cash flow statement also shows that depreciation expenses amounted to 197,118$. Thus, the

corresponding journal entry is as below:

Depreciation expenses…………………………………………………………197,118$

Accumulated depreciation…………………………………………………….197,118$

The T-accounts above shows that adjustment is needed to make fixed assets and accumulated

depreciation accounts equivalent. This can be done using one of the following methods:

544,263$ + 610,419$ - 1,146,229$ = 8,453$ OR 118,667$ + 197,118$ - 307,332$ = 8,453$

Fixed assets were fully depreciated and are no longer in use, thus the corresponding journal entry is as below:

Accumulated depreciation…………………………………………………………8,453$

Fixed assets…………………………………………………………………..8,453$