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Chapter 4

Reporting and Analyzing Cash Flows


Learning Objectives coverage by question
Mini-exercises LO1 Explain the purpose of the statement of cash flows and how it complements the income statement and balance sheet. LO2 Construct and explain the statement of cash flows. Exercises Problems Cases

21, 22, 24, 25

34, 36, 38, 39

44, 47, 51, 55

57, 58, 59

21, 22, 23, 24, 25, 26, 27, 28, 29, 30, 31

34, 35, 36, 37, 38, 39, 40, 41, 42, 43

44, 45, 46, 47, 48, 49, 50, 51, 52, 53, 54, 55, 56 46, 48, 50, 52, 56 57, 58

LO3 Compute and interpret ratios that reflect a companys liquidity and solvency. LO4 Appendix 4A: Use a spreadsheet to construct the statement of cash flows.

32, 33, 35, 43

59

56

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QUESTIONS
Q4-1 Cash equivalents are short-term, highly liquid investments that firms acquire with temporarily idle cash to earn interest on these excess funds. To qualify as a cash equivalent, an investment must (1) be easily convertible into a known cash amount and (2) be close enough to maturity so that its market value is not sensitive to interest rate changes (generally, investments with initial maturities of three months or less). Three examples of cash equivalents are Treasury bills, commercial paper, and money market funds. Q4-2 Cash equivalents are included with cash in a statement of cash flows because the purchase and sale of such investments are considered to be part of a firm's overall management of cash rather than a source or use of cash. Similarly, as statement users evaluate cash flows, it may matter very little to them whether the cash is on hand, deposited in a bank account, or invested in cash equivalents. Q4-3 Operating activities Inflow: Cash received from customers Outflow: Cash paid to suppliers Investing activities Inflow: Sale of equipment Outflow: Purchase of stocks and bonds Financing activities Inflow: Issuance of common stock Outflow: Payment of dividends Q4-4 a. b. c. d. e. f. g. h. Investing; outflow. Investing; inflow. Financing; outflow. Operating (direct method, inflow. Financing; inflow. Operating (direct method, inflow. Operating (direct method, outflow. Operating (direct method, inflow.

not shown separately under indirect method); not shown separately under indirect method); not shown separately under indirect method); not shown separately under indirect method);

Q4-5 This is a noncash investing and financing event. It must be reported in a supplementary schedule to the statement of cash flows.

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Financial Accounting, 3rd Edition

Q4-6 Noncash investing and financing transactions are disclosed as supplemental information to a statement of cash flows because a secondary objective of cash flow reporting is to present information about investing and financing activities. Noncash investing and financing transactions, generally, affect future cash flows. Issuing bonds payable to acquire equipment, for example, requires future cash payments for interest and principal on the bonds. On the other hand, converting bonds payable into common stock eliminates future cash payments related to the bonds. Knowledge of these types of events, therefore, should be helpful to users of cash flow data who wish to assess a firm's future cash flows. Q4-7 A statement of cash flows helps external users assess the amount, timing, and uncertainty of future cash flows to the enterprise. These assessments help users evaluate their own future cash receipts from their investments in, or loans to, the firm. A statement of cash flows shows the periodic cash effects of a firm's operating, investing, and financing activities. Distinguishing among these different categories of cash flows helps users compare, evaluate, and predict cash flows. With cash flow information, creditors and investors are better able to assess a firm's ability to settle its liabilities and pay its dividends. Over time, the statement of cash flows permits users to observe and analyze management's investing and financing policies. A statement of cash flows also provides information useful in evaluating a firm's financial flexibility (which is its ability to generate cash to respond to unanticipated needs and opportunities). Q4-8 The direct method presents the net cash flow from operating activities by showing the major categories of operating cash receipts and cash payments (such as cash received from customers, cash paid to employees and suppliers, cash paid for interest, and cash paid for income taxes). The indirect (or reconciliation) method, in contrast, presents the net cash flow from operating activities by applying a series of adjustments to the accrual net income to convert it to a cash basis. Under the indirect method, depreciation is added to net income because, as a noncash expense, it was deducted in computing net income. Adding depreciation to net income, therefore, eliminates it from the cash-basis income amount. Amortization and depletion expenses are handled the same way.

Q4-9

Q4-10 Under the indirect method, the $98,000 cash received from the sale of the land will appear in the cash flows from investing activities section of the statement of cash flows. In addition, the $28,000 gain from the sale will be deducted from net income as one of the adjustments made to determine the net cash flow from operating activities.

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Q4-11 Net income Add (deduct) items to convert net income to cash basis Depreciation Accounts receivable decrease Inventory increase Accounts payable decrease Income tax payable increase Net cash provided by operating activities

$ 88,000 6,000 13,000 (9,000) (3,500) 1,500 $ 96,000

Q4-12 The separate disclosures required for a company using the indirect method in the statement of cash flows are (1) cash paid during the year for interest (net of amount capitalized) and for income taxes, (2) all noncash investing and financing transactions, and (3) the policy for determining which highly liquid, short-term investments are treated as cash equivalents. Q4-13 The statement of cash flows will show a positive net cash flow from operating activities if operating cash receipts exceed operating cash payments. This could happen, for example, if noncash expenses (such as depreciation and amortization) exceed the net loss. It would also happen if operating cash receipts exceed sales by more than the loss or if operating cash payments are less than accrual expenses by more than the loss (or some combination of these events). Q4-14 Sales + Accounts receivable decrease = Cash received from customers Wages expense + Wages payable decrease = Cash paid to employees Advertising expense + Prepaid advertising increase = Cash paid for advertising $925,000 14,000 $939,000 $ 86,000 1,100 $ 87,100 $ 43,000 1,600 $ 44,600

Q4-15

Q4-16

Q4-17

Under the direct method, the $5,100 cash received from the sale of equipment will appear in the cash flows from investing activities section of the statement of cash flows. The separate disclosures required for a company using the direct method in the statement of cash flows are (1) a reconciliation of net income to net cash flow from operating activities, (2) all noncash investing and financing transactions, and (3) the policy for determining which highly liquid, short-term investments are treated as cash equivalents.

Q4-18

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Financial Accounting, 3rd Edition

Q4-19 The operating-cash-flow-to-current-liabilities ratio is calculated by dividing net cash flow from operating activities by average current liabilities. This ratio is a measure of a firm's ability to liquidate its current liabilities. Q4-20 The operating-cash-flow-to-capital-expenditures ratio is calculated by dividing a firm's cash flow from operating activities by its annual capital expenditures. A ratio below 1.00 means that the firm's current operating activities are not providing enough cash to cover the capital expenditures. A ratio above 1.0 is normally considered a sign of financial strength.

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MINI EXERCISES
M4-21 (5 minutes) a. b. c. d. e. __+__$823 increase in accounts payable __+__$319 increase in accrued liabilities __+__$853 decrease in inventory __+__$448 decrease in accounts receivable __+__$1,259 increase in depreciation and amortization

M4-22 (10 minutes) a. b. c. d. e. f. g. Cash flow from an operating activity. Cash flow from an investing activity. Cash flow from an investing activity. Cash flow from an operating activity. Cash flow from a financing activity. Cash flow from a financing activity. Cash flow from an investing activity.

M4-23 (15 minutes) Dole Food Company, Inc. Selected Items from the Cash Flow Statement Cash dividends paid Change in inventories Depreciation and amortization Long-term debt repayments Change in accounts payable and accrued liabilities Net income Proceeds from sales of assets Change in provision for deferred income taxes Change in prepaid expenses and other assets Short-term debt borrowings Capital additions

1 2 3 4 5 6 7 8 9 10 11

Financing Operating Operating Financing Operating Operating Investing Operating Operating Financing Investing

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Financial Accounting, 3rd Edition

M4-24 (10 minutes) a. b. c. d. e. f. Cash flow from a financing activity. Cash flow from an operating activity. Noncash investing and financing activity. Cash flow from an operating activity. Cash flow from an operating activity. None of the above (a change in the composition of cash and cash equivalents).

M4-25 (15 minutes) Pacific Sunwear of California, Inc. Selected Items from the Cash Flow Statement Depreciation and amortization Proceeds from sale of common stock and exercise of stock options Loss on disposal of equipment Change in accrued liabilities Repayments of long-term debt obligations Changes in income taxes payable and deferred income taxes Change in accounts receivable Purchases of property and equipment Repurchase and retirement of common stock Purchases of short-term investments

1 2 3 4 5 6 7 8 9 10

Operating Financing Operating Operating Financing Operating Operating Investing Financing Investing

M4-26 (15 minutes INDIRECT METHOD) Net income Add (deduct) items to convert net income to cash basis Depreciation Gain on sale of investments Accounts receivable increase Inventory increase Prepaid rent decrease Accounts payable increase Income tax payable decrease Net cash provided by operating activities $ 45,000 8,000 (9,000) (9,000) (6,000) 2,000 4,000 (2,000) $ 33,000

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M4-27 (20 minutes) A + indicates that the amount is added and a - indicates that it is subtracted when preparing the cash flow statement using the indirect method. Ethan Allen Interiors Inc. And Subsidiaries Consolidated Statements of Cash Flows Selected Items 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Purchases of short-term investments Payment of cash dividends Depreciation and amortization Increase in deferred income tax liability Decrease in customer deposits Capital expenditures Increase in income taxes and accounts payable Payments on long-term debt and capital leases Gain on disposal of property, plant and equipment Increase in prepaid and other current assets Net proceeds from issuance of common stock Proceeds from the disposal of property, plant and equipment Net income Decrease in inventories Borrowings on revolving credit facility Investing Financing Operating Operating Operating Investing Operating Financing Operating Operating Financing Investing Operating Operating Financing + + + + + + + +

M4-28 (15 minutesINDIRECT METHOD) Net loss Add (deduct) items to convert net loss to cash basis Depreciation Accounts receivable decrease Inventory decrease Prepaid expenses decrease Accounts payable increase Accrued liabilities decrease Net cash provided by operating activities Cairo Company's 2010 operating activities provided $4,000 cash. $(21,000) 8,600 9,000 3,000 3,000 4,000 (2,600) $ 4,000

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Financial Accounting, 3rd Edition

M4-29 (20 minutes) A + indicates that the amount is added and a - indicates that it is subtracted when preparing the cash flow statement using the indirect method. Nordstrom, Inc. Consolidated Statement of Cash Flows Selected Items Increase in accounts receivable Operating Capital expenditures Investing Purchases of short-term investments Investing Increase in deferred income tax liability Operating Principal payments on long-term debt Financing Increase in merchandise inventories Operating Decrease in income taxes payable Operating Proceeds from employee stock purchase plan Financing Increase in accounts payable Operating Net earnings Operating Repurchase of common stock Financing Increase in accrued salaries, wages and related benefits Operating Proceeds from sale of assets Investing Cash dividends paid Financing Depreciation and amortization of buildings and equipment Operating

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

+ + + + + + +

M4-30 (15 minutesDIRECT METHOD) a. Rent expense Prepaid rent decrease = Cash paid for rent Interest income Interest receivable increase = Cash received as interest Cost of goods sold + Inventory increase + Accounts payable decrease = Cash paid for merchandise purchased $ 60,000 (2,000) $ 58,000 $ 16,000 (700) $ 15,300 $ 98,000 3,000 4,000 $105,000

b.

c.

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M 4-31 (15 minutesDIRECT METHOD) Sales

Accounts receivable increase = Cash received from customers Cost of goods sold + Inventory increase + Accounts payable decrease = Cash paid for merchandise purchased

$825,000 (11,000) $814,000 $550,000 13,000 6,000 $569,000

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Financial Accounting, 3rd Edition

EXERCISES
E4-32 (20 minutes) a. Merck: $3,364/$5,618 = 0.60 Pfizer: $18,238/$24,422 = 0.75 Abbot Labs: $6,995/$10,347 = 0.68 b. Merck: $3,364 ($747 $44) = $2,661 Pfizer: $18,238 ($1,701 $0) = $16,537 Abbott Labs: $6,995 ($1,288 $0) = $5,707 c. None of the firms has sufficient cash flow to cover their current liabilities although none of the ratios is of major concern. Pfizer is the largest of these three companies and has relatively more cash left over after capital expenditures to consider using on other activities that could strengthen the firms operating or financial position. Given that these firms are of different sizes and have different research program success, it is difficult to generalize further. E4-33 (20 minutes) a. Wal-Mart: $23,147/$56,934 = 0.41 General Electric: $48,601/$246,925 = 0.20 Exxon: $59,725/$53,706 = 1.11 b. Wal-Mart: $23,147 ($11,499 $714) = $12,362 General Electric: $48,601 ($16,010 $10,975) = $43,566 Exxon: $59,725 ($19,318 $5,985) = $46,392 c. General Electric reports substantial current liabilities and its operating cash flow produces only 20% of what is needed to cover its obligations. Exxon appears to be in the best position, with a substantial amount of its operational cash flows available for dividends, expansion, and other business pursuits. The situation has improved as Exxons profits have increased substantially with higher oil prices. Extra cash does not earn any return, which provides Exxon a problem or, better, an opportunity. Because the firm is so large, it is unlikely that an acquirer may look with interest at the large cash position of the company.

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E4-34 (30 minutes) (a) Items from the table have been grouped into operating, investing, and financing categories in (b) the cash flow statement below. (c) The cash balance at the end of the period is $864 million. Target Corporation Consolidated Statement Of Cash Flows ($ millions) Net earnings . Loss on disposal of property and equipment . Depreciation and amortization Deferred income taxes .. Stock based compensation . Decrease in accounts receivable, net ... Decrease in inventory Decrease in accounts payable Decrease in accrued liabilities Other operating cash flow adjustments Total cash flow from operating activities . Expenditures for property and equipment .. Other investments .. Proceeds from disposals of property and equipment .. Cash flow used for investing activities . Additions to long-term debt . Reductions of long-term debt . Reduction of short-term debt . Stock issued and other . Repurchase of common stock Dividends paid . Cash flow used for financing activities . Net change in cash .. Cash balance, beginning of the period .. Cash balance, end of the period .. $2,214 33 1,826 91 72 793 77 (389) (230) (57) 4,430 (3,547) (865) 39 (4,373) 3,557 (1,455) (500) 35 (2,815) (465) (1,643) (1,586) 2,450 $ 864

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Financial Accounting, 3rd Edition

E 4-35 (15 minutesINDIRECT METHOD) a. Net income Add (deduct) items to convert net income to cash basis Accounts receivable increase Inventory decrease Prepaid insurance increase Accounts payable increase Wages payable decrease Net cash provided by operating activities b. $115,000/[($31,000 + $29,000)/2] =3.83 E4-36 (30 minutes) (a) (c) Items from the table have been grouped into operating, investing, and financing categories in (b) the cash flow statement below. The cash balance at the end of the period is $31,313,000. $113,000 (5,000) 6,000 (1,000) 4,000 (2,000) $115,000

(d) It is not unusual for companies like Oakley to borrow money from banks for short periods of time. For example, these borrowings may be needed to finance seasonal fluctuations in working capital. In many cases, cash might be borrowed and then repaid before the end of the accounting period, and consequently, never be reported on the year-end balance sheet. By presenting the amount borrowed and the amount repaid in the cash flow statement (rather than merely the net increase or decrease), the financial statements provide investors and creditors with potentially useful information about Oakleys short-term financing needs. The net change in bank borrowings is an increase of $22,538,000 ($254,211,000 - $231,673,000).

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E4-36continued. Oakley, Inc. And Subsidiaries Consolidated Statements Of Cash Flows ($ thousands) Net income Depreciation and amortization Loss on sale of equipment .. Loss on investment Noncash compensation Deferred income taxes .. Increase in accounts receivable . Increase in inventories . Increase in prepaid expenses and other current assets . Increase in accounts payable . Increase in accrued expenses and other current liabilities........ Increase in accrued income taxes Cash flow from operating activities .. Purchases of property and equipment . Proceeds from sale of property and equipment . Acquisitions of other businesses .. Purchase of investments .. Cash used for investing activities .. Proceeds from bank borrowings . Repayments of bank borrowings Stock issued and other . Repurchase of common stock Payment of cash dividends . Cash provided by financing activities ... Net increase in cash Cash and cash equivalents, beginning . Cash and cash equivalents, end .. $44,788 37,571 460 4,329 3,081 (11,222) (1,611) (23,177) (2,268) 10,135 14,886 4,937 81,909 (52,527) 221 (86,751) (705) (139,762) 254,211 (231,673) 5,774 (10,351) (10,952) 7,009 (50,844) 82,157 $31,313

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Financial Accounting, 3rd Edition

E4-37 (30 minutesINDIRECT METHOD) LUND CORPORATION STATEMENT OF CASH FLOWS FOR YEAR ENDED DECEMBER 31, 2010 Net Cash Flow from Operating Activities Net Income Add (Deduct) Items to Convert Net Income to Cash Basis Depreciation Amortization Gain on Sale of Equipment Accounts Receivable Increase Inventory Decrease Prepaid Expenses Increase Accounts Payable Increase Accrued Liabilities Decrease Net Cash Provided by Operating Activities .. Cash Flows from Investing Activities Sale of Equipment Purchase of Land Net Cash Used by Investing Activities ... Cash Flows from Financing Activities Issuance of Common Stock Retirement of Bonds Payable Payment of Dividends Net Cash Used by Financing Activities Net Decrease in Cash Cash at Beginning of Year Cash at End of Year $76,000 29,000 6,000 (4,000) (4,000) 13,000 (2,000) 9,000 (3,000) $120,000 17,000 (90,000) (73,000) 35,000 (60,000) (29,000) (54,000) (7,000) 22,000 $ 15,000

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E4-38 (30 minutes) a. Merchandise inventories, 2008 less Merchandise inventories, 2007 .. Increase in merchandise inventories . Cost of merchandise sold . Inventory purchases ... Accounts payable, 2007 . less Accounts payable, 2008 Cash paid for inventory . b. Property, net of depreciation, 2008 . Less, Property, net of depreciation, 2007 . Net increase in property Depreciation expense . Net property acquired c. Retained earnings, 2007 Net income Less Retained earnings, 2008 . Dividends paid .

$ 8,209 (7,611) 598 31,729 32,327 3,713 (4,109) $31,931 $22,722 (21,361) 1,361 1,539 $ 2,900 $ 15,345 2,195 (17,049) $ 491

E4-39 (15 minutes) a. Cash flows from investing activities will show: Purchase of stock investments Sale of stock investments b. Cash flows from financing activities will show: Issuance of bonds Retirement of bonds $130,000 (131,000) $ (80,000) 59,000

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Financial Accounting, 3rd Edition

E4-40 (30 minutes) a. Merchandise inventories, 2008 Less merchandise inventories, 2007 Decrease in merchandise inventories Cost of merchandise sold Inventory purchases Trade accounts payable, 2007 Less trade accounts payable, 2008 Cash paid for merchandise inventory b. Property and equipment, 2007 Expenditures for property and equipment Less depreciation expense Less property and equipment, 2008 Book value of property and equipment sold in 2008 Loss on sale of property and equipment Cash proceeds from the sale of property and equipment . c. Retained earnings, 2007 Less net loss Less retained earnings, 2008 Dividends paid d. Merchandise inventory (+A) .... Trade accounts payable )+L) Trade accounts payable (-L) Cash (-A) Cash (-A) ... Loss on sale of property and equipment (+E, -SE) Property and equipment, net (-A) .. 2,158.0 2,158.0 2,319.9 2,319.9 14.3 57.1 71.4

915.2 (1,242.0) (326.8) 2,484.8 2,158.0 511.9 (350.0) $ 2,319.9 $ 592.8 79.9 (107.1) (494.2) 71.4 (57.1) $ 14.3 $ 250.5 (186.7) (63.8) 0

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E4-41 (20 minutesDIRECT METHOD) a. Advertising expense + Prepaid advertising increase = Cash paid for advertising Income tax expense + Income tax payable decrease = Cash paid for income taxes Cost of goods sold Inventory decrease Accounts payable increase = Cash paid for merchandise purchased $ 62,000 4,000 $ 66,000 $ 29,000 2,200 $ 31,200 $180,000 (5,000) (2,000) $173,000

b.

c.

E4-42 (30 minutesDIRECT METHOD) MASON CORPORATION STATEMENT OF CASH FLOWS FOR YEAR ENDED DECEMBER 31, 2010 Cash flows from operating activities Cash received from customers Cash received as interest Cash paid to employees and suppliers Cash paid as income taxes Net cash provided by operating activities Cash flows from investing activities Sale of land Purchase of equipment Net cash used by investing activities Cash flows from financing activities Issuance of bonds payable Acquisition of treasury stock Payment of dividends Net cash provided by financing activities Net decrease in cash Cash at beginning of year Cash at end of year $194,000 6,000 148,000 11,000 40,000 (89,000) (49,000) 30,000 (10,000) (16,000) 4,000 (4,000) 16,000 $ 12,000

$200,000 (159,000) 41,000

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Financial Accounting, 3rd Edition

E4-43 (30 minutesDIRECT METHOD) a. Sales Accounts Receivable Increase = Cash Received from Customers Cost of Goods Sold Inventory Decrease Accounts Payable Increase = Cash Paid for Merchandise Purchased Wages Expense + Wages Payable Decrease = Cash Paid to Employees Insurance Expense + Prepaid Insurance Increase = Cash Paid for Insurance Cash Flows from Operating Activities Cash Received from Customers Cash Paid for Merchandise Purchased Cash Paid to Employees Cash Paid for Rent Cash Paid for Insurance Net Cash Provided by Operating Activities b. $115,000/[($31,000 + $29,000)/2] =3.83 E4-44 (15 minutes) 1. 2. 3. 4. True False False False --$25 $10 $0 $750,000 (5,000) $745,000 $470,000 (6,000) (4,000) $460,000 $110,000 2,000 $112,000 $ 15,000 1,000 $ 16,000 $745,000 $460,000 112,000 42,000 16,000

630,000 $115,000

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PROBLEMS
P4-45 (20 minutes)

Cash flows from operating activities Net income....................................................................................... Adjustments to reconcile net income to operating cash flows Depreciation............................................................................... Accounts receivable increase.................................................. Prepaid expenses decrease...................................................... Accounts payable increase...................................................... Wages payable decrease.......................................................... Gain on sale of assets............................................................... Net cash provided from operating activities................................ $25,000 (10,000) 3,000 6,000 (4,000) (5,000) 15,000 $150,000 $135,000

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Financial Accounting, 3rd Edition

P4-46 (45 minutesINDIRECT METHOD) a. Cash, December 31, 2010...................................................... $11,000 Cash, December 31, 2009...................................................... 5,000 Cash increase during 2010................................................... $ 6,000 b. STATEMENT OF CASH FLOWS (INDIRECT METHOD) WOLFF COMPANY STATEMENT OF CASH FLOWS FOR YEAR ENDED DECEMBER 31, 2010 Net Cash Flow from Operating Activities Net Income $56,000 Add (Deduct) Items to Convert Net Income to Cash Basis Depreciation 17,000 Accounts Receivable Increase (9,000) Inventory Increase (30,000) Prepaid Insurance Decrease 2,000 Accounts Payable Decrease (3,000) Wages Payable Increase 3,000 Income Tax Payable Decrease (1,000) Net Cash Provided by Operating Activities Cash Flows from Investing Activities Purchase of Plant Assets Cash Flows from Financing Activities Issuance of Bonds Payable 55,000 Payment of Dividends (29,000) Net Cash Provided by Financing Activities Net Increase in Cash Cash at Beginning of Year Cash at End of Year c. (1) $35,000/(($23,000 + $24,000)/2) = 1.49 (2) $35,000/$55,000 = 0.64 Wolffs cash flow ratios indicate that, while the company has sufficient cash flow to cover its current obligations, it must rely on external financing to pay for capital expenditures.

$35,000 (55,000)

26,000 6,000 5,000 $11,000

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P4-47 (30 minutes) a. Wolff Company Cash Flow from Operations Direct Method
Revenue or Expense Revenues/Cash Receipts: Sales revenue - Increase in accounts receivable Cash received from customers Less Expenses/Cash Payments: Cost of goods sold .. + Increase in inventory + Decrease in accounts payable Cash paid for merchandise Wages expense - Increase in wages payable Cash paid for wages Insurance expense - Decrease in prepaid insurance Cash paid for insurance Interest expense Cash paid for interest Depreciation expense - Depreciation expense Cash paid for deprecation Income tax expense + Decrease in income tax payable Cash paid for income taxes Net income Total adjustments Cash flow from operating activities $635,000 ($9,000) $626,000 430,000 30,000 3,000 463,000 86,000 (3,000) 83,000 8,000 (2,000) 6,000 9,000 9,000 17,000 (17,000) 0 29,000 1,000 30,000 $56,000 ($ 21,000) $35,000 Adjustments Operating Cash Flow

b. Computing cash flows from operating activities using the direct method provides additional detail about the specific cash flows that occurred during the period. For example, the indirect method does not reveal that Wolff paid $463,000 for merchandise during 2010, or $83,000 for wages. Because this detail is missing, the FASB requires supplemental disclosure of two specific (and important) cash payments interest and taxes if the indirect method is used.

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Financial Accounting, 3rd Edition

P4-48 (45 minutesINDIRECT METHOD) a. Cash, December 31, 2010 Cash, December 31, 2009 Cash increase during 2010 b. STATEMENT OF CASH FLOWS (INDIRECT METHOD) ARCTIC COMPANY STATEMENT OF CASH FLOWS FOR YEAR ENDED DECEMBER 31, 2010 Net Cash Flow from Operating Activities Net Loss Add (Deduct) Items to Convert Net Loss to Cash Basis Depreciation Gain on Sale of Land Accounts Receivable Decrease Inventory Decrease Prepaid Advertising Decrease Accounts Payable Decrease Interest Payable Increase Net Cash Used by Operating Activities Cash Flows from Investing Activities Sale of Land Purchase of Equipment Net Cash Used by Investing Activities Cash Flows from Financing Activities Issuance of Bonds Payable Purchase of Treasury Stock Net Cash Provided by Financing Activities Net Increase in Cash Cash at Beginning of Year Cash at End of Year $ (42,000) 22,000 (25,000) 8,000 6,000 3,000 (14,000) 6,000 $ (36,000) 70,000 (183,000)* (113,000) 200,000 (30,000) 170,000 21,000 28,000 $ 49,000 $49,000 28,000 $21,000

* The sum of the increase in PPE assets account ($138,000) and the book value of the land sold ($45,000).

c. -$36,000/(($23,000 + $31,000)/2) = -1.33 -$36,000/$183,000 = -0.20 Arctics operating cash flows are negative, primarily because the firm reported a net loss for the year. As a consequence, its cash flow ratios indicate insufficient cash flows to fund operations and capital expenditures.

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P4-49 (30 minutes) a. Arctic Company Cash Flow from Operations Direct Method
Revenue or Expense Revenues/Cash Receipts: Sales revenue .. + Decrease in accounts receivable . Cash received from customers Gain on sale of land - Gain on sale of land . Cash flow from gain Less Expenses/Cash Payments: Cost of goods sold . - Decrease in inventory + Decrease in accounts payable . Cash paid for merchandise .. Wages expense Cash paid for wages Advertising expense .. - Decrease in prepaid insurance . Cash paid for advertising . Interest expense . - Increase in interest payable .................... Cash paid for interest Depreciation expense - Depreciation expense . Cash paid for deprecation .. Net loss . Total adjustments .. Cash flow from operating activities .. $728,000 8,000 $736,000 25,000 (25,000) 753,000 534,000 (6,000) 14,000 542,000 190,000 190,000 31,000 (3,000) 28,000 18,000 (6,000) 12,000 22,000 (22,000) 795,000 ($42,000) $ 6,000 ($36,000) (23,000) 0 772,000 (17,000) 0 736,000 Adjustments Operating Cash Flow

b.

Computing cash flows from operating activities using the direct method provides additional detail about the specific cash flows that occurred during the period. For example, the indirect method does not reveal that Arctic paid $542,000 for merchandise during 2010, or $28,000 for advertising. Because this detail is missing, the FASB requires supplemental disclosure of two specific (and important) cash payments interest and taxes if the indirect method is used.

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Financial Accounting, 3rd Edition

P4-50 (50 minutesINDIRECT METHOD) a. Cash, December 31, 2010............................................. Cash, December 31, 2009............................................. Cash increase during 2010........................................... b. STATEMENT OF CASH FLOWS (INDIRECT METHOD) DAIR COMPANY STATEMENT OF CASH FLOWS FOR YEAR ENDED DECEMBER 31, 2010 Net Cash Flow from Operating Activities Net Income Add (deduct) items to convert net income to cash basis Depreciation Amortization of intangible assets Loss on bond retirement Accounts receivable increase Inventory decrease Prepaid expenses increase Accounts payable increase Interest payable decrease Income tax payable decrease Net cash provided by operating activities Cash flows from investing activities Sale of equipment Cash flows from financing activities Retirement of bonds payable Issuance of common stock Payment of dividends Net cash used by financing activities Net increase in cash Cash at beginning of year Cash at end of year $ 85,000 22,000 7,000 5,000 (5,000) 6,000 (2,000) 6,000 (3,000) (2,000) $119,000 17,000 (125,000) 24,000 (26,000) (127,000) 9,000 18,000 $ 27,000 $27,000 18,000 $ 9,000

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P4-50continued c. (1) Supplemental cash flow disclosures Cash paid for interest........................................................................ Cash paid for income taxes.............................................................. * Interest expense + Interest payable decrease Cash paid for interest Income tax expense + Income tax payable decrease Cash paid for income taxes $10,000 3,000 $13,000 $36,000 2,000 $38,000 $ 13,000* $ 38,000

(2) Schedule of noncash investing and financing activities Issuance of bonds payable to acquire equipment.......................... d. (1) (2) (3)

$ 60,000

$119,000/[($42,000 + $41,000)/2] = 2.87. The firm did not spend any cash on capital investments. The firm did issue debt for equipment, but this is not a capital expenditure. $119,000 + $17,000 = $136,000

Cambridge Business Publishers, 2011 4-26

Financial Accounting, 3rd Edition

P4-51 (45 minutes) a. Depreciation is a noncash expense that is deducted in the computation of net income. The depreciation add-back zeros this expense out of the income statement to focus on cash profitability. The positive amount for depreciation does not mean that the company is generating cash from depreciation, a common misconception. It is merely an adjustment to remove that expense from the computation of profit. b. The positive amount relating to merchandise inventories indicates that the dollar amount of inventories on hand has declined during the period. This is positive if decline is the result of the elimination of excess inventories, but is worrisome if the company is reducing inventories below the level necessary to maintain its competitive position in an effort to temporarily boost its operating cash flow. c. The $4.7 billion outflow for investing activities relates to the purchase of property, plant and equipment (PPE) and short-term investments. The company is growing its infrastructure and building liquidity, both of which are positive (provided that its PPE purchases are for new stores in good locations). d. Staples operates businesses in 26 countries outside of the U.S. including businesses in Europe, Asia, South America, Australia, and Canada. This means that some of its cash transactions occur in currencies other than the U.S. dollar. This fact requires the company to hold cash in other currencies that may be revalued relative to the dollar from one period to the next. When foreign cash balances are revalued in foreign exchange markets relative to the U.S. dollar, the dollar value of the companys cash balance changes even though there was no actual cash flow. Hence, this exchange rate effect is listed in the cash flow statement to explain the change in the cash balance. e. Although net cash decreased during the period, Staples presents a healthy cash flow picture for the year. It generated almost $1.7 billion of operating cash flow and raised $2.5 billion through financing transactions but spent $4.7 billion to grow its infrastructure.

Solutions Manual, Chapter 4

Cambridge Business Publishers, 2011 4-27

P4-52 (50 minutesINDIRECT METHOD) a. Cash and cash equivalents, December 31, 2010........................ Cash and cash equivalents, December 31, 2009........................ Cash and cash equivalents decrease during 2010.................... b. See the cash flow statement provided on the following page. c. (1) Supplemental Cash Flow Disclosures Cash paid for interest Cash paid for income taxes * Interest expense - Interest payable increase Cash paid for interest Income tax expense + Income tax payable decrease Cash paid for income taxes (2) d. (1) (2) $13,000 (1,000) $12,000 $44,000 2,000 $46,000 $ 25,000 $19,000 25,000 $ 6,000

$ 12,000* $ 46,000

Schedule of noncash investing and financing activities Issuance of preferred stock to acquire patent $101,000/[($34,000 + $31,000)/2] = 3.11. $101,000/($185,000) = 0.55.

(3): $101,000 ($90,000 + $95,000 - $14,000) = -$70,000

Cambridge Business Publishers, 2011 4-28

Financial Accounting, 3rd Edition

P4-52continued b. RAINBOW COMPANY STATEMENT OF CASH FLOWS FOR YEAR ENDED DECEMBER 31, 2010 Net cash flow from operating activities Net income Add (deduct) items to convert net income to cash basis Depreciation Patent amortization Loss on sale of equipment Gain on sale of investments Accounts receivable increase Inventory increase Prepaid expenses increase Accounts payable increase Interest payable increase Income tax payable decrease Net cash provided by operating activities Cash flows from investing activities Sale of investments Purchase of land Improvements to building Sale of equipment Net cash used by investing activities Cash flows from financing activities Issuance of bonds payable Issuance of common stock Payment of dividends Net cash provided by financing activities Net decrease in cash and cash equivalents Cash and cash equivalents at beginning of year . Cash and cash equivalents at end of year $ 90,000 39,000 7,000 5,000 (3,000) (10,000) (26,000) (4,000) 4,000 1,000 (2,000) $101,000 60,000 (90,000) (95,000) 14,000 (111,000) 30,000 24,000 (50,000) 4,000 (6,000) 25,000 $ 19,000

Solutions Manual, Chapter 4

Cambridge Business Publishers, 2011 4-29

P4-53 (35 minutes) a. Cash and cash equivalents, December 31, 2010 .. Cash and cash equivalents, December 31, 2009 .. Cash and cash equivalents decrease during 2010 .. b. RAINBOW COMPANY STATEMENT OF CASH FLOWS (DIRECT METHOD) FOR YEAR ENDED DECEMBER 31, 2010 Cash flows from operating activities Cash received from customers $740,000 Cash received as dividends .. 15,000 Cash paid for merchandise purchased .. 462,000 Cash paid for wages and other operating expenses 134,000 Cash paid for interest .. 12,000 Cash paid for income taxes 46,000 Net cash provided by operating activities .. Cash flows from investing activities Sale of investments .. Purchase of land Improvements to building Sale of equipment .. Net cash used by investing activities ... Cash flows from financing activities Issuance of bonds payable . Issuance of common stock . Payment of dividends Net cash provided by financing activities Net decrease in cash and cash equivalents .. Cash and cash equivalents at beginning of year . Cash and cash equivalents at end of year . 60,000 (90,000) (95,000) 14,000 (111,000) 30,000 24,000 (50,000) 4,000 (6,000) 25,000 $ 19,000 $19,000 25,000 $ 6,000

$755,000

(654,000) 101,000

Cambridge Business Publishers, 2011 4-30

Financial Accounting, 3rd Edition

P4-53continued. c. (1) Reconciliation of net income to net cash flow from operating activities Net income Add (deduct) items to convert net income to cash basis Depreciation Patent amortization Loss on sale of equipment Gain on sale of investments Accounts receivable increase Inventory increase Prepaid expenses increase Accounts payable increase Interest payable increase Income tax payable decrease Net cash provided by operating activities (2) Schedule of noncash investing and financing activities Issuance of preferred stock to acquire patent $ 90,000 39,000 7,000 5,000 (3,000) (10,000) (26,000) (4,000) 4,000 1,000 (2,000) $101,000 $ 25,000

Solutions Manual, Chapter 4

Cambridge Business Publishers, 2011 4-31

P4-54 (30 minutes) ($ millions) a. Net sales - Increase in accounts receivable Cash collected from customers .. b. Cost of goods sold . - Decrease in inventories .. Purchases . - Increase in accounts payable Cash paid for purchases of inventories c. Property, plant and equipment, ending balance . - Purchases of property, plant and equipment + Book value of PPE assets sold ($42 + 26) . + Depreciation of property, plant and equipment Property, plant and equipment, beginning balance

$36,537 (939) $35,598

$23,397 (54) 23,343 (92) $23,251

$2,954 (1,144) 68 577 $2,455

d. Stock-based compensation expense is deducted when calculating net income similar to cash compensation. The only difference is that the compensation is paid in shares of stock (or stock options) instead of cash. Because stock-based compensation does not require the payment of cash, it is treated as a noncash expense, much like depreciation, and added back to net income when the indirect method is used in the cash flow statement. Generally speaking, compensation cost is classified as part of operating activities whether or not the compensation is paid in cash.

Cambridge Business Publishers, 2011 4-32

Financial Accounting, 3rd Edition

P4-55 (60 minutes) ($ millions) a. Sales revenue + Decrease in accounts receivable .. - Decrease in deferred revenue . Cash collected from customers b. Cost of sales . - Decrease in merchandise inventories ($11,731-$10,673) ........ Purchases . + Decrease in accounts payable ($5,732-$4,822) ........ Cash paid for purchases of merchandise inventory c. Property and equipment, at cost, beginning balance . + Purchases of property and equipment - Property and equipment, at cost, ending balance . Original cost of property and equipment sold .. d. Property and equipment (+A) .. Long-term debt (+L) ..

$71,288 287 (309) $71,266

$47,298 (1,058) 46,240 910 $47,150

$36,412 1,884 (36,477) $ 1,819

37 37

e. Long-term debt, including current maturities, beginning balance ($11,383+$300) . + Increase from purchase of property and equipment .. - Long-term debt, including current maturities, ending balance ($9,667+$1,767) ....... Long-term debt repaid ..

$11,683 37 (11,434) $ 286

Solutions Manual, Chapter 4

Cambridge Business Publishers, 2011 4-33

P4-55 (continued) f. Provision for income taxes (income tax expense) .. - Increase in income taxes payable ($289-$60) + Decrease in deferred income taxes ($688-$369) .. Income taxes paid .. g. Retained earnings, beginning balance + Net income .. - Retained earnings, ending balance Dividends declared and paid .

$ 1,278 (229) 319 $ 1,368

$11,388 2,260 (12,093) $ 1,555

Cambridge Business Publishers, 2011 4-34

Financial Accounting, 3rd Edition

P4-56 (60 minutes) a. Home Depot cash flow spreadsheet:


A Assets: Cash & equivalents S.T. investments S.T. invest. sold Accounts receivable Merchandise inventory Other current assets Property & equipment, net Depreciation Prop. & equip. purchased Prop. & equip. sold: Goodwill and other Liabilities: Current installments of L.T. debt S.T. debt Accounts payable Accrued salaries and related expenses Deferred revenue Sales taxes payable Income tax payable Other accrued expenses L.T. debt Other L.T liabilities Deferred income taxes Equity: Common stock Treasury stock Retained earnings Net income Dividends Accumulated other comprehensive inc. Totals B 2010 519 6 972 10,673 1,192 26,234 C 2009 445 12 1,259 11,731 1,227 27,476 D Change 74 (6) (287) (1,058) (35) (1,242) 1,785 (1,847) 1,568 1,767 0 4,822 1,129 1,165 337 289 1,644 9,667 2,198 369 6,133 (372) 12,093 2,174 300 1,747 5,732 1,094 1,474 445 60 1,854 11,383 1,833 688 5,885 (314) 11,388 (606) 1,467 (1,747) (910) 35 (309) (108) 229 (210) (1,716) 365 (319) 248 (58) 705 (910) 35 (309) (108) 229 (210) (1,753) 365 (319) 176 72 (58) 37 580 606 761 (37) 287 1,058 35 E F G Effect of change on cash flow Operating Investing Financing (168) 174 H No effect on cash

1,467 (1,747)

2,260 (1,555) (77) 755 (832) (832) 4,728 (1,080) (3,574) 0

P4-56 (continued)
Solutions Manual, Chapter 4 Cambridge Business Publishers, 2011 4-35

b. The Home Depot, Inc. and Subsidiaries Consolidated Statement of Cash Flows Year ended February 1, 2009 ($ millions) Operating activities: Net income Depreciation . Loss on property and equipment Deferred income taxes .. Stock-based compensation . Changes in assets and liabilities affecting operations: Accounts receivable .. Merchandise inventory . Other current assets . Goodwill and other assets Accounts payable Accrued salaries and related expenses Deferred revenue Sales taxes payable Income tax payable . Other accrued expenses .. Other long-term liabilities . Accumulated other comprehensive income Cash flow from operating activities Investing activities: Purchase of short-term investments . Proceeds from the sale of short-term investments Purchases of property and equipment .. Proceeds from the sale of property and equipment Cash flow used for investing activities .. Financing activities: Short-term debt repaid .. Long-term debt repaid (includes current installments) . Issuance of common stock .. Purchases of treasury stock Dividends paid . Cash used for financing activities Net increase in cash Cash balance, beginning of period .. Cash balance, end of period .
Cambridge Business Publishers, 2011 4-36

$ 2,260 1,785 580 (319) 176 287 1,058 35 606 (910) 35 (309) (108) 229 (210) 365 (832) 4,728 (168) 174 (1,847) 761 (1,080) (1,747) (286) 72 (58) (1,555) (3,574) 74 $ 445 519

Financial Accounting, 3rd Edition

P4-56 (continued) c. Operating cash flow to current liabilities ($ millions): $4,728 / [($11,153 + $12,706) / 2] = 0.396 Operating cash flow to capital expenditures ($ millions): $4,728 / $1,847 = 2.56

Solutions Manual, Chapter 4

Cambridge Business Publishers, 2011 4-37

CASES AND PROJECTS


C4-57 (30 minutes) The required debt to equity ratio allows for total liabilities to be up to $477 million. That is $477 / ($125+$148) =1.747 < 1.75. This implies total short-term borrowing of $107 million and an ending cash balance of $70 million. Lambert Co. Statement of Cash Flows (projected) Cash from operations Net income Depreciation expense Increase in accounts receivable . Decrease in inventory Increase accounts payable .. Decrease in income taxes payable . Cash provided by (used in) operations .. Cash from investing Acquisitions of property, plant and equipment Disposal proceeds .. Cash provided by (used in) investing . Cash from financing Issue long-term debt .. Repay long-term debt .. Common stock issue .. Shareholder dividends Increase (decrease) in short-term borrowing Cash provided by (used in) financing .. Net change in cash .. Beginning cash balance . Ending cash balance ..
Cambridge Business Publishers, 2011 4-38

18 120 (40) 20 30 (10) $ 138

(225) 75 (150)

80 (100) 25 (30) 57 32 20 50 $ 70

Financial Accounting, 3rd Edition

C4-58 (45 minutes) a. 1 2 3 4 5 6 7 8 9 10 11 Accounts receivable (+A) Sales revenue (+R,+SE) Cash (+A) Accounts receivable (-A) Cost of goods sold (+E,-SE) Inventory (-A) . Inventory (+A) Accounts payable (+L) .... Accounts payable (-L) .. Cash (-A) ... Salaries and wages expense (+E,-SE) . Salaries and wages payable (+L) . Salaries and wages payable (-L) Cash (-A) .... Rent expense (+E,-SE). Prepaid rent (-A) .. Prepaid rent (+A) .. Cash (-A) ... Depreciation expense (+E,-SE) . Accumulated depreciation (+XA,-A) . Cash (+A) . Accumulated depreciation (-XA,+A) Fixtures and equipment (-A) Fixtures and equipment (+A) .. Cash (-A) .. Interest expense (+E,-SE) .... Cash (-A) .. Bank loan payable (-L) ... Cash (-A) .. Cash (+A) .. Long-term loan payable (+L) 3,800 3,800 3,500 3,500 1,800 1,800 1,200 1,200 1,100 1,100 700 700 730 730 200 200 600 600 150 150 10 70 80 800 800 16 16 1,600 1,600 2,000 2,000

12 13 14 15

Solutions Manual, Chapter 4

Cambridge Business Publishers, 2011 4-39

C4-58 (continued) 16 17 18 Income tax expense (+E,-SE) . Taxes payable (+L) .. Retained earnings (-SE) . Cash (-A) Revenue (-R) . Cost of goods sold (-E) . Salaries and wages expense (-E) Rent expense (-E) Depreciation expense (-E) Interest expense (-E) .. Income tax expense (-E) Retained earnings (+SE) 374 374 80 80 3,800 1,800 700 200 150 16 374 560

Entry 18 closes revenue and expense accounts to retained earnings.

Cambridge Business Publishers, 2011 4-40

Financial Accounting, 3rd Edition

b.
+ 2 Cash (A) 600 3,500 1,100 730 600 10 800 16 1,600 2,000 80 1,184 5 7 9 12 13 14 17 + Accounts Rec. (A) 6,500 1 3,800 3,500 2 Bal 6,800 + 4
Bal

- Accounts Payable (L) + 3,000 5 1,100 1,200 4 Bal 3,100 - Salaries and Wages + Payable (L) 100 7 730 700 6 70 Bal Taxes Payable (L) + 0 374 16 374 Bal

- Common Stock (SE) + 4,600 4,600 Bal - Retained Earnings (SE)+ 1,300 17 80 560 18 1,780 Bal 18 Revenue (R) + 3,800 1 3,800 0 Bal

11

15
Bal

- Bank Loan Payable (L) + 1,600 14 1,600 0 Bal - Long-term Loan (L) + 0 2,000 15 2,000 Bal

+ Cost of Goods Sold (E) 3 1,800 1,800 18 Bal 0 + Salaries & Wages (E) 6 700 700 18 Bal 0 + Rent Expense (E) 8 200 200 18 Bal 0 + Depreciation Exp. (E) 10 150 150 18 Bal 0 + Interest Expense (E) 13 16 16 18 Bal 0 + Income Tax Exp (E) 16 374 374 18 Bal 0

Inventory (A) 2,400 1,200 1,800 3 1,800

+ Prepaid Rent (A) 0 9 600 200 8 Bal 400 + 12


Bal

Fixtures and Equipment (A) 1,900 800 80 2,620

11

- Accum. Deprec. (XA) + 800 11 70 150 10 880 Bal

Solutions Manual, Chapter 4

Cambridge Business Publishers, 2011 4-41

C4-59 (30 minutes) a. Depreciation is a noncash expense that is deducted in the computation of net income. The depreciation add-back zeros this expense out of the income statement to focus on operating cash flow. The positive amount for depreciation does not mean that the company is generating cash from depreciation, a common misconception. It is merely an adjustment to remove that expense from net income to convert profit to cash flow. b. Share based compensation expense is deducted when calculating net income similar to cash compensation. The only difference is that the compensation is paid in shares of stock (or stock options) instead of cash. Because share based compensation does not require the payment of cash, it is treated as a noncash expense, much like depreciation, and added back to net income when the indirect method is used in the cash flow statement. Generally speaking, compensation cost is classified as part of operating activities whether or not the compensation is paid in cash. c. In a sale-leaseback transaction, a long-term asset is sold and then immediately leased (or rented) from the party it was sold to. The transaction is considered to be a financing transaction, so the proceeds from the sale are listed as financing cash flows. This is because there is no net change in assets (the original asset is replaced with a capital lease asset) but long-term liabilities (in the form of capital lease obligations) are increased. Any gain recognized in the income statement on a sale-leaseback transaction is noncash and nonoperating and must be deducted when calculating cash flow from operating activities. (Gains on the sale of the asset are normally deferred and amortized over the term of the lease.) d. Free cash flow ($ millions): $1,521 $923 = -$2,444. Southwests operating cash flow is negative, as is its free cash flow. e. Southwests cash flow from operating activities is negative, as is its cash flow from investing activities. It generated a positive cash flow of $1,654 million from financing activities. As a result, the net decrease in cash was $845 million. Southwest appears to be strong enough to withstand a reduction in cash of this magnitude, especially given that it has a record (in 2007 and 2006) of reporting positive cash flows from operations. To be thorough in analyzing Southwests liquidity and solvency, one would want to ask why operating cash flows were negative. The cash flow statement is useful here. The largest negative adjustment is for a decrease in accounts payable and accrued liabilities. This adjustment is considerably larger than others listed, and to better understand what it represents, one would need to search the notes to find an explanation. As it turns out, a substantial portion of this adjustment was to pay amounts owed to counterparties for fuel derivatives. Hence, we suspect that this is a nonrecurring cash outflow. In its 2009 cash flow statement (released after the text was completed), Southwest reported positive cash flow from operating activities of $985 million.
Cambridge Business Publishers, 2011 4-42 Financial Accounting, 3rd Edition

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