Professional Documents
Culture Documents
Chapter 13
Chapter 13
Brief Learning
Exercises Topic Objectives Skills
B. Ex. 13.1 Cash flows from operations (direct) 3 Analysis
B. Ex. 13.2 Cash flows from operations (indirect) 7 Analysis
B. Ex. 13.3 Cash flows from operations (direct) 3 Analysis
B. Ex. 13.4 Cash flows from operations (indirect) 7 Analysis
B. Ex. 13.5 Cash flows from investing activities 4 Analysis
B. Ex. 13.6 Cash flows from financing activities 4 Analysis
B. Ex. 13.7 Cash payment for merchandise 3 Analysis
B. Ex. 13.8 Determining beginning cash balance 2 Analysis
B. Ex. 13.9 Reconciling net income to cash from Analysis
operations 6
B. Ex. 13.10 Prepare statement of cash flows 2 Analysis
Learning
Exercises Topic Objectives Skills
13.1 Using a cash flow statement 1, 2 Analysis, communication
13.2 Using a cash flow statement 1, 2, 6 Analysis, communication
13.3 Using noncash accounts to compute cash 4 Analysis
flows
13.4 Relationship between accrual and cash 3, 6 Analysis, communication
flows
13.5 Accrual versus cash flows 3 Analysis
13.6 Investing activities and interest revenue 3, 4 Communication
1. The primary purpose of a statement of cash flows is to provide information about the cash
receipts and cash payments of a business. A related purpose is to provide information about the
investing and financing activities of the business.
2. The income statement provides the better measurement of profitability, especially when the
business is financially sound and short-run survival is not the critical issue. The statement of
cash flows is designed for measuring solvency, not profitability. An income statement, on the
other hand, is specifically designed to measure profitability but gives little indication of
solvency.
3. Two supplementary schedules usually accompany a statement of cash flows prepared by the
direct method. One discloses the noncash aspects of financing and investing activities, such as
the purchase of land in exchange for a note payable or the conversion of preferred stock into
common shares. The other schedule itemizes the differences between net income and net cash
flow from operations.
4. Examples of cash receipts and of cash payments in the three major classifications of a cash
flow statement are shown below (two receipts and two payments required):
a. Operating activities:
Receipts:
(1) Cash received from customers.
(2) Dividends and interest received.
Payments:
(1) Cash paid to suppliers and employees.
(2) Interest paid.
(3) Income taxes paid.
b. Investing activities: c. Financing activities:
Receipts: Receipts:
(1) Sales of investments. (1) Short-term or long-term borrowing.
(2) Collecting loans. (2) Issuance of capital stock.
(3) Sales of plant assets. (3) Sales of treasury stock.
Payments: Payments:
(1) Purchases of investments. (1) Repayment of debt.
(2) Lending cash. (2) Purchase of treasury stock or retirement of
(3) Purchases of plant assets. outstanding shares.
(3) Payment of dividends.
5. Net cash flow from operating activities generally reflects the cash effects of transactions
entering into the determination of net income. Because interest revenue and interest expense
enter into the determination of net income, these items are classified as operating activities.
6. Cash equivalents are investments that are so short-term and so highly liquid that there is no
significant distinction between them and cash held on hand or in bank accounts. Examples of
cash equivalents include (1) money market funds, (2) commercial paper, and (3) Treasury bills.
8. In the long run, it is most important for a business to have positive cash flows from operating
activities. To a large extent, the ability of a business to generate positive cash flows from
financing activities is dependent upon its ability to generate cash from operations. Investors are
reluctant to invest money in a business that does not have an operating cash flow sufficient to
assure interest and dividend payments.
Also, a business cannot sustain a positive cash flow from investing activities over the long run.
A company can only sell productive assets for a limited period of time. In fact, a successful and
growing company will often show a negative cash flow from investing activities, as the company
is increasing its investment in plant assets.
9. Among the classifications shown in the cash flow statement, a successful and growing company
is least likely to report a positive cash flow from investing activities. A growing company is
usually increasing its investment in plant assets, which generally leads to a negative cash flow
from investing activities. If the company is successful and growing, however, the cash flows
from operating activities and from financing activities usually are positive.
10. No; a statement of cash flows summarizes the effects of cash transactions, but ledger accounts
are maintained by the accrual basis of accounting. Therefore, the balances of ledger accounts
must be adjusted to the cash basis in order to determine the items and amounts appearing in a
statement of cash flows.
Both methods result in exactly the same net cash flows from operating activities.
15. Payments of accounts payable are viewed as operating activities and are included in the caption
―Cash paid to suppliers and employees.‖
16. One purpose of a statement of cash flows is to provide information about all the investing and
financing activities of a business. Although the acquisition of land by issuing capital stock does
not involve a receipt or payment of cash, the transaction involves both investing and financing
activities. Therefore, these activities are disclosed in a supplementary schedule that
accompanies the statement of cash flows.
17. The credit to the Land account indicates a sale of land and, therefore, a cash receipt. However,
the $220,000 credit represents only the cost (book value) of the land that was sold. This amount
must be adjusted by any gain or loss recognized on the sale in order to reflect the amount of cash
received.
18. Credits to paid-in capital accounts usually indicate the issuance of additional shares of capital
stock. Assuming that these shares were issued for cash, the transaction would be presented in
the financing activities section of a statement of cash flows as follows:
Proceeds from issuance of capital stock ($12,000,000 + $43,500,000) ……………$ 55,500,000
19. The amount of cash dividends paid during the current year may be determined as follows:
Dividends declared during the year ……………………………………………. $ 4,300,000
Add: Decrease during the year in the liability for dividends payable
($1,500,000 - $900,000) ………………………………………………………. 600,000
Dividends paid during the year ………………………………………………… $ 4,900,000
20. Free cash flow is that portion of the net cash flow from operating activities that is available for
discretionary purposes after the basic obligations of the business have been met.
From a short-term creditor’s point of view, free cash flow is a ―buffer,‖ indicating that the
business brings in more cash than it must have to meet recurring commitments. Long-term
creditors view free cash flow as evidence of the company’s ability to meet interest payments and
to accumulate funds for the eventual retirement of long-term debt.
From the stockholders’ viewpoint, free cash flow indicates a likelihood of future dividend
increases or, perhaps, expansion of the business, which will increase future profitability.
Management views free cash flow positively because it is available for discretionary purposes
rather than already committed to basic operations.
In summary, everyone associated with the business views free cash flow favorably—and the
more, the better.
22. Peak pricing means charging higher prices in periods in which customer demand exceeds the
company’s capacity, and lower prices in ―off-peak‖ periods. This serves the dual purposes of
increasing revenue during peak periods, and allowing the business to serve more customers by
shifting excess demand to off-peak periods.
Common examples include restaurants, which charge higher prices at dinner time, and movie
theaters, which offer low matinee prices during the daytime.
23. An effective product mix is one that generates more sales, both by attracting more customers and
inspiring customers to purchase more products.
24. Speeding up the collection of accounts receivable does not increase the total amount collected.
Rather, it merely shifts collections to an earlier time period. The only period(s) in which cash
receipts actually increase are those in which collections under both the older and newer credit
periods overlap.
B.Ex. 13.3
Cash flows from operating activities:
B.Ex. 13.5
Cash used for investing activities:
B.Ex. 13.8
Cash balance at the beginning of the year:
B.Ex. 13.9
Net income $56,000
Adjustments to reconcile net income to net cash from
operations:
Depreciation expense $12,000
Increase in accounts receivable (4,000)
Decrease in inventory 6,000
Increase in accounts payable 3,000
Decrease in accrued expenses payable (2,000)
Net cash provided by operating activities $71,000
Ex. 13.2 Note: All dollar figures in the following calculations are in thousands.
a. Cash from operations ………………………………………………………………… $ 280
Expenditures for property and equipment ………………………………………….. (30)
Dividends paid ………………………………………………………………………… (140)
Free cash flow …………………………………………………………………………. $ 110
b. The major sources and uses of cash from financing activities during
Source: ……………………………………………………………………………………
none
Use: Dividend paid ………………………………………………………………$ 140
Use: Retirement of Debt ……………………………………………………………
$ 150
b. Cash received from customers has two elements: (1) cash sales and (2) collections
of accounts receivable. For cash sales, the amounts of sales and cash receipts are
the same. However, collections on accounts receivable differ from the amount of
credit sales. If accounts receivable increased, credit sales for the period exceeded
cash collections on these accounts. If, however, accounts receivable decreased, cash
collections of accounts receivable exceeded credit sales. Thus, cash received from
customers may be greater or less than the amount of net sales.
Ex. 13.6 The new loans made ($15 million) will appear among the investing activities of the
company as a cash outflow. The $36 million collected from borrowers will be split into
two cash flows. The $30 million in interest revenue will be included among the cash
inflows from operating activities, whereas the $6 million in principal amounts collected
from borrowers ($36 million - $30 million) will appear as a cash inflow from investing
activities.
e. Omitted from the computation. Cash received from customers is a cash inflow
shown in the direct method of computing net cash flow from operating activities.
However, this cash inflow does not appear separately when the indirect method
is used.
f. Added to net income. A reduction in prepaid expenses indicates that the amounts
expiring (and, therefore, being recognized as expense) exceed cash outlays for
these items during the period. Thus, net income measured on the accrual basis is
lower than net cash flow.
g. Omitted from the computation. Declarations and payments of dividends do not
enter into the determination of either net income or net cash flows from
operating activities. Therefore, these transactions do not cause a difference
between these figures. Dividends paid are reported in the financing activities
section as a disbursement.
h. Added to net income. An increase in accounts payable means that purchases of
merchandise, measured on the accrual basis, exceed the payments during the
period made to suppliers. Thus, costs and expenses measured on the accrual basis
were greater than the actual cash payments during the period.
i. Deducted from net income. The $2 million reduction in accrued income taxes
payable means that cash payments to tax authorities exceeded by $2 million the
income tax expense of the current year. Therefore, cash outlays exceeded the
expenses shown in the income statement, and net cash flow from operating
activities is smaller than net income.
a. Operating activity
b. Financing activity
c. Operating activity
d. Financing activity
e. Operating activity
f. Operating activity
g. Not included in the statement of cash flows. A money market fund is viewed as a cash
equivalent. Therefore, transfers between bank accounts and money market funds are not
viewed as cash receipts or cash payments.
h. Investing activity
i. Not included in a statement of cash flows prepared by the direct method. Amortization is a
noncash expense; recording amortization does not require any cash outlay within the
accounting period.
j. Operating activity
k. Financing activity
l. Operating activity
m. Operating activity
n. Investing activity
o. Not included in the statement of cash flows. Transfers between cash equivalents and other
forms of cash are not regarded as cash receipts or cash payments.
1. Operating activity
2. Financing activity
3. Operating activity
4. Financing activity
5. Operating activity
6. Operating activity
7. Not included in the statement of cash flows. A money market fund is viewed as a cash
equivalent. Therefore, transfers between bank accounts and money market funds are not
viewed as cash receipts or cash payments.
8. Investing activity
9. Not included in a statement of cash flows prepared by the direct method. Depreciation is a
noncash expense; recording depreciation does not require any cash outlay within the
accounting period.
15. Not included in the statement of cash flows. Transfers between cash equivalents and other
forms of cash are not regarded as cash receipts or cash payments.
b. The amount of gain or loss is reflected in the cash receipts figure. For example,
equipment that was sold for $156,000 at a $34,000 loss had a book value (cost,
less accumulated depreciation) at the time of sale of $190,000:
Cost, less accumulated depreciation $190,000
Cash received from sale (156,000)
Loss on sale $34,000
Similarly, land that was sold for $160,000 and which resulted in a $50,000 gain
had a cost of $110,000:
Cash received from sale $160,000
Cost (100,000)
Gain on sale $50,000
Using the amount of cash received in the calculation of cash provided by investing
activities automatically incorporates the gain or loss on the sale.
c. The following items were excluded because they are financing activities, not
investing activities:
● Cash receipts from sale of common stock
● Cash payments to purchase treasury stock, retire debt, and pay dividends
on preferred and common stock
b. The following items were excluded from the above calculations because they are
classified as indicated below in the statement of cash flows:
Classified as operating activities:
● Cash received from customers
● Cash received from interest and dividends
● Cash
received
paid to employees
● Cash paid to purchase inventory
● Cash paid for interest expense
While the general trend is negative, the three primary elements in the free cash
flow calculation are positive-steady cash provided by operations, strong (and
growing) investment in new assets, and steady and increasing dividends to
stockholders. In general, the company appears to be in a strong cash position.
Supporting computations:
(1) Cash received from customers:
Cash sales $ 800,000
Collections on accounts receivable 2,200,000
Cash received from customers $ 3,000,000
Note to instructor: The transfer from the money market fund to the general bank account is not
considered a cash receipt because a money market fund is a cash equivalent.
Supporting computations:
(1) Proceeds from sales of marketable securities:
Cost of securities sold (credit entries to
Marketable Securities account) $ 90,000
Add: Gain on sales of marketable securities 42,000
Proceeds from sales of marketable securities $ 132,000
b.
Schedule of noncash investing and financing activities:
c. Cash must be generated to cover the company’s investment needs through operating or
financing activities. Ideally, cash to support investing activities should come from normal
operations. If this places undue strain on the company’s operations, however, financing via
borrowing and/or sale of capital stock are alternatives the company should consider.
Supporting computations:
(1) Proceeds from sales of marketable securities:
Cost of securities sold (credit entries to
Marketable Securities account) $ 62,000
Less: Loss on sales of marketable securities 16,000
Proceeds from sales of marketable securities $ 46,000
b.
Schedule of noncash investing and financing activities:
c. Management has more control over the timing and amount of outlays for investing activities
than for operating activities. Many of the outlays for operating activities are contractual,
reflecting payroll agreements, purchase invoices, taxes, and monthly bills. Most investing
activities, in contrast, are discretionary —both as to timing and dollar amount.
Credit sales cause receivables to increase, while collections cause them to decline. If receivables
decline over the year, collections during the year must have exceeded credit sales for the year.
Thus, cash receipts exceed revenue measured on the accrual basis.
Supporting computations:
(1) Cash received from customers:
Net sales $ 3,200,000
Less: increase in accounts receivable 60,000
Cash received from customers $ 3,140,000
b. (1) The primary reason why cash provided by operating activities substantially exceeded net
income was the company’s $150,000 in depreciation expense. Depreciation reduces net
income, but does not affect the cash flows from operating activities.
(2) The primary reason for the net decrease in cash was the large cash outlays for investing
activities —specifically, the cash paid to acquire plant assets.
c. To the extent that receivables increase, the company has not yet collected cash from its
customers. Thus, if the growth in receivables had been limited to $10,000, instead of $60,000,
the company would have collected an additional $50,000 from its customers. Thus, the net
decrease in cash (and cash equivalents) would have been $30,000, instead of $80,000.
c. Satellite 2010’s credit sales resulted in $750,000 in new receivables, which were uncollected
as of year-end. These credit sales all were included in the computation of net income, but
those that remained uncollected at year-end do not represent cash receipts. Therefore, the
cash flow from operating activities was substantially below the amount of net income
measured on the accrual basis.
Note to instructor: It is not uncommon for cash flows to lag behind a rising net income figure in a
growing business. This is why many rapidly growing businesses find themselves “strapped for
cash” to finance their growth.
d. Satellite 2010 does not appear headed for insolvency. First, the company has a $6 million
line of credit, against which it has drawn only $1,450,000. This gives the company
considerable debt-paying ability. Next, if Satellite 2010’s rapid growth continues, the
company should not have difficulty issuing additional capital stock to investors as a means
of raising cash. If a company is obviously successful, it usually is able to raise the cash
necessary to finance expanding operations.
Miracle Tool, Inc. is not replacing plant assets as quickly as these assets are being
depreciated. In any given year, this may not be significant. But on the other hand, this
relationship certainly indicates that the business is not expanding, and it may indicate
that the company is deferring replacements of plant assets in an effort to conserve
cash.
Miracle Tool, Inc. is allowing its accounts payable to rise much more quickly than it is
increasing inventory. This indicates that the company is not paying its bills as quickly
as it used to. While this conserves cash, the “savings” are temporary. Also, if the
company’s credit rating is damaged, this strategy may reduce both earnings and cash
flows in the near future.
d. Miracle Tool, Inc. has substantially more cash than it did a year ago. Nonetheless, the
company’s financial position appears to be deteriorating. Its marketable securities—a
highly liquid asset—are almost gone. Its accounts payable are rising rapidly, and
substantially exceed the amount of cash on hand. Most importantly, sales and accounts
receivable both are falling, which impairs the company’s ability to generate cash from
operating activities in the future. Also, the liquidity of the company’s inventory is
questionable in light of the declining sales.
If the company is to be liquidated, this should be done quickly to avoid future operating
losses. Information should be gathered to determine whether it would be best to sell the
company as a going concern or whether management should sell the assets individually. In
either event, management should stop purchasing tools. Assuming that sales continue to
decline, the company’s current inventory appears to be approximately a one-year supply.
• Stop buying the combination tool—at least until the current inventory is sold. This will not
improve profitability, but will help cash flows. (As explained above, the company’s current
inventory appears about equal to next year’s potential sales.)
• Look for ways to reduce operating expenses. In 2007, sales declined by 30%, but the
company was able to reduce operating expenses by only about 6.5% ($17,000 decline from
a level of $260,000).
• Stop paying dividends. The company has no cash to spare. As sales continue to fall,
the net cash flow from operating activities is likely to turn negative. Collecting
existing receivables and letting payables go unpaid can only bolster net cash flow for a
limited period of time.
• Develop forecasts of future operations and cash flows. If a turnaround does not appear
realistic, management should reconsider the option of liquidating the company.
Supporting computations:
(1) Cash received from customers:
Cash sales $ 230,000
Collections on accounts receivable 2,810,000
Cash received from customers $ 3,040,000
Note to instructor: The transfer from the money market fund to the general bank account is not
considered a cash receipt because a money market fund is a cash equivalent.
Supporting computations:
(1) Proceeds from sales of marketable securities:
Cost of securities sold (credit entries to
Marketable Securities account) $ 74,000
Add: Gain on sales of marketable securities 15,000
Proceeds from sales of marketable securities $ 89,000
b.
Schedule of noncash investing and financing activities:
c. Cash must be generated to cover the company’s investment needs through operating or
financing activities. Ideally, cash to support investing activities should come from normal
operations. If this places undue strain on the company’s operations, however, financing via
borrowing and/or sale of capital stock are alternatives the company should consider.
Supporting computations:
(1) Proceeds from sales of marketable securities:
Cost of securities sold (credit entries to
Marketable Securities account) $ 60,000
Less: Loss on sales of marketable securities 8,000
Proceeds from sales of marketable securities $ 52,000
b.
Schedule of noncash investing and financing activities:
c. Management has more control over the timing and amount of outlays for investing activities
than for operating activities. Many of the outlays for operating activities are contractual,
reflecting payroll agreements, purchase invoices, taxes, and monthly bills. Most investing
activities, in contrast, are discretionary —both as to timing and dollar amount.
b. Management could increase cash flows from operations by (only two required):
Reducing the amount of inventories being held.
Reducing the amount of short-term prepayments of expenses.
Taking greater advantage of accounts payable as a short-term means of financing
purchases of goods and services.
More aggressive collection of accounts receivable.
Credit sales cause receivables to increase, while collections cause them to decline. If receivables
increase over the year, collections during the year must have been less than credit sales for the
year. Thus, cash receipts were less than revenue measured on the accrual basis.
Supporting computations:
(1) Cash received from customers:
Net sales $ 3,400,000
Less: increase in accounts receivable 60,000
Cash received from customers $ 3,340,000
b. Cash paid to suppliers, presented in the operating activities section of the statement of cash
flows, totaled $2,330,000. Cost of goods sold, presented in the income statement, was only
$1,500,000. The primary reasons for the difference are as follows:
● Adjustments to the amount of cost of goods sold plus the amount of operating expenses
were required as a result of the following:
--Decrease in inventory
--Decrease in accounts payable
--Depreciation expenses (which did not require cash payment)
--Increase in prepaid operating expenses
--Decrease in accrued liabilities for operating expenses
c. On the contrary, the fact that cash flows from investing and financing activities are negative
attests to the strength of the cash position of the company. The amount of cash increased
significantly during the year, going from a beginning balance of $20,000 to $473,000. Cash
flows from operating activities were a significant positive amount, $923,000. In addition, the
company was able to purchase marketable securities and plant assets and make loans to
borrowers (all investing activities) and retire debt and pay dividends (financing activities).
b. LGIN’s credit sales resulted in $865,000 in new receivables, which were uncollected as of
year-end. These credit sales all were included in the computation of net income, but those
that remained uncollected at year-end do not represent cash receipts. Therefore, the cash
flow from operating activities was substantially below the amount of net income measured
on the accrual basis.
Note to instructor: It is not uncommon for cash flows to lag behind a rising net income figure in a
growing business. This is why many rapidly growing businesses find themselves “strapped for
cash” to finance their growth.
c. LGIN does not appear headed for insolvency. First, the company has a $5 million line of
credit, against which it has drawn only $1,490,000. This gives the company considerable
debt-paying ability. Next, if LGIN’s rapid growth continues, the company should not have
difficulty issuing additional capital stock to investors as a means of raising cash. If a
company is obviously successful, it usually is able to raise the cash necessary to finance
expanding operations.
Investing activities:
Proceeds from sale of
marketable securities (8) 11,000
Cash paid for plant assets (9) 8,000
Financing activities
Dividends paid (2) 4,000
Payment of notes payable (10) 10,000
Sale of capital stock (11) 35,000
Extra-Ordinaire, Inc. is not replacing plant assets as quickly as these assets are being
depreciated. In any given year, this may not be significant. But on the other hand, this
relationship certainly indicates that the business is not expanding, and it may indicate that
the company is deferring replacements of plant assets in an effort to conserve
cash.
Extra-Ordinaire, Inc. is allowing its accounts payable to rise much more quickly than it is
increasing inventory. This indicates that the company is not paying its bills as quickly as it
used to. While this conserves cash, the “savings” are temporary. Also, if the company’s
credit rating is damaged, this strategy may reduce both earnings and cash flows in the near
future.
d. Extra-Ordinaire, Inc. has substantially more cash than it did a year ago. Nonetheless, the
company’s financial position appears to be deteriorating. Its marketable securities—a
highly liquid asset—are almost gone. Its accounts payable are rising rapidly, and
substantially exceed the amount of cash on hand. Most importantly, sales and accounts
receivable both are falling, which impairs the company’s ability to generate cash from
operating activities in the future. Also, the liquidity of the company’s inventory is
questionable in light of the declining sales.
e. This company is contracting its operations (or collapsing). Its investment in marketable
securities, receivables, and plant assets all are declining. Further, the income statement
shows that operations are eroding the owners’ equity in the business. The decline in
sales—already apparent in the income statement—soon will reduce the cash collected from
customers, which is the principal factor contributing to a positive cash flow from operating
activities.
In summary, this company appears to be in real trouble.
f. The company’s principal revenue source—sales of Pulsas—appears to be collapsing. If
nothing is done, it is likely that the annual net losses will increase, and that operating cash
flows soon will turn negative. Thus, management’s first decision is whether to attempt to
revive the company, or liquidate it.
If the company is to be liquidated, this should be done quickly to avoid future operating
losses. Information should be gathered to determine whether it would be best to sell the
company as a going concern or whether management should sell the assets individually. In
either event, management should stop purchasing Pulsas. Assuming that sales continue to
decline, the company’s current inventory appears to be approximately a one-year supply.
If management decides to continue business operations, it should take the following actions:
• Expand the company’s product lines! The Pulsas alone can no longer support profitable
operations. Also, dependency upon a single product—especially a faddish product with a
limited market potential—is not a sound long-term strategy.
• Stop buying Pulsas—at least until the current inventory is sold. This will not improve
profitability, but will help cash flows. (As explained above, the company’s current
inventory appears about equal to next year’s potential sales.)
• Look for ways to reduce operating expenses. In 2007, sales declined by 36%, but the
company was able to reduce operating expenses by only about 3.8% ($10,000 decline from
a level of $260,000).
• Stop paying dividends. The company has no cash to spare. As sales continue to fall,
the net cash flow from operating activities is likely to turn negative. Collecting
existing receivables and letting payables go unpaid can only bolster net cash flow for a
limited period of time.
• Develop forecasts of future operations and cash flows. If a turnaround does not appear
s
realistic, management should reconsider the option of liquidating the company.
a. Based on past performance, it does not appear that Allison Corporation can continue to
pay annual dividends of $40,000 without straining the cash position of the company. In a
typical year, Allison generates a positive cash flow from operating activities of
approximately $50,000. However, about $45,000 is required in a normal year to replace
the plant assets retired. This leaves only about $5,000 per year of the net operating cash
flow available for dividends and other purposes. If Allison is to continue paying cash
dividends of $40,000 per year, the company must raise about $35,000 from investing and
financing activities.
Over the long run, it is quite difficult for a company to continually finance its cash
dividends through increased borrowing (financing activity) or through sales of assets
(investing activity). Therefore, Allison Corporation may have to reduce its cash dividends in
future years.
b. Two of the unusual factors appearing in the current statement of cash flows should be
considered in assessing the company’s ability to pay future dividends. First, the company
spent an unusually large amount ($160,000) to purchase plant assets during the year.
This expenditure for plant assets may increase net operating cash flow above the levels
of prior years. Second, the company issued $100,000 of bonds payable and an additional
1,000 shares of capital stock. The interest on the new bonds payable will reduce future
cash flows from operations. Also, the additional shares of capital stock mean that total
dividend payments must be increased if the company is to maintain the current level of
dividends per share.
In summary, the unusual investing and financing activities will improve the company’s ability
to continue its dividends only if the new plant assets generate more cash than is needed to
meet the increased interest and dividend requirements.
You have a bigger problem coming up in February. You will have more difficulty paying
February’s rent than you did January’s. The sad fact is that you cannot afford rent of
$200 per month. You are earning $400 per month and spending $240 on things other than
rent. Thus, you can afford only about $160 per month for rent unless you reduce other
expenses.
To solve this problem, you might find a roommate to share the rent, move into less expensive
housing, or somehow increase your monthly cash receipts. (It does not appear practical to
trim $40 per month from your other expenses.)
(2) Changing from an accelerated method to the straight-line method of depreciation will
(generally) reduce the amount of depreciation expense included in the income statement,
thus increasing reported net income. Lengthening estimates of useful lives has a similar
effect. Depreciation is a noncash expense; therefore, cash flows are not affected by the
choice of depreciation method or the estimate of useful lives, except to the extent that
these choices may affect income tax payments. The problem stated, however, that no
changes would be made in the depreciation claimed for tax purposes.
(3) Pressuring dealers (customers) to increase their inventories will increase General
Wheels’ sales for the year. This should increase net income and cash flows from
operating activities (collections from customers).
(4) Requiring dealers to pay more quickly will speed up cash collections from customers,
thus increasing operating cash flows and total cash. The timing of these collections has
no direct effect upon net income. However, offering shorter credit terms may have the
indirect effect of reducing net sales. Thus, one might argue that this proposal could
decrease both net income and future collections from customers.
(6) Incurring short-term interest charges of 10% to replace long-term interest charges of 13%
will reduce interest expense and cash payments of interest. Therefore, net income, cash flows
from operating activities, and total cash flow will improve. Management’s only risks in
pursuing this proposal are that short-term rates may rise or that the company may be
unable to renew the short-term loans as they mature.
(7) Dividend payments do not enter into the determination of net income or net cash flow from
operating activities. Therefore, these two amounts will not be affected by the proposal. Cash
dividends are classified as financing activities and do affect total cash flows from operating
activities. Therefore, replacing cash dividends with stock dividends (which require no cash
payment) will increase net cash flow from all sources. However, management should be
aware that discontinuing cash dividends may adversely affect the company’s ability to raise
capital through the issuance of additional shares of capital stock.
a. The statement is not valid because it addresses only the peak-period aspect of a peak-pricing
strategy. It is true that during the peak period, some customers will be priced out of the
market (or at least encouraged to purchase in an off-peak period). But in off-peak periods,
prices tend to be lower than they would under a single-price strategy. Thus, peak pricing
may, in fact, allow some customers to purchase goods or services that they otherwise could
not afford.
b. The alternative to peak pricing is a single all-the-time price. In this case, excess demand is
handled on a first-come, first-served basis.
c. (1) Hotels in Palm Springs charge their highest daily rates during the sunny but
comfortable winter months. The uncomfortably hot summers are their off-season, and
they offer their rooms at greatly reduced rates.
(2) Movie theaters charge peak prices in the evenings. Daytime is the off-peak period, and
they normally offer substantially discounted matinee prices. Also, they often lower
prices on Monday and/or Tuesday evenings, which are periods of little customer
demand.
d. In the opinion of the authors, peak pricing normally is an ethical business practice. But
there are exceptions, and management should think carefully about its responsibilities.
Peak pricing may be unethical if the services are funded in whole or in part by
taxpayers—but not in every case. For example, we would consider it unethical for public
schools to provide a more convenient class schedule to students willing to pay an extra fee.
But we would not object to a museum or national park varying admission prices between
peak and off-peak periods.
Also, an ethical distinction may be drawn between peak pricing and a concept called
“profiteering.” Profiteering means exploiting customers in an emergency situation. For
example, we would view raising the price of medical supplies during a local disaster, such as
the September 11, 2001 terrorist attacks on the World Trade Center and the Pentagon, as
profiteering. (To our knowledge, this did not occur. In fact, many health-care organizations
provided goods and services at no charge during this emergency.) Other examples are
increased prices of salt and shovels in preparation for a blizzard and increased prices of
generators, pumps, bottled water, and batteries at the time of a hurricane.
But what represents an emergency situation? For example, we would not view it as unethical
for hotels to raise their room rates because the Superbowl is being played in town.
Following are several points that are appropriate for inclusion in the student's response to this
case:
• It is difficult for one person or a few people to make improvements in financial
reporting.
• Improvement can come by looking at reporting as a communications exercise rather than
a compliance exercise.
• Preparers of financial statements should make choices that provide more information
rather than those that minimally comply with the rules.
• Regarding the statement of cash flows, any company can improve its reporting by
voluntarily presenting cash flows by the direct rather than the indirect method.
• Users (of financial statements) indicate that they prefer the direct method information,
and FASB Statement #95 provides a framework in which to provide this information.
b. In order to keep cash from going out the door, management at Texas Instruments can:
cut capital spending
lay off employees
trim inventories
demand quicker payment from customers
slow down payments to suppliers
cut cash dividends
slow or stop stock buybacks
forego acquisitions by cash or
defer income taxes.
c. In order to bring in fresh cash, management can:
issue debt
generate cash through operations
issue securities
practice peak pricing or
create an effective product mix.
d. Companies that may have negative cash flows from operations are companies that are
in the early stage of development or companies competing in new industries. High start-
up costs and marketing costs to develop the company’s business have adverse effects
on cash flows. Companies with net operating losses will often have negative cash flows
from operations.
e. Companies with established products or services in established industries will often
have large positive cash flows from operations, which result from positive operations
that result in large net income amounts.
AMAZON.COM, INC.
Consolidated Statement of Cash Flows
(in millions)
For the Year Ended December 31
2005 2004 2003
OPERATING ACTIVITIES
Net income (loss) $ 359 588 35
Adjustments to reconcile net income (loss) to net cash
from operating activities:
Depreciation of fixed assets and other amort. 121 76 75
Stock-based compensation 87 58 88
Other operating expense (income) 7 (8) 3
Losses (gains) on sales of marketable securities, net (1) (1) (9)
Remeasurements and other (42) 1 130
Non-cash interest expense and other 5 5 13
Deferred income taxes 70 (257) 1
Cumulative effect of change in accounting principle (26) — —
Changes in operating assets and liabilities:
Inventories (104) (169) (76)
Accounts receivable, net, and other current assets (84) (2) 2
Accounts payable 274 286 167
Accrued expenses and other current liabilities 60 (14) (27)
Additions to unearned revenue 156 110 102
Amortization of previously unearned revenue (149) (107) (112)
Net cash provided by (used in) operating activities 733 566 392