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Total assets $58,830 $67,646
(Continued)
F167
CHAPTER F4: Reporting Earnings and Financial Position
166 Reporting Earnings and Financial Position


June 30 2001 2002
Liabilities and stockholders™ equity
Current liabilities:
Accounts payable $ 1,188 $ 1,208
Accrued compensation 742 1,145
Income taxes 1,468 2,022
Short-term unearned revenue 4,395 5,920
Other 1,461 2,449
Total current liabilities 9,254 12,744
Long-term unearned revenue 1,219 1,823
Deferred income taxes 409 398
Other long-term liabilities 659 501
Commitments and contingencies
Stockholders™ equity:
Common stock and paid-in capital-shares
authorized 12,000; shares issued
and outstanding 5,383 and 5,359 28,390 31,647
Retained earnings, including accumulated other
comprehensive income of $587 and $583 18,899 20,533
Total stockholders' equity 47,289 52,180
Total liabilities and stockholders' equity $58,830 $67,646



Required
A. Microsoft reports property and equipment, net on the balance sheet. Calculate property
and equipment as a percentage of total assets for 2001 and 2002.
B. Microsoft reports cash and short-term investments as a current asset. Calculate cash
and short-term investments as a percentage of total assets.
C. Comment on your analysis from Requirements A and B.
D. Calculate the working capital ratio for 2001 and 2002. Discuss your results.

Preparing Financial Statements
P4-11
Objs. 2, 3 Argyle Company has the following account balances at December 31, 2004. During the year,
Argyle had 10,000 shares of stock outstanding.


Argyle Company
Account Balances
at December 31, 2004

Account Balance
Cash $ 4,650
Accounts receivable 16,350
Inventory 30,500
Supplies 7,700
Prepaid insurance 3,550
Equipment 42,500
Accumulated depreciation”equipment 17,500
Buildings 170,000
Accumulated depreciation”buildings 105,000
Land 10,000
Patents 3,000
Accounts payable 18,250
Wages payable 3,450
Interest payable 1,700
Income taxes payable 4,050
Notes payable, current portion 2,500
(Continued)
F168 SECTION F1: The Accounting Information System
167
Reporting Earnings and Financial Position


Account Balance
Notes payable, long-term 37,500
Owners' investment 25,000
Retained earnings, December 31, 2003 60,150
Dividends 15,000
Sales revenue 130,000
Cost of goods sold 62,500
Wages expense 16,000
Utilities expense 2,000
Depreciation expense 1,050
Insurance expense 1,500
Supplies expense 2,300
Interest expense 3,650
Advertising expense 1,450
Patent expense 400
Income tax expense 11,000



Required
A. Prepare an income statement in good form based on Argyle Company's account bal-
ances.
B. Prepare a classified balance sheet as of December 31, 2004. Include appropriate head-
ings and subheadings.

Preparing Financial Statements
P4-12
Objs. 2, 3 The following account balances are provided for Rustic Company at December 31, 2004. Rev-
enues and expense accounts cover the fiscal year ending on that date. All numbers are dollars
except shares outstanding.

Account Amount
Accounts payable $ 14,000
Accounts receivable 18,000
Accumulated depreciation 30,000
Cash 6,000
Common stock, par value 20,000
Cost of goods sold 35,000
Current portion of long-term debt 2,000
Income taxes 6,000
Interest expense 4,000
Interest payable 500
Inventory 34,000
Long-term debt 40,000
Net income 12,000
Paid-in capital in excess of par 30,000
Patents and trademarks 4,000
Prepaid insurance 2,500
Property, plant and equipment, cost 150,000
Retained earnings 78,000
Sales revenues 110,000
Selling, general, and administrative expenses 65,000
Service revenues 12,000
Supplies 3,000
Wages payable 3,000
Shares outstanding 20,000

Required
A. Prepare an income statement in good form for Rustic Company.
B. Prepare a classified balance sheet.
F169
CHAPTER F4: Reporting Earnings and Financial Position
168 Reporting Earnings and Financial Position

Information in the Statement of Stockholders' Equity
P4-13
Obj. 4 A recent annual report for Wal-Mart Stores, Inc. and its subsidiaries is provided below.

Required From the information provided, answer the following questions:
A. What is the total amount of contributed capital as of January 31, 1999?
B. Did total contributed capital increase or decrease between January 31, 1999 and Janu-
ary 31, 2001? By what amount?
C. How much profit has been distributed to owners in cash during the three years covered
by this statement?
D. Has stockholders' equity increased or decreased over the three years and what is the
main reason?
E. Compute the ratio of cash dividends to net income for each year. Did the portion of
profits paid out in dividends each year increase, decrease, or stay about the same?
F. Compute the percentage change in net income between 2000 and 2001, and between
2001 and 2002. (Hint: Divide the increase in net income from 2000 to 2001 by the net
income for 2000.) Do you believe this is an encouraging sign or a discouraging sign?
G. Compute the percentage change in dividends between 2000 and 2001, and between
2001 and 2002. Is the rate of dividend increase greater or smaller than the rate of profit
increase?



Wal-Mart Stores, Inc.
Consolidated Statements of Shareholders' Equity

Other
Capital in accumulated
Number Common excess of Retained comprehensive
(Amounts in millions) of shares stock par value earnings income Total
Balance January 31, 1999 4,448 $445 $ 435 $20,741 ($509) $21,112
Comprehensive Income
Net income 5,377 5,377
Other accumulated
comprehensive income 54 54
Total Comprehensive Income 5,431
Cash dividends ($.20 per share) (890) (890)
Purchase of Company stock (2) (2) (99) (101)
Stock options exercised and other 11 1 281 282
Balance January 31, 2000 4,457 446 714 25,129 (455) 25,834
Comprehensive Income
Net income 6,295 6,295
Other accumulated
comprehensive income (229) (229)
Total Comprehensive Income 6,066
Cash dividends ($.24 per share) (1,070) (1,070)
Purchase of Company stock (4) (8) (185) (193)
Issuance of Company stock 11 1 580 581
Stock options exercised and other 6 125 125
Balance January 31, 2001 4,470 447 1,411 30,169 (684) 31,343
Comprehensive Income
Net income 6,671 6,671
Other accumulated
comprehensive income (584) (584)
Total Comprehensive Income 6,087
Cash dividends ($.28 per share) (1,249) (1,249)
Purchase of Company stock (24) (2) (62) (1,150) (1,214)
Stock options exercised and other 7 135 135
Balance January 31, 2002 4,453 $445 $1,484 $34,441 ($1,268) $35,102
Note: Slight modifications have been made to the statement for purposes of simplifying the presentation.
F170 SECTION F1: The Accounting Information System
169
Reporting Earnings and Financial Position

Understanding Stockholders™ Equity
P4-14
Obj. 4 Recent stockholders' equity statements for Microsoft are presented below.

Required
A. What was the amount of common stock and paid-in capital at June 30, 2000, 2001, and
2002?
B. Does Microsoft pay dividends on common stock?
C. How can you explain the increase in Common stock and paid-in capital over the three-
year period?
D. Without consulting Microsoft's Statement of Income, can we determine net income re-
ported in 2000, 2001, and 2002? Why or why not?
E. Microsoft's Stockholders' Equity Statements report Common stock repurchased. Why
do you think a company would repurchase its own shares? If the shares are later reis-
sued at a higher price, do you think Microsoft should report a gain on shares reissued?


Microsoft Corporation
Stockholders' Equity Statements

(In millions)
Year Ended June 30 2000 2001 2002
Convertible preferred stock
Balance, beginning of year $ 980 $ 0 $ 0
Conversion of preferred to common stock (980)
Balance, end of year 0 0 0
Common stock and paid-in capital
Balance, beginning of year 13,844 23,195 28,390
Common stock issued 3,554 5,154 1,801
Common stock repurchased (210) (394) (676)
Other, net 6,007 435 2,132
Balance, end of year 23,195 28,390 31,647
Retained earnings
Balance, beginning of year 13,614 18,173 18,899
Net income 9,421 7,346 7,829
Other comprehensive income:
Cumulative effect of accounting change (75)
Other, net (283) (826) (86)
Translation adjustments and other 23 (39) 82
Comprehensive income 9,161 6,406 7,825
Preferred stock dividends (13)
Common stock repurchased (4,589) (5,680) (6,191)
Balance, end of year 18,173 18,899 20,533
Total stockholders' equity $41,368 $47,289 $52,180
Note: Slight modifications have been made to the statement to simplify the presentation.




Using Interrelationships among Financial Statements
P4-15
Objs. 2, 3, 4 Corey Issacson is an investor in Stone Cold Enterprises. Last week he received the company's
most recent financial statements but some of the numbers were smudged and unreadable.
Each of the unreadable numbers is represented with a letter on the following page.
F171
CHAPTER F4: Reporting Earnings and Financial Position
170 Reporting Earnings and Financial Position


Stone Cold Enterprises
Comparative Balance Sheet
December 31, 2004 and 2005

(In thousands)
December 31, 2005 December 31, 2004
Assets
Cash $ 2,940 $ 1,020
Accounts receivable 1,850 1,225
Merchandise 2,855 1,000
Prepaid insurance (a) 3,000
Property, plant and equipment 25,000 (b)
Accumulated depreciation (c) (6,250)
Other assets 8,400 3,000
Total assets $35,545 $ (d)
Liabilities and equity:
Accounts payable $ 1,580 $ 950
Wages payable 125 700
Rent payable 500 500
Long-term notes payable (8%) 12,000 12,000
Common stock (e) (f)
Retained earnings (g) 10,845
Total liabilities and equity $ (h) $ (i)




Stone Cold Enterprises
Statement of Stockholders' Equity
Year Ended December 31, 2005

Common Retained
Stock Earnings Total
Balance, December 31, 2004 $3,000 $ (j) $ (k)
Issued common stock (l) (m)
Net income 14,495 14,495
P4-17
Dividends paid (9,000) (9,000)
Objs.$21,340
2, 3, 4
Balance, December 31, 2005 $5,000 $ (n)




Stone Cold Enterprises
Income Statement
Year Ended December 31, 2005

Sales revenue $103,000
Cost of goods sold 66,000
Gross profit 37,000
Operating expenses:
Wages $5,490
Interest (o)
Rent (p)
Insurance 1,000
Depreciation 1,250
Total operating expenses (q)
Pretax income (r)
Income taxes (35%) (s)
Net income $ (t)



(Continued)
F172 SECTION F1: The Accounting Information System
171
Reporting Earnings and Financial Position

Additional information:
1. No items of plant, property and equipment were purchased or sold during the year.
2. The prepaid insurance account represents the remaining portion of a four-year policy
purchased on January 1, 2004.
3. The rent payable account at year end (both years) represents December's rent that had
not yet been paid.

Required Use your knowledge regarding the interrelationships among financial statements
to determine each of the missing amounts.

Preparing Financial Statements
P4-16
Objs. 2, 3, 4 ABC, Inc. has the following account balances at December 31, 2004.

Accounts payable $17,080 Income tax expense $ 1,300
Accounts receivable 9,400 Land 50,000
Accumulated depreciation 26,100 Notes payable 30,000
Buildings 60,000 Retained earnings,
Cash 20,880 December 31, 2003 17,000
Contributed capital 31,000 Sales revenue 26,000
Cost of goods sold 15,600 Supplies 7,500
Depreciation expense 2,200 Wages expense 3,000
Dividends paid 1,200 Wages payable 23,900

During the year 2004, the company issued $6,000 of new common stock.

Required From this information, prepare (A) an income statement, (B) a statement of stock-
holders' equity, and (C) a classified balance sheet. (D) Show how the three financial state-
ments articulate. (Note: In parts (A), (B), and (C), include appropriate headings and
subheadings in the financial statements that you prepare.)

Understanding the Information in Financial Statements
P4-17
Objs. 2, 3, 4 Today is April 1 and Dale has just received the annual report of Clam Chowder Company, in
which he owns stock. Displayed below are the comparative balance sheet and income state-
ment that have drawn his attention.

Dec. 31, Dec. 31, For Year
Balance Sheet 2005 2004 Income Statement 2005
Cash $ 1,244 $ 1,512 Sales revenue $485,000
Accounts receivable 6,914 5,886 Cost of goods sold 300,700
Inventory 11,211 9,099 Gross profit 184,300
Buildings and equipment 49,900 46,500 Operating expenses:
Accumulated depreciation (5,319) (2,497) Advertising 31,330
Land 22,000 22,000 Depreciation 2,822
Utilities 19,200
Total assets $85,950 $82,500
Wages 113,698
Accounts payable $ 2,313 $ 1,988 Operating income 17,250
Interest payable -0- 2,563 Interest expense 2,400
Wages payable 7,364 6,327 Pretax income 14,850
7%, 10-year note payable 20,000 20,000 Income tax expense 5,200
Contributed capital 42,300 42,300 Net income $ 9,650
Retained capital 13,973 9,322
Total liabilities and equity $85,950 $82,500 Earnings per share $ 3.86

After reviewing this information, Dale makes the following comments.
1. I'm surprised that the value of the company's land has not increased. Prices have been
increasing rapidly in the area the company is located.
F173
CHAPTER F4: Reporting Earnings and Financial Position
172 Reporting Earnings and Financial Position

2. I'm sure that I received a dividend from this company, but they don't report that they
paid any.
3. I don't see how the company's cash balance could have declined when it took in
$485,000 in cash from sales to customers.
4. I see that the value of the buildings and equipment declined by $2,822. That seems
about right.
5. I don't understand why the company's highly trained workforce is not listed as an asset.
It is one of the most important resources that the company has.
6. One thing I really like about this company is the up-to-the-minute financial reports it
provides.
7. It's good to see that the value of the inventory has increased since last year.

Required
A. Help Dale better understand these financial statements by responding to each of his
comments. Explain whether you agree or disagree with each comment and why.
B. Did the company declare and pay cash dividends during the year just ended? If so,
what total amount was distributed?
C. Approximately how many shares of stock does the company have outstanding?


The Transformation Process as Reported in Financial Statements
P4-18
Objs. 2, 3, 4 Far East Specialties is an import company, financed primarily by stockholders and bank loans.
It imports handmade goods from Central and East Asia to the United States, where they are
sold to retail stores. The company's buyers contract with small companies for goods, which
the buyers ship to a central location in the United States. The goods are inventoried and then
redistributed as orders are received from retailers. The company receives a bill from the man-
ufacturers along with the goods it receives. Payment is made each month. Bills are sent to re-
tailers along with orders. Most retailers pay their bills each month, as well. It can be several
months from the time goods are shipped to the United States until cash is received from re-
tailers.

Required
A. Explain how the various aspects of Far East Specialties' transformation process are re-
ported in its financial statements. That is, consider the events just described and iden-
tify where information about each event is reported in the financial statements. In
particular, consider the relationship the company has with its investors, suppliers, and
customers.
B. Why is it important that time, and the timing of events, be considered in reporting ac-
counting information?

Limitations on Financial Statements
P4-19
Obj. 5 Markus O'Realius is considering the purchase of Caesar Company. The potential seller has
provided Markus with a copy of the business's financial statements for the last three years.
The financial statements reveal total assets of $350,000 and total liabilities of $150,000. The
seller is asking $300,000 for the business. Markus believes that the business is worth only about
$200,000, the amount of owners' equity reported on the balance sheet. He has asked your as-
sistance in determining a price to offer for the business.

Required Write a memo to Markus explaining why he should not interpret the balance sheet
as an accurate measure of the value of the business. Describe limitations of financial state-
ments that might mean that the market value of the business was higher (or lower) than the
financial statement amounts.

Limitations of Financial Statements
P4-20
Obj. 5 Limits, Ltd. had the following financial statements for the fiscal year ending December 31,
2004 (the statement of stockholders' equity and the statement of cash flows are not shown).

(Continued)
F174 SECTION F1: The Accounting Information System
173
Reporting Earnings and Financial Position


Limits, Ltd.
Income Statement
For the Year Ending December 31, 2004

Sales revenue $20,000
Operating expenses:
Cost of sales $1,000
Wages expense 800
Advertising expense 100
Depreciation expense 300
Research and development expense 300
Total operating expense 2,500
Operating income 17,500
Other expenses:
Interest expense 500
Income before taxes 17,000
Income tax 5,100
Net income $11,900




Limits, Ltd.
Balance Sheet
as of December 31, 2004

Assets Liabilities and stockholders' equity
Current assets: Current liabilities:
Cash $ 2,300 Accounts payable $ 3,000
Accounts receivable 8,000 Wages payable 7,600
Inventory 15,000 Interest payable 900
Total current assets 25,300 Total current liabilities 11,500
Property, plant and equipment: Notes payable, long-term 9,000
Equipment 21,000 Total liabilities 20,500
Accumulated depreciation (8,000) Stockholders' equity:
Buildings 90,000 Owners' investment 9,700
Accumulated depreciation (85,000) Retained earnings 13,100
PP&E 18,000 Total stockholders' equity 22,800
Total liabilities and
Total assets $43,300 stockholders' equity $43,300




Required The text lists several limitations of financial statements. Using the financial state-
ments given here, identify as many examples of limitations or items that relate to limitations
of financial statements as you can.

Excel in Action
P4-21
Listed below are account balances and other data for The Book Wermz at the close of No-
vember 30, 2004. Revenue and expense account balances are for the month of November. All
amounts are dollars except shares of common stock. The Book Wermz operates as a corpo-
ration.

Accounts payable $ 6,131.77
SPREADSHEET Accounts receivable 375.00
Accumulated depreciation 13,891.82
Cash 12,307.99
Contributed capital 100,000.00
Cost of goods sold 30,937.32
Depreciation expense 817.20
Dividends paid 1,500.00
F175
CHAPTER F4: Reporting Earnings and Financial Position
174 Reporting Earnings and Financial Position

Equipment 57,650.00
Income tax expense 897.45
Interest expense 932.03
Inventory 235,255.06
Notes payable, current portion 1,122.77
Notes payable, long-term 120,084.57
Rent expense 1,738.15
Sales 43,312.25
Service revenues 1,566.23
Shares of common stock 1,000
Supplies 2,130.12
Supplies expense 2,411.53
Wages expense 4,697.35
Wages payable 1,150.68

Required Use the account balances to produce an income statement, a statement of stock-
holders' equity, and a balance sheet for The Book Wermz in a spreadsheet. The financial state-
ments should follow the examples illustrated in Chapter F4. The balance sheet should contain
columns for November and October. October 31 balances should be obtained from data pro-
vided in the Chapter F3 spreadsheet problem.
Enter account titles in column A. Use columns B, C, and D as necessary for amounts. Use
the Borders button to produce single and double lines by selecting the cell to be for-
matted, using the button down arrow to select the proper line type, and clicking on the but-
ton. Use the Indent button to indent titles and captions as needed by selecting the cell
and clicking on the button. Use the Comma and Currency buttons to format amounts
by selecting the cell and clicking on the appropriate buttons. The Comma button also formats
numbers so that negative amounts appear in parentheses. The first and last amounts in a col-
umn of numbers should include dollar signs as illustrated in the chapter. Set column widths
by placing the cursor at the right edge of a column header so the Change Width cursor
appears. Then click and drag the column to the right or left as needed. Use functions to sum
subtotals and totals, SUM(B5:B8) for example, so the spreadsheet will automatically recal-
culate any changes in account numbers. To merge adjacent cells for titles, select the cells to
be merged and click on the Merge Cells button. Put titles in bold type by selecting the cell
containing the title and clicking on the Bold Type button .
Suppose sales for November had been $45,000 and the cash balance at November 30 had
been $13,995.74. How much net income would the company report for November? How much
total assets and stockholders' equity would it report at November 30?

Multiple-Choice Overview of the Chapter
P4-22
1. Which of the following is not a statement you would expect to find in a corporate an-
nual report?
a. Statement of financial position
b. Statement of earnings
c. Statement of stockholders' equity
d. Statement of accounts receivable

2. The following information was reported on the income statement of Wagon Wheel
Company.
Sales revenues $450,000
Cost of goods sold 200,000
Selling, general, and administrative expenses 150,000
Interest expense 30,000
Wagon Wheel's gross profit and operating income would be
Gross profit Operating income
a. $300,000 $70,000
b. $250,000 $70,000
c. $250,000 $100,000
d. $100,000 $70,000
(Continued)
F176 SECTION F1: The Accounting Information System
175
Reporting Earnings and Financial Position

3. Which of the following is a false statement regarding the statement of stockholders' eq-
uity?
a. It lists changes in contributed capital and retained earnings for a fiscal period.
b. It contains information about net income and dividends for a fiscal period.
c. It reports the net change in stockholders' equity for a fiscal period.
d. It reports increases or decreases in stocks and bonds for a fiscal period.

4. The following assets appear on the balance sheet for Astroid Company:
Accounts receivable $ 50,000
Accumulated depreciation 160,000
Cash 20,000
Intangible assets 60,000
Inventory 100,000
Plant assets 400,000
The amount of current assets reported by Astroid is
a. $170,000.
b. $150,000.
c. $230,000.
d. $470,000.

5. A balance sheet that provides information for more than one fiscal period is:
a. a classified balance sheet.
b. a comparative balance sheet.
c. a consolidated balance sheet.
d. a combined balance sheet.

6. Working capital is the amount of
a. cash and cash equivalents available to a company at the end of a fiscal period.
b. long-term investments available at the end of a fiscal period less long-term debt at
the end of the period.
c. current assets available at the end of a fiscal period less current liabilities at the end
of the period.
d. total assets available at the end of a period that can be converted to cash.

7. Orange Bowl Company reported plant assets for the latest fiscal year of $5 million, net
of accumulated depreciation. From this information, which of the following is an accu-
rate statement about the company?
a. The book value of the company's plant assets at the end of the fiscal year was $5
million.
b. The company would have to pay $5 million to replace its assets if they were re-
placed at the end of the fiscal year.
c. The amount the company would receive if it sold its plant assets at the end of the
fiscal year would be $5 million.
d. The amount the company paid for the plant assets it controlled at the end of the
fiscal year was $5 million.

8. A consolidated financial statement is one in which
a. more than one year's financial data is included.
b. the personal financial activities of the owner are combined with those of the com-
pany.
c. the income statement and the balance sheet are combined into a single statement.
d. the financial information of multiple corporations is reported as if they were a sin-
gle firm.

9. Which of the following is false?
a. Financial statement information is not always presented in a timely manner.
b. The purpose of a balance sheet is to report the market value of assets and liabilities.
c. Certain types of resources and costs are not reported in financial statements.
d. Many of the numbers reported in financial statements result from estimates and al-
locations.
F177
CHAPTER F4: Reporting Earnings and Financial Position
176 Reporting Earnings and Financial Position

10. Where on an income statement would you expect to find administrative salaries ex-
pense?
a. just after cost of goods sold
b. grouped with other operating expenses
c. as part of cost of goods sold
d. following income taxes




Projects
CASES
Evaluating the Transformation Process
C4-1
Objs. 1, 5 Italiano Pizza Company has just completed its first month in business. The owners, Charla
and Maria, had previously worked for a major pizza chain but were convinced that they could
offer a better product in a better atmosphere. They knew the importance of accurate finan-
cial records and hired a bookkeeper. Yesterday, the bookkeeper hand-delivered financial state-
ments to the owners and announced her resignation. You have been retained by Charla and
Maria to interpret the following financial information and explain its significance.


Italiano Pizza Company
Financial Statements
After One Month in Business

Balance sheet accounts Income statement accounts
Assets: Liabilities Owners' Equity: Revenues $ 4,000
Cash $ 2,240 Wages payable $ 180 Expenses:
Food products 980 Advertising payable 400 Store rent 800
Supplies 1,000 Loan from bank 6,800 Food products 1,475
Prepaid rent 2,400 Owners' investment 4,340 Wages 990
Equipment 5,150 Advertising 1,430
Accumulated Interest 40
depreciation (50) Supplies 375
Total $11,720 Total $11,720 Depreciation 50
Net income $(1,160)



Required
A. Discuss whether the information provided could be helpful to the owners and, if so,
describe how. If not, describe why not.
B. Identify at least 10 events that occurred as part of the transformation process during
the firm's first month in business. For each event, identify the amount of cash involved.
C. Did Charla and Maria make a good judgment when they decided to get into this business?
Would you recommend that they continue with the pizza business or discontinue it? What
additional information would be helpful to you in making such a recommendation?

The Financial Statements of General Mills, Inc.
C4-2
Objs. 2, 3, 4 The General Mills 2002 Annual Report is reproduced in Appendix B at the end of the text.

Required
A. Answer the following questions about the General Mills Consolidated Statements of
Earnings:
1. General Mills recorded sales of almost $8 billion. Is this the amount of cash col-
lected? Explain.
2. Sales increased each year from 2000 to 2002. Compute the percentage increase for
each year.
(Continued)
F178 SECTION F1: The Accounting Information System
177
Reporting Earnings and Financial Position

3. What is the largest expense for General Mills? Compute this expense as a percentage
of sales for each of the three years. Is there a trend?
4. Compare the net income figures for three years. What do you observe?
5. Explain why a company's stock price generally is influenced by the amount of net
income.
6. General Mills paid dividends in 2002, 2001, and in 2000, yet the corresponding total
dividend payments do not appear as expenses on the income statement. Why not?
B. Answer the following questions about the General Mills Consolidated Balance Sheets:
1. Why does a company have assets?
2. What is the total amount of assets at the end of 2002?
3. For 2002, compare the assets at the beginning of the year to the assets at the end of
the year.
a. Compute the percentage increase in assets during the year.
b. Which type of assets account for most of the increase?
4. What two groups have contributed assets to General Mills and have claims on the
company's assets?
C. Answer the following questions about the General Mills Consolidated Statement of
Stockholders' Equity:
1. General Mill's total stockholders' equity has increased significantly from May 27, 2001
to May 26, 2002. What is the major cause of the increase in stockholders' equity?
2. The consolidated statement of stockholders' equity identifies comprehensive in-
come. Briefly explain the concept of comprehensive income. What kinds of activi-
ties are included in comprehensive income?
F5
5
REPORTING CASH
FLOWS
How is cash flow information determined and reported
to external users?

C hapter F4 examined the reporting of operating results and financial position to stock-
holders and other external users. Corporations and other companies also report in-
formation about their cash flows for a fiscal period to external users. The statement of
cash flows identifies the cash created by and used for operating, investing, and financing
activities. Stan and Maria realize it is important for their company to provide information
about how much cash is generated from business activities and how this cash was used. In ad-
dition to helping them, as managing owners of the firm, this information helps external stock-
holders and other decision makers determine whether a company is likely to grow and to meet
its financial obligations.


FOOD FOR THOUGHT
As a stockholder of Mom™s Cookie Company, what information about cash flows do you need to make
decisions about your investment? How do companies determine how much cash they received and paid
during a fiscal period? Knowing they need to provide key cash flow information to stockholders and
others, Maria and Stan have arranged to meet with their accountant, Ellen, to discuss these issues.


We prepared an income statement, balance sheet, and statement of stockholders™ equity for our
Stan:
stockholders. I understand we also need to report cash flow information.
Yes, the statement of cash flows is an important part of your total financial report. This statement
Ellen:
requires you to look carefully at your business activities to identify activities that created cash and those
that used it.
We know how much cash the company had at the end of the year. Many of our transactions during the
Maria:
year involved cash. Do we have to look at all of these transactions to prepare the statement of cash flows?
No. You can summarize your cash flows without looking at individual transactions. Most of the information
Ellen:
for the statement can be obtained from the income statement and balance sheets you have already
prepared.
Those statements don™t include much cash information. How can they tell us anything about cash flows?
Stan:
The income statement contains information about the results of operating activities measured using the
Ellen:
accrual basis. Timing differences between when revenues and expenses were recognized and when cash
was received and paid are reported on the balance sheets for this fiscal year end and the prior one.
Preparing the statement of cash flows is largely a matter of adjusting income statement numbers for these
timing differences and looking at other activities that increased or decreased balance sheet amounts
during the year.
That sounds complicated.
Maria:
It requires a good understanding of accrual accounting and working systematically with the income
Ellen:
statement and balance sheet numbers. Once you learn how the statement is prepared, you™ll have a good
understanding of how accrual and cash flow information is related. Also, you will see how valuable cash
flow information can be for understanding your company.
F180 ReportingSECTION F1: The Accounting Information System
180 Cash Flows


OBJECTIVES

Once you have completed this chapter, you 2 Explain information reported on a
should be able to: statement of cash flows using the indirect
format.
1 Explain information reported on a
statement of cash flows using the direct 3 Interpret cash flow information as a basis
format. for analyzing financial performance.




THE STATEMENT CASH FLOWS
OF
The purpose of the statement of cash flows is to identify the primary activities of a fis-
cal period that resulted in cash inflows and outflows for a company. The statement de-
scribes the cash flow results of financing, investing, and operating activities for a
company for a fiscal period, and it explains the change in a company™s cash balance
during the period. GAAP permit the statement of cash flows to be presented in either
of two formats: direct or indirect. The two formats differ only with respect to the pre-
sentation of operating activities.




THE DIRECT FORMAT
Some companies, especially smaller companies, use the direct format to present the
OBJECTIVE 1
statement of cash flows. Most large corporations use the indirect format. Exhibit 1 pro-
Explain information vides an example of the cash flow statement for Mom™s Cookie Company using the di-
reported on a statement rect format.
of cash flows using the The direct format of the statement of cash flows presents each major source and
direct format. use of cash. The statement of cash flows is divided into three sections corresponding to
the three primary types of business activities: operating, investing, and financing.
The source of data for the direct format of the statement of cash flows is the trans-
actions that affect the cash account. The operating cash flow section of the statement
includes those transactions that affected cash and were associated with operating ac-
tivities: sales to customers, purchases of merchandise, wages, and other operating ac-
tivities. GAAP require that interest payments be included in the operating activities
section of the statement of cash flows because interest expense is reported on the in-
come statement. Thus, operating cash flows are the cash equivalent of the accrual re-
sults reported on the income statement. That is, they represent a cash-basis income
statement for the fiscal period.
The investing activities section includes cash transactions associated with the pur-
chase or sale of long-term assets. The financing activities section includes cash trans-
actions associated with debt (short- or long-term) and owners™ equity, including
payments to owners.
The direct format of the statement of cash flows lists the direct effects of transac-
tions that affect the cash account during a period. It answers the question, “Where did
cash come from and where did cash go?” Therefore, it is an explanation of business ac-
tivities that resulted in an increase or decrease in cash. In total, these activities explain
the change in a company™s cash account balance for a fiscal period. Because 2004 was
Mom™s Cookie Company™s first year of operations, the beginning cash balance was $0.
F181
CHAPTER F5: Reporting Cash Flows
181
Reporting Cash Flows

The company™s ending cash balance was equal to the net increase in cash for 2004,
$10,680. The net increase (or decrease) in cash for a fiscal period is the sum of net cash
flow from operating, investing, and financing activities.




Exhibit 1
Mom™s Cookie Company
Statement of Cash
Statement of Cash Flows
Flows, Direct Format
For the Year Ended December 31, 2004

Operating Activities
Receipts: Collections from customers $ 682,080
Payments:
For inventory (471,590)
To employees (70,800)
For rent (24,000)
For utilities (4,500)
For supplies (15,990)
For insurance (3,700)
For advertising (6,500)
For interest (4,150)
For income tax (22,710)
Net cash flow from operating activities 58,140
Investing Activities
Payments for purchase of equipment (216,000)
Receipts from sale of equipment 340
Net cash flow for investing activities (215,660)
Financing Activities
Receipts from sale of common stock 100,000
Payment of dividends (10,000)
Receipts from borrowing 80,000
Repayments of debt (1,800)
Net cash flow from financing activities 168,200
Net increase in cash 10,680
Cash balance, December 31, 2003 0
Cash balance, December 31, 2004 $ 10,680




Operating Activities
Operating activities are transactions involving the acquisition or production of goods
and services and the sale and distribution of these goods and services to customers.
Cash flow from operating activities identifies cash received from the sale of goods and
services. Also, it identifies cash paid for resources used to provide goods and services.
An important relationship exists between the income statement and the operating ac-
tivities section of the statement of cash flows”both are based on the same set of ac-
tivities. On the income statement, operating activities are measured on an accrual basis.
On the cash flow statement, these activities are measured on a cash basis. These amounts
can be compared to determine timing differences between accrual basis recognition of
revenues and expenses and cash flows for the period.
To understand how the cash flow numbers in Exhibit 1 were computed, we need
to refer to the income statement and balance sheet from Chapter F3. These are repro-
duced in Exhibit 2.
F182 ReportingSECTION F1: The Accounting Information System
182 Cash Flows

Selling, general and administrative expenses are as follows:
Wages $ 70,800
Utilities 4,500
Insurance 3,700
Advertising 6,500
Depreciation 25,500
Rent 22,000
Supplies 15,300
Total $148,300




Exhibit 2
Mom™s Cookie Company
Income Statement and
Income Statement
Balance Sheet for
For the Year Ended December 31, 2004
Mom™s Cookie Company
Sales revenue $ 686,400
Cost of goods sold (457,600)
Gross profit 228,800
Selling, general and administrative expenses (148,300)
Operating income 80,500
Interest expense (4,800)
Pretax income 75,700
Income taxes (22,710)
Net income $ 52,990




Mom™s Cookie Company
Balance Sheet
At December 31, 2004

Assets
Current assets:
Cash $ 10,680
Accounts receivable 8,570
Merchandise inventory 23,600
Supplies 690
Prepaid rent 2,000
Total current assets 45,540
Property and equipment, at cost 215,660
Accumulated depreciation (25,500)
Total assets $235,700
Liabilities and Stockholders™ Equity
Current liabilities:
Accounts payable $ 9,610
Unearned revenue 4,250
Interest payable 650
Notes payable, current portion 5,000
Total current liabilities 19,510
Notes payable, long-term 73,200
Total liabilities 92,710
Stockholders™ equity:
Common stock, 10,000 shares issued 100,000
Retained earnings 42,990
Total stockholders™ equity 142,990
Total liabilities and stockholders™ equity $235,700
F183
CHAPTER F5: Reporting Cash Flows
183
Reporting Cash Flows

Of these items, wages, utilities, insurance, and advertising were paid in cash. Observe
that there are no noncash assets or liabilities (prepaid insurance or wages payable, for
example) on the balance sheet associated with these items. Depreciation expense does
not require the payment of cash. Rent and supplies expenses were not completely paid
in cash because prepaid rent and supplies are reported on the balance sheet. Income
tax also was paid in cash. Again, observe that there are no noncash assets or liabilities
associated with income taxes, such as income taxes payable. There are noncash assets
and liabilities associated with sales revenue, cost of goods sold, and interest expense.
These assets and liabilities result from timing differences between when revenues and
expenses are recognized and when cash is received or paid. Therefore, they must be ad-
justed to determine cash flows. Exhibit 3 explains the calculation of operating cash flows
from the data in Exhibit 2.



Exhibit 3 Calculation of Operating Cash Flows for Direct Method

Accounts Accrual Adjustment Cash Flow Explanation

a. Sales Revenue $ 686,400 Accrual
Less: Accounts Receivable $ (8,570) Sales for which cash not received
Add: Unearned Revenue 4,250 Cash received but not yet earned
Cash Collected from Customers $ 682,080 Cash flow
b. Cost of Goods Sold (457,600) Accrual
Add: Merchandise Inventory (23,600) Cash paid but goods not sold
Less: Accounts Payable 9,610 Goods purchased but cash not paid
Cash Paid for Merchandise (471,590) Cash flow
c. Wages (70,800) Cash paid equals accrual amount
Utilities (4,500) Cash paid equals accrual amount
Insurance (3,700) Cash paid equals accrual amount
Advertising (6,500) Cash paid equals accrual amount
Income Taxes (22,710) Cash paid equals accrual amount
Cash Paid for Other Operating Items (108,210) Cash paid equals accrual amount
d. Rent Expense (22,000) Accrual
Prepaid Rent (2,000) Cash paid but not expensed
Cash Paid for Rent (24,000) Cash flow
e. Supplies Expense (15,300) Accrual
Supplies (690) Cash paid but not expensed
Cash Paid for Supplies (15,990) Cash flow
f. Interest Expense (4,800) Accrual
Interest Payable 650 Cash not paid in 2004
Cash Paid for Interest (4,150) Cash flow
g. Depreciation Expense (25,500) 0 Accrual
25,500 Cash not paid
0 Cash flow
Net Income $ 52,990
Net Cash Flow from Operating $ 58,140




To determine cash collected from customers (a), revenue is adjusted for cash not
received (because it is still owed) and for cash received that has not been earned. To
determine cash paid for merchandise (b), cost of goods sold is adjusted for cash paid
for merchandise that has not been sold and for amounts owed suppliers. It is im-
portant in these computations that expenses and cash outflows are shown as nega-
tive amounts.
Other operating cash flows are either accrued expenses that were paid in cash, as
those in (c), or expenses that require adjustment, as with rent, supplies, and interest.
F184 ReportingSECTION F1: The Accounting Information System
184 Cash Flows

To determine cash paid for rent (d), rent expense is adjusted for cash paid for rent
of future periods. To determine cash paid for supplies (e), supplies expense is ad-
justed for supplies that have been purchased but that have not been used. To deter-
mine cash paid for interest (f), interest expense is adjusted for interest that has not
been paid.
Depreciation and amortization expenses (g) are tied to operating activities but are
not cash flow items. When the direct format is used, these expenses are not listed in
the statement of cash flows.


Investing Activities
Investing activities involve acquisition or sale of long-term assets and financial invest-
ments during a fiscal period. As noted above, depreciation and amortization expenses
are not part of investing activities. Cash flow for investing activities occurs when fixed
assets are purchased or sold, not when these assets are depreciated.
Calculation of investing cash flow in Exhibit 1 is straightforward. Mom™s Cookie
Company purchased $216,000 of equipment for cash in 2004. It sold equipment for
$340 in cash. Investing cash flow is simply the amount paid for long-term assets minus
the amount received from selling these assets.
Some transactions affect investing and financing activities without affecting cash
directly. For example, suppose a company borrows $300,000 from a bank to purchase
a building. The transaction increases Buildings and Notes Payable but does not have a
direct effect on Cash. GAAP require that such transactions be reported. Most of these
events are reported as though they were cash transactions: cash received from borrow-
ing and then paid for property and equipment.


Financing Activities
Financing activities are transactions between a company and its owners or creditors.
The financing activities section reports only the cash flow effects of transactions asso-
ciated with borrowing or repaying debt and investments by owners. Cash flows result
when debt is issued or repaid and when stock is issued or repurchased. Payment of div-
idends or other cash distributions to owners also are financing activities.
The calculation of financing cash flow for Mom™s Cookie Company is straight-
forward. The company received $100,000 from issuing common stock and paid
$10,000 of dividends to stockholders. It received $80,000 of cash from borrowing and
paid back $1,800 of the amount borrowed. (It is important to remember the repay-
ment of debt is the repayment of the amount actually borrowed, not the payment of
interest on the borrowed money. As noted above, the payment of interest is an op-
erating activity.)
GAAP require a schedule to reconcile cash flows from operating activities with net
income when the direct format is used. This schedule is similar to the presentation of
the statement of cash flows using the indirect format described in the next section of
this chapter.




1 SELF-STUDY PROBLEM Listed below are cash activities for Jerome, Inc. for a recent fiscal
period. Jerome™s cash balance at the beginning of the period was
$16,350.

Paid for dividends $ 2,500
Paid to employees 4,000
F185
CHAPTER F5: Reporting Cash Flows
185
Reporting Cash Flows

Paid for utilities 2,200
Paid for equipment 13,500
Received from sale of stock 100,000
Paid for supplies 1,800
Paid for inventory 8,400
Received from customers 14,750
Paid for debt repayment 35,000
Received from sale of land 20,000
Paid for building 75,000

Required Use these activities to prepare a statement of cash flows for Jerome, Inc., us-
ing the direct format. What were Jerome™s primary sources and uses of cash for the pe-
riod?
The solution to Self-Study Problem 1 appears at the end of the chapter.




THE INDIRECT FORMAT
The direct format of the statement of cash flows identifies the sources of cash received
OBJECTIVE 2
and the purposes for which cash is paid during a period. Thus, operating activities iden-
Explain information tify cash received from customers and paid to suppliers, employees, and so on. In prac-
reported on a statement tice, however, this format is rarely used by major corporations.
of cash flows using the Instead, nearly all major corporations use the indirect format for reporting the state-
indirect format. ment of cash flows. The differences between the direct and indirect formats are in the
operating activities section only. The indirect format reconciles net income on an ac-
crual basis with cash flow from operating activities on a cash basis. It answers the ques-
tion, “Why was cash flow from operations different from net income?” Consequently,
operating cash flows are presented as the indirect result of changes in current assets,
current liabilities, and other accounts.
Exhibit 4 provides the statement of cash flows for Mom™s Cookie Company using the
indirect method. In this method, the operating activities section begins with net income.
This is the amount reported on the company™s income statement (see Exhibit 2). The in-
direct format begins with the results of operating activities reported on an accrual basis
(net income) and adjusts this amount to arrive at the amount that explains the results of
operating activities on a cash basis (net cash flow from operating activities). Adjustments
are made for activities that had a different effect on net income than they had on cash flow.
Observe that the net cash flows in each section (operating, investing, and financing)
are the same as those reported using the direct method in Exhibit 1. In fact, the in-
vesting and financing sections are identical in the two methods.
The operating activities section looks quite different, however. To understand
this method, refer to Exhibit 2. The adjustments column of the exhibit identifies the
differences between the accrual amounts from the income statement and the cash
flow amounts. Starting with net income, we can simply list these adjustments to
compute cash flow from operating activities. The indirect method does just that. It
starts with the accrual amount (net income) and lists the adjustments necessary to
determine cash flow from operating activities.
Though the determination of the adjustments may seem somewhat complicated,
they are actually fairly simple. They consist of subtracting any revenues that did not re-
sult in cash inflow or adding any expenses that did not require cash outflow. Most ad-
justments are associated with current assets and current liabilities, with the exclusion
of financial resources such as cash and investments.
When current assets increase during a fiscal period, one of two things has occurred:
• Revenue was earned but cash was not received”increase in accounts receivable, or
• Cash was paid for resources that have not been expensed”increase in inventory
or prepaid expenses.
F186 ReportingSECTION F1: The Accounting Information System
186 Cash Flows



Exhibit 4
Mom™s Cookie Company
Indirect Format of
Statement of Cash Flows
Statement of Cash
For the Year Ended December 31, 2004
Flows
Operating Activities
Net income $ 52,990
Depreciation expense 25,500
Increase in accounts receivable (8,570)
Increase in merchandise inventory (23,600)
Increase in supplies (690)
Increase in prepaid rent (2,000)
Increase in accounts payable 9,610
Increase in unearned revenue 4,250
Increase in interest payable 650
Net cash flow from operating activities 58,140
Investing Activities
Payments for purchase of equipment (216,000)
Receipts from sale of equipment 340
Net cash flow for investing activities (215,660)
Financing Activities
Receipts from sale of common stock 80,000
Payment of dividends (1,800)
Receipts from borrowing 100,000
Repayment of debt (10,000)
Net cash flow from financing activities 168,200
Net increase in cash 10,680
Cash balance, December 31, 2003 0
Cash balance, December 31, 2004 $ 10,680




In either case, cash flow is less than net income. Therefore, increases in current assets
are subtracted from net income to calculate operating cash flow.
When current assets decrease, the opposite has occurred, either:
• Cash has been received from customers that was not earned this period”decrease
in accounts receivable, or
• Resources have been used that were not paid for this period”decrease in inven-
tory or prepaid expenses.
In either case, cash flow is greater than net income. Therefore, decreases in current as-
sets are added to net income to calculate operating cash flow.
When current liabilities increase, either:
• Cash has been received from customers but has not been earned”increase in un-
earned revenue, or
• Resources have been used but payment has not been made”increase in accounts
and other payables.
In either case, cash flow is greater than net income. Therefore, increases in current li-
abilities are added to net income to calculate operating cash flow.
When current liabilities decrease, either:
• Revenue has been earned but cash was received in a previous period”decrease in
unearned revenue, or
• Payment has been made for resources that were used in a previous period”de-
crease in accounts and other payables.
F187
CHAPTER F5: Reporting Cash Flows
187
Reporting Cash Flows

In either case, cash flow is less than net income. Therefore, decreases in current lia-
bilities are subtracted from net income to calculate operating cash flow.
Exhibit 5 summarizes these rules. The rules apply to changes in current asset and
current liability accounts during a fiscal period. Because 2004 was the first year of op-
erations for Mom™s Cookie Company, the beginning balances of all current asset and
current liability accounts was zero. Consequently, the changes in these accounts were
equal to the ending balances. When working with a company that has beginning and
ending balances, it is necessary to compute the change in current asset and current li-
ability balances and use these in the calculations in Exhibit 2. Also keep in mind that
some current asset and current liability accounts, such as short-term investments and
short-term debt (including the current portion of notes payable), are not associated
with operating activities. These accounts are associated with financial resources and in-
volve investing activities (for assets) or financing activities (for liabilities). Finally, some
revenue and expense items, depreciation and amortization expenses in particular, do
not require cash payments. Therefore, they are always added to net income to calcu-
late operating cash flow.



Exhibit 5 Event Rule
Rules for Adjusting Net
Increase in Current Assets Subtract from Net Income
Income to Calculate
Decrease in Current Assets Add to Net Income
Operating Cash Flow
Increase in Current Liabilities Add to Net Income
Decrease in Current Liabilities Subtract from Net Income




Exhibit 6 provides the statement of cash flows for Krispy Kreme Doughnuts, Inc.,
from the company™s 2002 annual report. Though the statement contains more items
than that for Mom™s Cookie Company, the interpretation is similar. For each operat-
ing cash flow adjustment, a note identifies why the amount was added (or subtracted).
All of these items identify either revenues for which cash was not received, cash re-
ceived that was not earned, expenses for which cash was not paid, or cash paid for
which expenses were not incurred. In short, all are timing differences between when
revenue or expense was recognized and when cash was received or paid.
We can determine from Exhibit 6 that, usually, all of Krispy Kreme™s current as-
sets and current liabilities increased. Observe that receivables, inventories, and pre-
paid expenses were all subtracted, and accounts payable and other current liabilities
were added.
It is not uncommon for a company to report a noncash revenue (or gain) or a
noncash expense (or loss). Gains are always subtracted because they increase net in-
come but do not provide cash inflow, and losses are always added because they de-
crease net income but do not require cash outflow. Gains and losses from sales of
long-term assets (plant assets or investments) are subtracted (for gains) or added (for
losses) because these gains and losses do not provide or use cash as part of operating
activities. Cash received or paid from these transactions is correctly reported in the
investing activities section.
The investing activities section of Krispy Kreme™s cash flow statement is similar
to that for Mom™s Cookie Company. Purchases of property and equipment and other
long-term assets decrease cash flow. Sale of these items increases cash flow. The fi-
nancing activities section also is similar. Borrowing and issuing stock increase cash
flow, and repayment of debt and payments to owners decrease cash flow.
The net increase in cash of $14,878,000 in 2002 explains the change in Krispy
Kreme™s cash account reported on its balance sheet. (See Exhibit 4 in Chapter F4.)
F188 ReportingSECTION F1: The Accounting Information System
188 Cash Flows

Exhibit 6 Indirect Format of Statement of Cash Flows


Krispy Kreme Doughnuts, Inc.
Consolidated Statements of Cash Flows

In thousands
Year ended Jan. 30, 2000 Jan. 28, 2001 Feb. 3, 2002
CASH FLOW FROM OPERATING ACTIVITIES:
Net income $ 5,956 $ 14,725 $ 26,378
Items not requiring (providing) cash:
Depreciation and amortization 4,546 6,457 7,959
Deferred income taxes 258 1,668 2,553
Loss on disposal of property and equipment, net ” 20 235
Other 1,012 2,357 11,573
Change in assets and liabilities:
Receivables (4,760) (3,434) (13,317)
Inventories (93) (2,052) (3,977)
Prepaid expenses (1,619) 1,239 (682)
Income taxes, net (2,016) 902 (2,575)
Accounts payable 540 2,279 3,884
Accrued expenses 4,329 7,966 4,096
Deferred compensation 345 (15) 83
Net cash provided by operating activities 8,498 32,112 36,210
CASH FLOW FROM INVESTING ACTIVITIES:
Purchase of property and equipment (11,335) (25,655) (37,310)
Proceeds from disposal of property and equipment ” 1,419 3,196
Acquisitions ” ” (20,571)
Investments in joint ventures ” (4,465) (1,218)
(Increase) decrease in other assets 1,309 (3,216) (4,237)
(Purchase) sale of investments, net ” (35,371) 7,877
Net cash used for investing activities: (10,026) (67,288) (52,263)
CASH FLOW FROM FINANCING ACTIVITIES:
Repayment of long-term debt (2,400) (3,600) ”
Net short-term (repayments) borrowings ” (15,775) 345
Borrowings of long-term debt 4,282 ” 4,643
Proceeds from stock offering ” 65,637 17,202
Proceeds from exercise of stock options ” 104 3,906
Cash dividends paid (1,518) (7,005) ”
Other 934 (144) 5,483
Net cash provided by financing activities: 398 39,019 30,931
Net increase (decrease) in cash and cash equivalents (1,130) 3,843 14,878
Cash and cash equivalents at beginning of year 4,313 3,183 7,026
Cash and cash equivalents at end of year $ 3,183 $ 7,026 $ 21,904
Note: Modifications have been made to the original format to simplify the presentation.




2 SELF-STUDY PROBLEM The following information appears on the income statement and
balance sheet of Bryson Co. for a recent fiscal period.

Net income $16,540
Depreciation and amortization expense 3,560
Increase in accounts receivable 2,500
Decrease in merchandise 3,200
Increase in supplies 430
Increase in accounts payable 660
Decrease in wages payable 375
Increase in interest payable 280
Decrease in income tax payable 700
F189
CHAPTER F5: Reporting Cash Flows
189
Reporting Cash Flows

Required Use the information provided to prepare the operating activities section of
the statement of cash flows for Bryson Co. using the indirect format.
The solution to Self-Study Problem 2 appears at the end of the chapter.




INTERPRETING CASH FLOWS
Understanding a company™s cash flows and the reasons for the cash flows is critical to
OBJECTIVE 3
investors, managers, and other decision makers. To survive and prosper, a company
Interpret cash flow must create sufficient cash flows to pay its bills, repay its debt, and provide a reason-
information as a basis for able return to its owners. The statement of cash flows provides important information
analyzing financial for evaluating past decisions and future prospects.
performance. A company™s net income and operating cash flow are seldom equal. A major dif-
ference between the two amounts is Depreciation and Amortization Expense. This ex-
pense reduces net income but does not require the use of cash. As shown in Exhibit 6,
much of the difference between Krispy Kreme™s net income and its operating cash flows
is due to its depreciation and amortization expense. Other differences are explained by
changes in current asset and current liability accounts. Changes in these accounts can
provide useful information about a company™s operations. Increases in current assets
(Accounts Receivable and Inventory) and increases in Accounts Payable are common
for companies that exhibit increases in net income. Higher sales lead to more receiv-
ables and require larger amounts of inventories. Payables also increase because of the
increased demand for inventories. Increases in operating cash flows over time and large
operating cash flows relative to net income (as seen in Exhibit 6) usually indicate good
financial performance.
The amount of cash flow from operating activities normally is approximately equal
to the amount of cash flow from (for) investing activities plus the amount of cash flow
from (for) financing activities. A company depends on its operating activities to meet
most of its cash flow needs. In the long run, operating cash flows must be sufficient to
meet the cash needs of a company. If net operating cash flows are negative, a company
is normally facing serious financial problems. In the short run, the company may be
able to borrow cash or sell long-term assets to generate cash. But in the long run, it will
be unable to stay in business using these methods. Creditors will refuse to lend money
to a company that cannot create operating cash flows to ensure repayment of the debt.
Also, the company will run out of assets that it can sell and still stay in business. Ac-
cordingly, negative operating cash flows combined with cash inflows from investing ac-
tivities (from selling assets) and cash inflows from financing activities (from borrowing)
is clearly a negative sign.
A company that is performing well normally creates net cash flow from operating
activities. This excess cash can be used for expansion (to buy additional assets) or for
financing purposes (to repay debt, repurchase stock, or pay dividends to stockholders).
Accordingly, a combination of positive net cash flows from operating activities and neg-
ative cash flows for investing activities normally is a sign of good performance and
growth. A growing company usually is increasing in value. As the company expands by
purchasing more assets, it has the ability to produce and sell more products, which may
result in additional profitability and increased operating cash flows. Observe that Krispy
Kreme is using most of its operating cash flows for investing purposes. The company
is acquiring additional assets each year.
If a company creates more cash from operating activities than it can use for in-
vesting purposes, it normally will use the cash to repay debt or to make payments
to stockholders. If these payments are large, they may be an indication that the com-
pany is performing well but does not have a lot of good investing opportunities.
Krispy Kreme was not able to generate sufficient cash flows from operating activi-
F190 ReportingSECTION F1: The Accounting Information System
190 Cash Flows

ties to meet its investing needs. Additional cash was obtained from financing activ-
ities.
A company with a lot of good investing opportunities may borrow money or sell
stock to provide additional cash to take advantage of these opportunities. Thus, cash
inflow from financing activities is a positive sign if a company is using this cash to pur-
chase additional assets (for investing activities). Cash inflow from financing activities
is a bad sign if the cash is used for operating activities. This may indicate that the com-
pany cannot create enough cash from its operations to meet ongoing needs.
The cash flow information presented in Exhibit 6 suggests that Krispy Kreme was
performing well during the three years reported. Operating cash flows were large and
generally increasing, and cash was being invested in additional assets. The company
was not experiencing any difficulty in repaying debt or in meeting any of its cash flow
needs.
Exhibit 7 summarizes the types of information provided by a cash flow statement.
Other cash flow combinations are possible, but these are the most common and the
most likely to provide a clear indication of how well a company is performing.



Exhibit 7 Operating Investing Financing
Cash Flow Patterns and Cash Flows Cash Flows Cash Flows Normal Interpretation
the Financial Health of a
The company is prosperous and growing.
Company
Financing cash flow is used to take
advantage of growth opportunities.

The company is facing serious financial
problems. It is selling assets and using
financing activities to meet current cash
needs.

or The company is prosperous but may not
have a lot of good growth opportunities.
It is using operating cash to pay off debt
and pay stockholders.

or The company may be facing a current
cash flow problem. It is selling assets to
supplement current cash flows to cover
its financing needs. This is especially a
problem if the company is short of cash
to repay debt.




The amount of change in a company™s cash balance usually is not of major im-
portance. This change usually is small, and a small increase or decrease does not signal
financial problems or strengths. In particular, you should not assume that a net de-
crease in cash is an indication of a major financial problem for a company. You should
focus instead on changes in operating, investing, and financing cash flows.
F191
CHAPTER F5: Reporting Cash Flows
191
Reporting Cash Flows


Case in Point
In
Cash Flow Problems
The airlines industry faced financial problems in 2001 because of the declining econ-
omy. As economic activity decreases, fewer people travel and airline revenues de-
crease. The tragic events of September 11 were catastrophic for the industry. Many
http://ingram.swlearning. flights were cancelled, and passenger mileage dropped dramatically. The result of these
com events was a sharp decrease in profits and operating cash flows, leaving many airlines
struggling for survival.
Find out more about
The following information was reported by United Airlines in its 2001 annual report:
United Airlines.

(In millions) Year Ended December 31 2001 2000 1999
Net earnings (loss) $(2,145) $ 50 $ 1,235
Cash flows from (for) operating activities (160) 2,472 2,421
Cash flows from investing activities (1,969) (2,521) (1,624)
Cash flows from (for) financing activities 2,138 1,418 (877)

Profits decreased steadily from 1999 to 2001. Operating cash flow became neg-
ative in 2001. To meet its investing cash flow needs, the company increased its bor-
rowing in 2001. The company™s assets did not increase much from 2000 to 2001. Most
of its investing activities were to replace existing assets. Most of United™s assets were
airplanes that it could not sell, since there was a surplus among all airlines. Some of
the airplanes were mothballed pending an increase in demand.
Borrowing to meet operating and investing needs is a short-term solution. A
company cannot stay in business long if it does not generate sufficient cash from

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