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On January 3, 2003, SW, Inc., purchased 8,000 shares of the outstanding common stock of
IM Corporation. At the time of this transaction, IM has 20,000 shares of common stock out-
standing. The cost of the purchase (including brokerage fees) was $47 per share. During the
year, IM reported income of $18,000 and paid dividends of $10,000. On December 31,
2003, IM™s stock was valued at $51 per share.
Provide the entries necessary to record the above transactions.

EXERCISE 12-18 EQUITY METHOD
Foster Enterprises purchased 20% of the outstanding common stock of Novelties, Inc., on
January 2, 2003, paying $150,000. During 2003, Novelties, Inc., reported net income of
$20,000 and paid dividends to shareholders of $15,000. On December 31, 2003, Foster™s in-
vestment in Novelties stock had a fair market value of $158,000. Assuming this is the only se-
curity owned by Foster, prepare all journal entries required by Foster in 2003 assuming:
1. The security is classified as a trading security.
2. The security is classified as an available-for-sale security.
3. The equity method is applied to the investment.

EXERCISE 12-19 INVESTMENTS IN STOCK”EQUITY METHOD
During 2003, Genco Corporation purchased 10,000 shares of Wiener Company stock for
$85 per share. Wiener had a total of 40,000 shares of stock outstanding.
600 f601
Investments In Debt And Equity Securities Investments in Debt and Equity Securities EOC Chapter 12


1. Prepare journal entries for the following transactions:
Jan. 1 Purchased 10,000 shares of common stock at $85.
Dec. 31 Wiener Company declared and paid a $4.60-per-share dividend.
Dec. 31 Wiener Company reported net income for 2003 of $360,000.
2. On December 31, 2003, the market price of Wiener™s stock was $79 per share. Show
how this investment would be reported on Genco™s balance sheet at December 31, 2003,
assuming that this is the only stock investment owned by Genco.




problems


PROBLEM 12-1 INVESTMENT IN SECURITIES”RECORDING AND ANALYSIS
The following data pertain to the securities of Linford Company during 2003, the company™s
first year of operations:
a. Purchased 400 shares of Corporation A stock at $40 per share plus a commission of
$200. This security is classified as trading.
b. Purchased $6,000 of Corporation B bonds. These bonds are classified as trading.
c. Received a cash dividend of $0.50 per share on the Corporation A stock.
d. Sold 100 shares of Corporation A stock for $46 per share.
e. Received interest of $240 on the Corporation B bonds.
f. Purchased 50 shares of Corporation C stock for $3,500. Classified the stock as available-
for-sale.
g. Received interest of $240 on the Corporation B bonds.
h. Sold 150 shares of Corporation A stock for $28 per share.
i. Received a cash dividend of $1.40 per share on the Corporation C stock.
j. Interest receivable at year-end on the Corporation B bonds amounts to $60.
Prepare journal entries to record the preceding transactions. Post the entries to T-accounts, and
Required:
determine the amount of each of the following for the year:
1. Dividend revenue.
2. Bond interest revenue.
3. Net gain or loss from selling securities.

PROBLEM 12-2 BUYING AND SELLING TRADING SECURITIES
Fox Company incurred the following transactions relating to the common stock of NOP Company:
July 10, 2001 Purchased 10,000 shares at $45 per share.
Sep. 29, 2002 Sold 2,000 shares at $51 per share.
Aug. 17, 2003 Sold 2,500 shares at $33 per share.
The end-of-year market prices for the shares were as follows:
Dec. 31, 2001 $47 per share
Dec. 31, 2002 $39 per share
Dec. 31, 2003 $31 per share
Fox Company classifies the NOP stock as trading securities.
1. Determine the amount of (a) realized gain or loss and (b) unrealized gain or loss to be re-
Required:
ported on the income statement each year relating to the NOP stock.
2. How would your answer to (1) change if the securities were classified as available-for-sale?
Explain.
601
f602 Investments In Debt And Equity Securities
Part 3 EOC Investing and Financing Activities



PROBLEM 12-3 TRADING AND AVAILABLE-FOR-SALE SECURITIES
Lorien Technologies, Inc., purchased the following securities during 2002:

Market Value
Security Classification Cost (12/31/02)

A Trading $ 5,000 $ 4,000
B Trading 7,000 10,000
C Available-for-sale 10,000 8,000
D Available-for-sale 6,000 3,500


The following transactions occurred during 2003:
a. On January 1, 2003, Lorien purchased Security E for $12,000. Security E is classified as
available-for-sale.
b. On March 23, 2003, Security B was sold for $4,700.
c. On July 23, 2003, Security C was sold for $19,500.
The remaining securities had the following market values as of December 31, 2003:

Market
Security Value

A $ 4,500
D 5,000
E 13,000


1. Determine the amount of (a) realized gain or loss and (b) unrealized gain or loss to be re-
Required:
ported relating to Lorien™s trading securities for 2003.
2. Determine the amount of (a) realized gain or loss and (b) unrealized gain or loss to be re-
ported relating to Lorien™s available-for-sale securities for 2003. Which amounts will ap-
pear on the income statement?

PROBLEM 12-4 INVESTMENTS IN TRADING SECURITIES
In December 2003, the treasurer of Marble Company concluded that the company had excess
cash on hand and decided to invest in Sandy Corporation stock. The company intends to hold
the stock for a period of 6 to 12 months and classifies the security as trading. The following
transactions took place:
Jan. 1 Purchased 5,500 shares of Sandy Corporation stock for $82,500.
Apr. 15 Received a cash dividend of $0.65 per share on the Sandy Corporation stock.
May 22 Sold 1,500 shares of the Sandy Corporation stock at $20 per share for cash.
July 15 Received a cash dividend of $0.45 per share on the Sandy Corporation stock.
Aug. 31 Sold the balance of the Sandy Corporation stock at $8 per share for cash.
Required: Prepare the appropriate journal entries to record each of these transactions.

PROBLEM 12-5 INVESTMENTS IN DEBT AND EQUITY SECURITIES
Menlo Company often invests in the debt and equity securities of other companies as short-
term investments. During 2003, the following events occurred:
July 1 Menlo purchased the securities listed here:

Security Type Classification Cost

1 Debt Trading $28,800
2 Equity Trading 27,600
3 Equity Trading 46,800
4 Equity Available-for-sale 16,800
602 f603
Investments In Debt And Equity Securities Investments in Debt and Equity Securities EOC Chapter 12


Sep. 30 Menlo received a cash dividend of $1,500 on Security 2.
Dec. 1 Menlo sold Security 4 for $14,800.
31 Menlo received interest of $2,600 on Security 1.
31 The market prices were quoted as follows: Security 1, $25,600; Security 2, $28,800;
Security 3, $45,000.

1. Prepare journal entries to record the events.
Required:
2. Illustrate how these investments would be reported on the balance sheet at December 31.
3. What items and amounts would be reported on the income statement for the year?

PROBLEM 12-6 UNIFYING CONCEPTS: SHORT-TERM INVESTMENTS IN
STOCKS AND BONDS
FRC Manufacturing Company produces and sells one main product. There is significant sea-
sonality in demand, and the unit price is quite high. As a result, during the heavy selling
season, the company generates cash that is idle for a few months. The company uses this
cash to acquire investments. The following transactions relate to FRC™s investments during
2003:

Mar. 15 Purchased 800 shares of Lewis Corporation stock at $25 per share, plus brokerage
fees of $624. This stock is classified as trading.
Apr. 1 Purchased $42,000 of 12% bonds of Martin Company. This investment is classi-
fied as available-for-sale.
June 3 Received a cash dividend of $1.80 per share on the Lewis Corporation stock.
Oct. 1 Received a semiannual interest payment of $2,520 on the Martin Company bonds.
10 Sold 600 shares of the Lewis Corporation stock at $29 per share less a $325 bro-
kerage fee.
Dec. 31 Recorded $1,260 of interest earned on the Martin Company bonds for the period
October 1, 2003, through December 31, 2003.
31 The market price of the Lewis Corporation stock was $22 per share; the market
price of the Martin Company bonds was $40,320.
Required: Prepare journal entries to record these transactions.

PROBLEM 12-7 RECORDING INVESTMENT TRANSACTIONS
The following data pertain to the investments of Sumner Company during 2003, the company™s
first year of operations:
a. Purchased 200 shares of Corporation A stock at $40 per share, plus brokerage fees of
$100. Classified as trading.
b. Purchased $10,000 of Corporation B bonds at face value. Classified as trading.
c. Received a cash dividend of $0.50 per share on the Corporation A stock.
d. Received interest of $600 on the Corporation B bonds.
e. Purchased 50 shares of Corporation C stock for $3,500. Classified as available-for-sale.
f. Received interest of $600 on the Corporation B bonds.
g. Sold 80 shares of Corporation A stock for $32 per share due to a significant decline in
the market.
h. Received a cash dividend of $1.40 per share on the Corporation C stock.
i. Interest receivable at year-end on the Corporation B bonds amounts to $200.
j. Market value of securities at year-end: Corporation A stock, $42 per share; Corporation
B bonds, $10,200; Corporation C stock, $3,450.

Enter these transactions in T-accounts, and determine each of the following for the year:
Required:
1. Dividend revenue.
2. Bond interest revenue.
3. Net gain or loss from selling securities.
4. Unrealized gain or loss from holding securities.
603
f604 Investments In Debt And Equity Securities
Part 3 EOC Investing and Financing Activities



PROBLEM 12-8 INVESTMENTS IN AVAILABLE-FOR-SALE SECURITIES
Durham Company often purchases common stocks of other companies as long-term invest-
ments. At the end of 2002, Durham held the common stocks listed. (Assume that Durham
Company exercises no significant influence over these companies; that is, they are classified as
available-for-sale securities.)

Number of Cost
Corporation Shares per Share

A 2,000 $ 70
B 3,000 50
C 1,500 148
D 1,000 82


Additional information for 2002:
Sep. 30 Durham received a cash dividend of $2.50 per share on Corporation A stock.
Dec. 31 The market prices were quoted as follows:
Corporation A stock, $64; Corporation B stock, $48;
Corporation C stock, $150; Corporation D stock, $78.
1. Illustrate how these investments would be reported on the balance sheet at December 31,
Required:
2002, and prepare the adjusting entry at that date.
2. What items and amounts would be reported on the income statement for 2002?
3. Prepare the journal entry for the sale of Corporation D stock for $74 per share in 2003.
4. Interpretive Question: Why are losses from the write-down of available-for-sale securi-
ties not included in the current year™s income, whereas similar losses for trading securities
are included?

PROBLEM 12-9 UNIFYING CONCEPTS: INVESTMENTS IN DEBT AND EQUITY
SECURITIES
On January 1, Draxton Company had surplus cash and decided to make some long-term in-
vestments. The following transactions occurred during the year:
Jan. 1 Purchased twenty $1,000, 12% bonds of Sifco Corporation at face value. Semian-
nual interest payment dates are January 1 and July 1 each year. The bonds are clas-
sified as available-for-sale.
Feb. 15 Purchased 4,000 shares of Porto Corporation stock at $35 per share, plus broker-
age fees of $1,500. The stock is classified as available-for-sale.
July 1 Received a semiannual interest payment on the Sifco Corporation bonds.
Sep. 30 Received an annual cash dividend of $1.50 per share on Porto Corporation stock.
Oct. 15 Sold 1,000 shares of the Porto Corporation stock at $42 per share.
Dec. 31 Adjusted the accounts to accrue interest on the Sifco Corporation bonds.
1. Prepare journal entries for these transactions.
Required:
2. The market quote for Sifco Corporation™s bonds at closing on December 31 was 104.
The Porto Corporation stock closed at $40 per share. Prepare a partial balance sheet
showing all the necessary data for these securities. Assume that Draxton exercises no sig-
nificant influence over its investees.

INVESTMENTS IN EQUITY SECURITIES
PROBLEM 12-10
On March 15, 2003, Boston Company acquired 5,000 shares of Richfield Corporation com-
mon stock at $45 per share as a long-term investment. Richfield has 50,000 shares of outstanding
voting common stock. Boston does not own any other stocks. The following additional events
occurred during the fiscal year ended December 31, 2003:
Dec. 1 Boston received a cash dividend of $2.50 per share from Richfield Corporation.
31 Richfield Corporation announced earnings for the year of $150,000.
31 Richfield common stock had a closing market price of $42 per share.
604 f605
Investments In Debt And Equity Securities Investments in Debt and Equity Securities EOC Chapter 12


1. What accounting method should be used to account for this investment? Why?
Required:
2. Prepare journal entries for the above transactions.
3. Prepare a partial income statement and balance sheet to show how the investments ac-
counts would be shown on the financial statements.


PROBLEM 12-11 INVESTMENT PORTFOLIO
General Corporation has the following investments in equity securities at December 31, 2002
(there are no existing balances in the market adjustment account):

Percentage
of Shares Market Price
Company Classification Shares Owned Cost at 12/31/02

Clarke Corporation Trading 1,000 2% $75 $78
Marlin Company Available-for-sale 4,000 15 34 32
Air Products, Inc. Available-for-sale 3,000 10 46 43



1. Prepare any adjusting entries required at December 31, 2002.
Required:
2. Illustrate how these investments would be presented on General Corporation™s balance
sheet at December 31, 2002. The available-for-sale securities are expected to be held for
two to five years.
3. Prepare the journal entry on April 10, 2003, when General Corporation sold the Clarke
Corporation investment for $72 per share.
4. Assume that General Corporation still owns its investment in Marlin Company and Air
Products at December 31, 2003; the market prices on that date are $37 for Marlin and
$44 for Air Products. Prepare all adjusting journal entries needed at December 31, 2003.




PROBLEM 12-12 INVESTMENTS IN HELD-TO-MATURITY SECURITIES
Cyril Corporation purchased $25,000 of Baker Construction Company™s 12% bonds at 102½
plus accrued interest on February 1, 2002. The bonds mature on April 1, 2009, and interest is
payable on April 1 and October 1. Cyril Corporation uses the straight-line method of amortiz-
ing bond premiums and discounts.
Required: 1. Record all journal entries to account for this investment during the years 2002 and 2003,
assuming that Cyril closes its books annually on December 31.
2. Interpretive Question: At the time these bonds were purchased (February 1, 2002), was
the market rate of interest above or below 12%? Explain.


INVESTMENTS IN HELD-TO-MATURITY SECURITIES
PROBLEM 12-13
On January 1, 2003, Eurowest Company purchased a $25,000, 12% bond at 104 as a long-
term investment. The bond pays interest annually on each December 31 and matures on De-
cember 31, 2005.
Assuming straight-line amortization, answer the following questions:
Required:
1. What will be the net amount of cash received (total inflows minus total outflows) from
this investment over its life?
2. How much cash will be collected each year?
3. How much premium will be amortized each year?
4. By how much will Investment in Held-to-Maturity Securities decrease each year?
5. How much revenue will be reported on the income statement each year relating to this
security?
605
f606 Investments In Debt And Equity Securities
Part 3 EOC Investing and Financing Activities



PROBLEM 12-14 DETERMINING THE PURCHASE PRICE OF HELD-TO-MATURITY
SECURITIES AND EFFECTIVE-INTEREST AMORTIZATION
Corbett Corporation decided to purchase twenty $1,000, 10%, six-year bonds of Texas Manu-
facturing Company as a long-term investment on February 1, 2002. The bonds mature on Feb-
ruary 1, 2008, and interest payments are made semiannually on February 1 and August 1.
Required: 1. How much should Corbett Corporation be willing to pay for the bonds if the current in-
terest rate on similar bonds is 8%?
2. Prepare a schedule showing the amortization of the bond premium or discount over the
remaining life of the bonds, assuming that Corbett Corporation uses the effective-interest
method of amortization.
3. How much bond interest revenue would be recorded each year if the straight-line
method of amortization were used? Show how these amounts differ from the annual in-
terest recognized using the effective-interest method. (Assume a fiscal year ending July
31.)
4. Interpretive Question: Which of the two amortization methods is preferable? Why?

PROBLEM 12-15 INVESTMENTS IN HELD-TO-MATURITY SECURITIES
Strong Equipment Company made the following purchases of debt securities during 2003. All
are classified as held-to-maturity, and all pay interest semiannually.

Last
Interest
Purchase Face Interest Maturity Payment
Date Corp. Amount Cost Rate, % Date Date

10/15/03 A $ 5,000 102 9 1/1/08 7/1/03
11/30/03 B 10,000 96 12 4/1/06 10/1/03
12/15/03 C 15,000 98 14 6/1/07 12/1/03
12/31/03 D 12,000 105 10¼ 5/1/04 11/1/03


Required: 1. Prepare journal entries for the purchases.
2. Show all adjusting entries relating to the bonds on December 31, 2003, assuming that
Strong Equipment Company closes its book on that date and uses the straight-line amor-
tization method.

PROBLEM 12-16 LONG-TERM INVESTMENTS IN EQUITY SECURITIES
Century Corporation acquired 8,400 common shares of Fidelity Company on January 10, 2003,
for $12 per share and acquired 15,000 common shares of Essem Corporation on January 25,
2003, for $22 per share. Fidelity has 60,000 shares of common stock outstanding, and Essem
has 50,000 shares outstanding. At December 31, 2003, the following information was obtained
about the operations of Fidelity and Essem:

Fidelity Essem

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $36,000.00 $100,000.00
Dividends paid per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.40 1.00
Market value per share at December 31, 2003 . . . . . . . . . . . . . . . 10.00 20.00


Assume that Century Corporation exerted significant influence over the policies of Essem Cor-
poration, but influenced the policies of Fidelity Corporation only to a very limited extent. Cen-
tury classified its investment in Fidelity as an available-for-sale security.
1. How should Century account for its investments in Essem Corporation?
Required:
2. Prepare the journal entries for each investment for the year 2003 using the method or
methods you selected in (1).
606 f607
Investments In Debt And Equity Securities Investments in Debt and Equity Securities EOC Chapter 12



PROBLEM 12-17 INVESTMENTS IN STOCKS”EQUITY METHOD
On April 20, 2003, Samson Company acquired 20,000 shares of Salem Industries common
stock at $38 per share as a long-term investment. Salem has 50,000 shares of outstanding vot-
ing common stock. The following additional information is presented for the calendar year ended
December 31, 2003:
Nov. 20 Samson received a cash dividend of $2 per share from Salem Industries.
Dec. 31 Salem announced earnings for the year of $135,000.
31 Salem Industries common stock had a closing market price of $35 per share.
Required: 1. Interpretive Question: What accounting method should be used by Samson Company
to account for this investment? Why?
2. Prepare journal entries for the transactions and events described.

PROBLEM 12-18 LONG-TERM INVESTMENTS IN STOCK”AVAILABLE-FOR-SALE
AND EQUITY METHOD
The following activities relate to the Hilton Company during the years 2002 and 2003:
2002
Feb. 15 Hilton purchased 5,000 shares of Brock Equipment stock for $35 per share.
Dec. 1 Hilton received a $1.25-per-share cash dividend from Brock Equipment.
31 Brock Equipment common stock had a closing market price of $32 per share. Brock™s
2002 net income was $60,000.
2003
July 1 Hilton sold all 5,000 shares of Brock Equipment stock for $37 per share.
Additional information: Brock Equipment had 25,000 shares of common stock outstanding on
January 1, 2002.
Required: 1. Prepare journal entries to record the transactions assuming:
a. The securities are classified as available-for-sale.
b. The equity method is used.
2. Show the amounts that would be reported on the financial statements of Hilton Com-
pany at December 31, 2002, under each assumption.
3. Interpretive Question: What is the minimum number of shares of stock that Brock
could have outstanding in order for Hilton to use the equity method?

PROBLEM 12-19 LONG-TERM INVESTMENTS IN EQUITY SECURITIES
During January 2003, Danbury, Inc., acquired 40,000 shares of Corporation A common stock
for $24 per share. In addition, it purchased 5,000 shares of Corporation B preferred (nonvot-
ing) stock for $112 per share. Corporation A has 160,000 shares of common stock outstand-
ing, and Corporation B has 12,000 shares of nonvoting stock outstanding. Danbury anticipates
holding both securities for at least five years.
The following data were obtained from operations during 2003:

2003

Net income:
Corporation A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $190,000
Corporation B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Dividends paid (per share):
Corporation A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $0.60
Corporation B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.50
Market value per share at December 31:
Corporation A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 25
Corporation B . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
607
f608 Investments In Debt And Equity Securities
Part 3 CEO Investing and Financing Activities



Required: 1. Interpretive Question: What method should Danbury, Inc., use in accounting for the
investment in Corporation A stock? Why? What accounting method should be used in
accounting for Corporation B nonvoting stock? Why?
2. Prepare the journal entries necessary to record the transactions for 2003.

PROBLEM 12-20 UNIFYING CONCEPTS: LONG-TERM INVESTMENTS IN STOCKS
AND BONDS
On January 2, 2003, Drexello, Inc., purchased $75,000 of 10%, five-year bonds of Greasy Truck-
ing as a held-to-maturity security at a price of $77,610 plus accrued interest. The bonds mature
on November 1, 2007, and interest is payable semiannually on May 1 and November 1. Drex-
ello uses the straight-line method of amortizing bond premiums and discounts.
In addition to the bonds, Drexello purchased 30% of the 50,000 shares of outstanding com-
mon stock of Mellon Company at $42 per share, plus brokerage fees of $450, on January 10,
2003. On December 31, 2003, Mellon announced that its net income for the year was $150,000
and paid an annual dividend of $2 per share as advised by the board of directors of Drexello.
The closing market price of Mellon common stock on December 31 was $38 per share.
Required: 1. Record all the 2003 transactions relating to these two investments in general journal
form.
2. Show how the long-term investments and the related revenues would be reported on the
financial statements of Drexello at December 31, 2003.




competency enhancement opportunities
LLL
LLLL




Analyzing Real Company Information The Debate
International Case Cumulative Spreadsheet Project
Ethics Case Internet Search
Writing Assignment




The following additional assignments provide opportunities for students to de-
velop critical thinking, ethical perspectives, oral and written communication
skills, experience with electronic research, and teamwork through group and
business activities.
L




ANALYZING REAL COMPANY INFORMATION
• Analyzing 12-1 (Microsoft)
The 1999 annual report for MICROSOFT is included in Appendix A. Locate that
annual report and consider the following questions:
1. Find Microsoft™s note on accounting policies. Using the information in that
note (under the heading “Financial Instruments”), determine what frac-
tion of Microsoft™s investment securities are classified as “available-for-
sale.”
2. In its note on “Cash and short-term investments,” Microsoft lists the gen-
eral types of investments that make up its $17.236 billion portfolio. Certifi-
cates of deposit are listed both as “cash and cash equivalents” and as
608 f609
Investments In Debt And Equity Securities Investments in Debt and Equity Securities CEO Chapter 12




“short-term investments.” What is the difference between these two cate-
gories? HINT: Go back to the note you looked at to answer (1).
3. Look at Microsoft™s stockholders™ equity statement. Where in the equity sec-
tion does Microsoft report the unrealized gains and losses from available-
for-sale securities?
• Analyzing 12-2 (Berkshire Hathaway)
The following note comes from the 1999 annual report of BERKSHIRE HATH-
AWAY:

(5) Investments in equity securities
Aggregate data with respect to the consolidated investment in equity securities are shown
below (in millions):


December 31, 1999
Unrealized Fair
Cost Gains Value

Common stock of:
American Express Company . . . . . . . . $ 1,470 $ 6,932 $ 8,402
The Coca-Cola Company . . . . . . . . . . 1,299 10,351 11,650
The Gillette Company . . . . . . . . . . . . . 600 3,354 3,954
Other equity securities . . . . . . . . . . . . . . 6,305 7,461 13,766
Other investments . . . . . . . . . . . . . . . . . 1,651 85 1,736
$11,325 $28,183 $39,508

December 31, 1998
Unrealized Fair
Cost Gains Value

Common stock of:
American Express Company . . . . . . . . $ 1,470 $ 3,710 $ 5,180
The Coca-Cola Company . . . . . . . . . . . 1,299 12,101 13,400
The Gillette Company . . . . . . . . . . . . . 600 3,990 4,590
Other equity securities . . . . . . . . . . . . . . 5,889 9,062 14,951
Other investments . . . . . . . . . . . . . . . . . 1,639 1 1,640
$10,897 $28,864 $39,761



Berkshire Hathaway also discloses that it classifies each of these investments
as an available-for-sale security.
1. All securities included in the tables in Berkshire Hathaway™s Note 5 are clas-
sified as available-for-sale. Make all journal entries that were required in
1999 to account for Berkshire Hathaway™s investments in:
a. AMERICAN EXPRESS COMPANY.
b. Other equity securities.
2. Did the performance of Berkshire Hathaway™s portfolio of equity securities
have any bright spots in 1999?
3. How has Berkshire Hathaway™s portfolio of equity securities performed over
time?
L




INTERNATIONAL CASE
• Sony
SONY CORPORATION was organized in 1946 under the name TOKYO TSUSHIN
KOGYO. The name “Sony” is a combination of the Latin word sonus (sound)
609
f610 Investments In Debt And Equity Securities
Part 3 CEO Investing and Financing Activities




and the English word sonny; it was given to a small transistor radio sold by
the company in the United States, starting in 1954. The radio was so popular
that the entire company changed its name to Sony in 1958.
In its 2000 annual report, Sony included the note to its financial statements
shown below.



(10) Marketable securities and securities investments
Yen in millions

March 31, 1999 March 31, 2000

Gross Gross Gross Gross
unrealized unrealized unrealized unrealized
Cost gains losses Fair value Cost gains losses Fair value

Available-for-sale:
Debt securities . . . . . . . . . ¥746,005 ¥36,632 ¥12,187 ¥770,450 ¥739,563 ¥ 40,646 ¥7,268 ¥772,941
Equity securities . . . . . . . . 57,712 13,774 3,156 68,330 55,321 66,905 2,594 119,632
Total . . . . . . . . . . . . . . . ¥803,717 ¥50,406 ¥15,343 ¥838,780 ¥794,884 ¥107,551 ¥9,862 ¥892,573

Dollars in millions

March 31, 2000

Gross Gross
unrealized unrealized
Cost gains losses Fair value

Available-for-sale:
Debt securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $6,977 $ 384 $69 $7,292
Equity securities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 522 631 24 1,129
Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,499 $1,015 $93 $8,421



1. In the notes to its English-language financial statements, Sony states that
those statements “conform with accounting principles generally accepted
in the United States.” However, Sony™s official accounting records are main-
tained using Japanese accounting principles. Why would Sony go to the
trouble of preparing a separate set of English-language financial statements
using U.S. accounting principles?
2. Assuming that approximately the same available-for-sale securities were
on hand in both 1999 and 2000, how well did Sony™s investments perform
in 2000?
3. What journal entries did Sony make during the year to record the revalu-
ation of available-for-sale securities? Use only the total amounts (that is,
don™t use the separate amounts for debt and equity securities), and ignore
the fact that securities were bought and sold during the year.
L




ETHICS CASE
• Is It OK to Strategically Classify Securities?
You have recently been hired as a staff assistant in the office of the chairman
of the board of directors of Clefton, Inc. Because you have some background
in accounting, the chairman has asked you to review the preliminary financial
statements that have been prepared by the company™s accounting staff. After
610 f611
Investments In Debt And Equity Securities Investments in Debt and Equity Securities CEO Chapter 12




the financial statements are approved by the chairman of the board, they will
be audited by external auditors. This is the first year that Clefton has had its
financial statements audited by external auditors.
In examining the financial statement note on investment securities, you no-
tice that all of the securities that had unrealized gains for the year have been
classified as trading, whereas all of the securities that had unrealized losses
have been classified as available-for-sale. You realize that this has the impact
of placing all the gains on the income statement and hiding all the losses in
the equity section of the balance sheet. You call the chief accountant who con-
firms that the securities are not classified until the end of the year and that the
classification depends on whether a particular security has experienced a gain
or a loss during the year. The chief accountant states that this policy was
adopted, with the approval of the chairman of the board, in order to maximize
the reported net income of the company. The chief accountant tells you that
investment security classification is based on how management intends to use
those securities; therefore, management is free to classify the securities in any
way it wishes.
You are uncomfortable with this investment security classification strategy.
You are also dismayed that the chief accountant and the chairman of the board
seem to have agreed on this scheme to maximize reported income. You are
also worried about what the external auditors will do when they find out about
this classification scheme. You have been asked to report to the chairman of
the board this afternoon to give your summary of the status of the preliminary
financial statements. What should you do?
L




WRITING ASSIGNMENT
• Why Doesn™t the Gain Go on the Income Statement?
You are the controller for Chong Lai Company. You just received a very strongly
worded e-mail message from the president of the company. The president has
learned that a $627,000 gain on a stock investment made by the company last
year will not be reported in the income statement because you have classified
the security as available-for-sale. With the gain, the company would report a
record profit for the year. Without the gain, profits are actually down slightly
from the year before. The president wants an explanation”now.
It has been your policy for the past several years to routinely classify all
investments as available-for-sale. Your company is not in the business of ac-
tively buying and selling stocks and bonds. Instead, all investments are made
to strengthen relationships with either suppliers or major customers. As such,
your practice is to buy securities and hold them for several years.
Write a one-page memo to the president explaining the rationale behind
your policy of security classification.
L




THE DEBATE
• Market Values Do Not Belong in the Financial Statements!
Accounting traditionalists opposed the move to report investment securities in
the balance sheet at their current market value. These traditionalists complain
that inclusion of market values reduces the reliability of the financial statements
and introduces an unnecessary amount of variability in the reported numbers.
On the other hand, supporters of reporting market values claim that market
values are extremely relevant and, for investment securities traded on active
markets, are reliable as well.
611
f612 Investments In Debt And Equity Securities
Part 3 CEO Investing and Financing Activities




Divide your group into two teams.

• One team represents “Market Value.” Prepare a two-minute oral presen-
tation arguing that the market value of investment securities should be re-
ported in the balance sheet. To do otherwise is to make the statements an
out-of-date curiosity rather than a useful tool.
• The other team represents “Historical Cost.” Prepare a two-minute oral pre-
sentation arguing for a return to strict historical cost in the balance sheet.
L


CUMULATIVE SPREADSHEET PROJECT
This spreadsheet assignment is a continuation of the spreadsheet assignments
given in earlier chapters. If you completed those spreadsheets, you have a head
start on this one.
This assignment is based on the spreadsheet prepared in part (1) of the
spreadsheet assignment for Chapter 9. Review that assignment for a summary
of the assumptions made in preparing a forecasted balance sheet, income state-
ment, and statement of cash flows for 2003 for Handyman Company. Using
those financial statements, complete the following exercise.
Handyman has decided that, in 2003, it will create an available-for-sale in-
vestment portfolio. Handyman plans to invest $20 million in a variety of stocks
and bonds. (Recall that the numbers in the Handyman spreadsheet are in mil-
lions.) As of the end of 2002, Handyman has no investment portfolio. Adapt
your spreadsheet to include this expected $20 million investment portfolio as
a current asset in 2003. Ignore the possibility of any interest, dividends, gains,
or losses on this portfolio. Answer the following questions:
1. With the assumptions built into your spreadsheet, where will Handyman
get the $20 million in funding necessary to acquire these investment se-
curities?
2. Where in the statement of cash flows did you put the cash outflow asso-
ciated with the acquisition of these investment securities? Explain your
placement.
L




INTERNET SEARCH
• Berkshire Hathaway
The history of BERKSHIRE HATHAWAY was outlined at the beginning of this chap-
ter. Access Berkshire Hathaway™s Web site at http://www.berkshirehathaway.
com. Sometimes Web addresses change, so if this address doesn™t work, access
the Web site for this textbook (http://albrecht.swcollege.com) for an updated link.
Once you™ve gained access to the site, answer the following questions:
1. Berkshire Hathaway can be described as primarily a holding company,
which is a company that has no real operations of its own but instead holds
ownership shares of other companies. Berkshire Hathaway™s Web site of-
fers links to a number of the subsidiaries that it holds. What are some of
these subsidiaries?
2. Warren Buffett writes the best “Chairman™s Letters to Shareholders” in cor-
porate America. A historical collection of these letters is included in Berk-
shire Hathaway™s Web site. Look at the 1994 letter and find out whom War-
ren Buffett quoted on the dangers of hard work.
3. Berkshire Hathaway has two classes of common stock. What does the Web
site say about the difference between them?
4. Berkshire Hathaway is constantly making new investments. Search the Web
site for recent news releases and identify the most recent investments.
comprehensive problem 9“12
Hannah Company started business on January 1, 2002. The following transactions and events
occurred in 2002 and 2003. For simplicity, information for sales, inventory purchases, collec-
tions on account, and payments on account is given in summary form at the end of each year.
2002
Jan. 1 Issued 100,000 shares of $1-par common stock to investors at $20 per share.
1 Purchased a building for $550,000. The building has a 25-year expected useful life
and a $50,000 expected salvage value. Hannah uses the straight-line method of de-
preciation.
1 Leased equipment under a five-year lease. The five lease payments of $30,000 each
are to be made on December 31 of each year. The cash price of the equipment is
$113,724. This lease is accounted for as a capital lease with an implicit interest rate
of 10%. The equipment has a five-year useful life and zero expected salvage value;
Hannah uses straight-line depreciation with all of its equipment.
Feb. 1 Borrowed $1.5 million from Burtone Bank. The loan bears an 11% annual inter-
est rate. Interest is to be paid each year on February 1. The principal on the loan
will be repaid in four years.
Mar. 1 Purchased 40,000 shares of Larry Company for $35 per share. Hannah classifies this
as an investment in trading securities. These securities are reported as a current as-
set.
July 15 Purchased 50,000 shares of Frances Ann Company for $21 per share. Hannah clas-
sifies this as an investment in available-for-sale securities. These securities are re-
ported as a long-term asset.
Nov. 17 Declared a cash dividend of $0.25 per share, payable on January 15, 2003.
Dec. 31 Made the lease payment.
31 The Larry Company shares had a market value of $30 per share. The Frances Ann
Company shares had a market value of $27 per share.
Summary
a. Sales for the year (all on credit) totaled $800,000. The cost of inventory sold was $350,000.
b. Cash collections on credit sales for the year were $370,000.
c. Inventory costing $420,000 was purchased on account. (Hannah Company uses the per-
petual inventory method.)
d. Payments on account totaled $400,000.

2003
Jan. 1 Issued $500,000 in bonds at par value. The bonds have a stated interest rate of 8%,
payable semiannually on July 1 and January 1.
1 The estimated useful life and salvage value for the building were changed. It is now
estimated that the building has a remaining life (as of January 1, 2003) of 20 years.
Also, it is now estimated that the building will have no salvage value. These changes
in estimate are to take effect for the year 2003 and subsequent years.
15 Paid the cash dividend declared in November 2002.
Feb. 1 Hannah Company repurchased 10,000 shares of its own common stock to be held
as treasury stock. The price paid was $37 per share.
1 Paid the interest on the loan from Burtone Bank.
Apr. 10 Sold all 40,000 shares of the Larry Company stock. The shares were sold for $28
per share.
July 1 Paid the interest on the bonds.
Oct. 1 Retired the bonds that were issued on January 1. Hannah had to pay $470,000 to
retire the bonds. This amount included interest that had accrued since July 1.
Nov 20 Declared a cash dividend of $0.40 per share. The dividend applies only to out-
standing shares, not to treasury shares.
613
f614 Investments In Debt And Equity Securities
Part 3 Comprehensive Problem 9-12


Dec. 31 Made the lease payment.
31 After recording depreciation expense for the year, the building was evaluated for
possible impairment. The building is expected to generate cash flows of $20,000
per year for its 19-year remaining life. The building has a current market value of
$325,000.
31 The Frances Ann Company shares had a market value of $18 per share.
Summary
a. Sales for the year (all on credit) totaled $1.7 million. The cost of inventory sold was
$800,000.
b. Cash collections on credit sales for the year were $1.43 million.
c. Inventory costing $900,000 was purchased on account.
d. Payments on account totaled $880,000.
1. Prepare all journal entries to record the information for 2002. Also prepare any necessary
Required:
adjusting entries.
2. Prepare a trial balance as of December 31, 2002. There is no need to show your ledger T-
accounts; however, preparing and posting to T-accounts may aid in the preparation of the
trial balance.
3. Prepare an income statement for the year ended December 31, 2002, and a balance sheet
as of December 31, 2002.
4. Prepare all journal entries to record the information for 2003. Also prepare any necessary
adjusting entries.
5. Prepare a trial balance as of December 31, 2003. (As you compute the amounts to include
in the trial balance, don™t forget the beginning balances left over from 2002.)
6. Prepare an income statement for the year ended December 31, 2003, and a balance sheet
as of December 31, 2003.
The Statement
of Cash Flows

chapter



13
f13
learning objectives After studying this chapter, you should be able to:


1 Understand the purpose of a 3 Prepare a simple statement 5 Use information from the
statement of cash flows. of cash flows. statement of cash flows to
make decisions.
2 Recognize the different types 4 Analyze financial statements
of information reported in to prepare a statement of
the statement of cash flows. cash flows.
616 chapter f13
The Statement Of Cash Flows


HOME DEPOT is the leading retailer in the age sales for 75 days. By 1985, the num-
“do-it-yourself” home handyman market. ber of days™ sales in inventory had in-
In January 2000, Home Depot had 913 creased to 83 days. Combined with Home
stores in the United States, five Canadian Depot™s rapid growth, this inventory inef-
provinces, and Chile. With each store av- ficiency caused total inventory to increase
eraging 108,000 square feet (and an addi- by $69 million in 1985, and this increase in
tional 24,000 square feet in the outside gar- inventory was instrumental in Home De-
den center), a lot of shelf space is filled pot™s negative cash from operations of $43
with paint, lumber, hardware, and plumb- million. Concerns about this declining
ing fixtures. If plumbing fixtures don™t profitability and negative cash flow caused
seem very exciting to you, consider this: Home Depot™s stock value to take a dive in
Home Depot is the 22nd largest company 1985, and the beginning of 1986 found
in the United States (in terms of market Home Depot wondering where it would
value), with a 2000 market value of $122.9 find the investors and creditors to finance
billion.1 And if lumber and hardware seem its aggressive expansion plans. Exhibit
obsolete in this high-tech world, consider 13-1 summarizes the differences between
that, for the past 10 years, Home Depot™s Home Depot™s reported net income and
earnings per share (EPS) have grown an the company™s cash flow from operations
average of 30.4% per year, close to the for the fiscal years 1984 through 1986 as
32.2% annual growth in EPS experienced well as the company™s recent performance.
by high-flying INTEL during the same pe- Home Depot™s current success is the
riod. In fiscal 1999, Home Depot™s sales result of an incredible operating cash flow
reached $38.4 billion.2 turnaround that the company pulled off
But Home Depot™s prospects weren™t in fiscal 1987. Operating income almost
always so rosy. Back in 1985, when sales tripled compared to fiscal 1986, and net in-
were only $700 million, Home Depot ex- come increased from $8.2 million to $23.9
perienced cash flow problems, in large million. A computerized inventory man-
part due to rapid increases in the level of agement program was instituted, and the
inventory. Part of this inventory increase number of days™ sales in inventory dropped
was the natural result of Home Depot™s ex- to 80 days. Improved profitability and more
setting the stage
pansion. But Home Depot stores were also efficient management of inventory com-
starting to fill up with excess inventory be- bined to transform the negative $43 mil-
cause of lax inventory management. In lion operating cash flow in fiscal 1986 into
1983, the average Home Depot store con- positive cash from operations of $66 mil-
tained enough inventory to support aver- lion in fiscal 1987.



Home Depot™s Net Income and Cash Flows from Operations
exhibit 13-1


Fiscal Year Ended

February 2, February 3, January 29,
(in thousands) 1986 1985 1984

Net earnings $ 8,219 $14,122 $ 10,261
Net cash provided by operations (43,120) (3,056) (10,574)

Fiscal Year Ended

January 30, January 31, February 1,
(in thousands) 2000 1999 1998

Net earnings $2,320,000 $1,614,000 $1,160,000
Net cash provided by operations 2,446,000 1,917,000 1,029,000




1 See the Fortune 500 listing at http://www.fortune.com.
2 January 30, 2000, 10-K filing of The Home Depot, Inc.
617
f618 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting


In this chapter, we will study the statement of cash flows. You will learn that this statement provides
one of the earliest warning signs of cash concerns of the type experienced by Home Depot. The state-
ment of cash flows alerts financial statement readers to increases and decreases in cash as well as to
the reasons and trends for the changes.
In today™s business environment, it is not enough simply to monitor earnings and earnings per
share measurements. An entity™s financial position and especially its inflows and outflows of cash are
also critical to its financial success.
The three primary financial statements were introduced and illustrated in Chapter 2. In subse-
quent chapters, we examined in detail the components of the balance sheet and income statement. For
our discussion of the statement of cash flows, we will first describe the purpose and general format of
a statement of cash flows. We will then show how easy it is to prepare a statement of cash flows if de-
tailed cash flow information is available. A statement of cash flows can also be prepared based on an
analysis of balance sheet and income statement accounts. We will also distinguish between the direct
and indirect methods of reporting operating cash flows and discuss the usefulness of the statement of
cash flows. Finally, we will explain how the statement of cash flows can be used to make investment
and lending decisions.




1 WHAT™S THE PURPOSE OF A STATEMENT OF
CASH FLOWS?
Understand the purpose of
a statement of cash flows.
The statement of cash flows, as its name implies, summarizes a company™s cash flows for a pe-
statement of cash flows
riod of time. It provides answers to such questions as, “Where did our money come from?” and
The financial statement that
“Where did our money go?” The statement of cash flows explains how a company™s cash was
shows an entity™s cash in-
generated during the period and how that cash was used.
flows (receipts) and out-
flows (payments) during a You might think that the statement of cash flows is a replacement for the income state-
period of time.
ment, but the two statements have two different objectives. The income statement, as you know,
measures the results of operations for a period of time. Net income is the accountant™s best es-
timate at reflecting a company™s economic performance for a period. The income statement pro-
vides details as to how the retained earnings account changes during a period and ties together,
in part, the owners™ equity sections of comparative balance sheets.
The statement of cash flows, on the other hand, provides details as to how the cash ac-
count changed during a period. The statement of cash flows reports the period™s transactions
and events in terms of their impact on cash. In Chapter 4, we compared the cash-basis and
accrual-basis methods of measuring income and explained why accrual-basis income is consid-
ered a better measure of periodic income. The statement of cash flows provides important in-
formation from a cash-basis perspective that complements the income statement and balance
sheet, thus providing a more complete picture of a company™s operations and financial posi-
tion. It is important to note that the statement of cash flows does not include any transactions
or accounts that are not already reflected in the balance sheet or the income statement. Rather,
the statement of cash flows simply provides information relating to the cash flow effects of
those transactions.
Users of financial statements, particularly investors and creditors, need information about
a company™s cash flows in order to evaluate the company™s ability to generate positive net cash
flows in the future to meet its obligations and to pay dividends. In some cases, careful analysis
of cash flows can provide early warning of impending financial problems, as was the case with
HOME DEPOT.
Before moving on, it is important to reiterate that the statement of cash flows does not re-
place the income statement. The income statement summarizes the results of a company™s op-
erations, whereas the statement of cash flows summarizes a company™s inflows and outflows of
cash. Information contained in the income statement can be used to facilitate the preparation
of a statement of cash flows; information in the statement of cash flows sheds some light on the
company™s ability to generate income in the future. The statement of cash flows and the income
statement provide complementary information about different aspects of a business.
618 f619
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows




to summarize
The statement of cash flows, one of the three primary financial statements,
provides information about the cash receipts and payments of an entity dur-
ing a period. It provides important information that complements the income
statement and balance sheet.




WHAT INFORMATION IS REPORTED IN THE
2
STATEMENT OF CASH FLOWS?
Recognize the different
types of information
reported in the statement of Accounting standards include specific requirements for the reporting of cash flows. The general
cash flows.
format for a statement of cash flows, with details and dollar amounts omitted, is presented in
cash equivalents Short- Exhibit 13-2. As illustrated, the inflows and outflows of cash must be divided into three main
term, highly liquid invest-
categories: operating activities, investing activities, and financing activities. Further, the state-
ments that can easily be
ment of cash flows is presented in a manner that reconciles the beginning and ending balances
converted into cash.
of cash and cash equivalents. Cash equivalents are short-term, highly liquid investments that
can easily be converted into cash. Generally, only investments with maturities of three months
or less qualify as cash equivalents. Examples are U.S. Treasury bills, money market funds, and
commercial paper (short-term debt issued by corporations). In this chapter, as is common in
practice, the term cash will be used to include cash and cash equivalents.
net work
Speaking of cash, what is
Major Classifications of Cash Flows
the largest denomination
ever printed by the U.S.
Exhibit 13-3 shows the three main categories of cash inflows and outflows”operating, invest-
Treasury Department? Go
to http://www.ustreas.gov/ ing, and financing. Exhibit 13-4 summarizes the specific activities included in each category. Be-
currency to find out.
ginning with operating activities, each of the cash flow categories will be explained. We will also
discuss the reporting of significant noncash transactions and events.

Operating activities include those transactions and events that
OPERATING ACTIVITIES
enter into the determination of net income. Cash receipts from the sale of goods or services are
the major cash inflows for most businesses. Other inflows are cash receipts for interest revenue,
dividend revenue, and similar items. Major outflows of cash are for the purchase of inventory
and for the payment of wages, taxes, interest, utilities, rent, and similar expenses. As we will ex-
plain later, the amount of cash provided by (or used in) operating activities is a key figure and
operating activities Trans-
should be highlighted on the statement of cash flows.
actions and events that en-
Note that our focus in analyzing operating activities is to determine cash flows from oper-
ter into the determination
of net income. ations. An analysis is required to convert income from an accrual-basis to a cash-basis number.



General Format for a Statement of Cash Flows
exhibit 13-2


Cash provided by (used in):
Operating activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $XXX
Investing activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX
Financing activities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX
Net increase (decrease) in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . $XXX
Cash and cash equivalents at beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . . . XXX
Cash and cash equivalents at end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $XXX
619
f620 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting



The Flow of Cash
exhibit 13-3


Cash received Cash received
Cash received
from investing from financing
from operating
activities activities
activities




Inflows




Cash and cash
equivalents



fyi
Outflows
Although cash inflows from in-
terest and dividends logically
might be classified as financing
Cash paid
Cash paid Cash paid
activities, the FASB has de-
for investing
for operating for financing
cided to classify them as oper- activities
activities activities
ating activities, which con-
forms to their presentation on
the income statement.
To do this, we begin with the net income figure, remove all items relating to investing
activities (such as depreciation and gains/losses on the sale of equipment) and financing activi-
ties (such as gains/losses on retirement of debt), and then adjust for changes in those current as-
sets and current liabilities that involve cash and relate to operations (which are most of the cur-
rent assets and current liabilities).


Operating activities, in-
cluding the sale of goods,
help determine net income
and are reported on the
statement of cash flows.
620 f621
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows



Major Classifications of Cash Flows
exhibit 13-4


Operating Activities
Cash receipts from:
Sale of goods or services
Interest revenue
Dividend revenue
Sale of investments in trading securities
Cash payments to:
Suppliers for inventory purchases
Employees for services
Governments for taxes
Lenders for interest expense
Brokers for purchase of trading securities
Others for other expenses (e.g., utilities, rent)

Investing Activities
Cash receipts from:
Sale of property, plant, and equipment
Sale of a business segment
Sale of investments in securities other than trading securities
Collection of principal on loans made to other entities
Cash payments to:
Purchase property, plant, and equipment
Purchase debt or equity securities of other entities (other than trading securities)
Make loans to other entities

Financing Activities
Cash receipts from:
Issuance of own stock
Borrowing (e.g., bonds, notes, mortgages)
Cash payments to:
Stockholders as dividends
Repay principal amounts borrowed
investing activities Transac- Repurchase an entity™s own stock (treasury stock)
tions and events that in-
volve the purchase and sale
of securities (excluding
cash equivalents), property,
Transactions and events that involve the purchase and sale of se-
INVESTING ACTIVITIES
plant, equipment, and other
assets not generally held curities (other than trading securities), property, buildings, equipment, and other assets not gen-
for resale, and the making
erally held for resale, and the making and collecting of loans are classified as investing activi-
and collecting of loans.
ties. These activities occur regularly and result in cash inflows and outflows. They are not classified
under operating activities because they relate only indirectly to the entity™s central, ongo-
fyi ing operations, which usually involve the sale of goods or services.
The analysis of investing activities involves identifying those accounts on the bal-
The purchase and sale of trad-
ance sheet relating to investments (typically long-term asset accounts) and then ex-
ing securities is classified as an
plaining how those accounts changed and how those changes affected the cash flows for
operating activity.
the period.

financing activities Transac-
tions and events whereby Financing activities include transactions and events whereby
FINANCING ACTIVITIES
resources are obtained
resources are obtained from or paid to owners (equity financing) and creditors (debt financ-
from, or repaid to, owners
ing). Dividend payments, for example, fit this definition. As noted earlier, the receipt of div-
(equity financing) and credi-
idends and interest and the payment of interest are classified under operating activities sim-
tors (debt financing).
621
f622 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting



business environment essay


The W. T. Grant Company™s Negative Act. Only four months later, the creditors™ committee
Cash Flows Perhaps the most famous voted for liquidation, and W. T. Grant ceased to exist.
case highlighting the deficiencies of Why didn™t creditors and stockholders see W. T.
accrual-basis net income was that of the Grant™s impending problems sooner? As the chart
W. T. GRANT COMPANY. In 1906, shows, net income and working capital provided by
William T. Grant opened his first 25-cent operations were of little help in predicting W. T.
store in Lynn, Massachusetts. Twenty- Grant™s problems, but a careful analysis of the com-
two years later, stock of the W. T. Grant pany™s cash flows would have revealed the problems
Company was offered for sale to the as much as a decade before the collapse.
public. By 1953, the company had ex- How could this happen? Oddly enough, firms were
panded to include over 500 stores, and the expansion not required to provide investors and creditors with in-
continued into the 1960s. In 1969 alone, 410 new formation about cash flows until 1987. Prior to that
stores were opened. In 1973, the company™s stock was time, companies prepared a statement of changes in
selling at nearly 20 times earnings and peaked at $705/8 financial position, which measured changes in current
assets and current liabilities. This statement of changes
per share. As late as September 1974, a group of
in financial position provided information that, if not
banks loaned the company $600 million.
carefully interpreted, could lead one to believe that a
A careful analysis of W. T. Grant™s financial state-
buildup of inventory and receivables was as good as
ments, however, would have indicated that although
money in the bank (as was the case with W. T. Grant).
the company was reporting profits through 1974, cash
The requirement of a statement of cash flows elim-
flows from operations were almost always negative
inated many of the alternatives used by companies to
from 1966 to 1975. Once the market realized the mag-
detail their liquidity position. Now, under generally ac-
nitude of W. T. Grant™s cash flow problems, it reacted
cepted accounting principles, companies must dis-
quickly. In December 1974, the company™s stock was
close their liquidity position in terms of cash. Had this
trading at $2 per share. The company closed 107 stores
standard been applied to W. T. Grant, the negative
and laid off 7,000 employees in September 1975. On
cash flows from operations would have been high-
October 2, 1975, the nation™s largest retailer filed for
lighted and easily detected.
protection under Chapter 11 of the National Bankruptcy




ply because they are reported as a part of income on the income statement. The receipt
fyi
or payment of the principal amount borrowed or repaid (but not the interest) is con-
The activities are typically
sidered a financing activity.
listed in this order: operating, Analyzing the cash flow effects of financing activities involves identifying those ac-
investing, and financing. How- counts relating to financing (typically long-term debt and common stock) and explaining
ever, there is no requirement how changes in those accounts affected the company™s cash flows. Exhibit 13-5 summa-
rizes the activities reflected on the statement of cash flows and indicates how the balance
that they be listed in this way.
sheet and income statement accounts relate to the various activities.
MICROSOFT, for example, uses
this order: operating, financing,
and investing.
Noncash Investing and Financing Activities
Some investing and financing activities do not affect cash. For example, equipment may be pur-
chased with a note payable, or land may be acquired by issuing stock. These noncash transac-
tions are not reported in the statement of cash flows. However, if a company has significant
noncash financing and investing activities, they should be disclosed in a separate schedule or in
a narrative explanation. The disclosures may be presented below the statement of cash flows or
in the notes to the financial statements.
622 f623
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows




Financial History of the W. T. Grant Company 1966“1975



W. T. Grant Company
Net Income, Working Capital,
and Cash Flows from Operations
For Fiscal Years Ending January 31, 1966 to 1975
Working Capital
Provided by
Operations
Net Income
40
Millions of Dollars




20
0
1966 1967 1968 1969 1970 1971 1972 1973 1974 1975
“20 Year Ending
January 31
“40



“100 Cash Flows
Provided by
Operations

“150




How Balance Sheet and Income Statement Accounts Relate to the Statement
exhibit 13-5
of Cash Flows


Cash Related Balance Chapters in Which
Flow Sheet and Income Accounts
Activity Statement Accounts Examples Were Covered

Operating All income statement accounts Sales, Cost of Goods Sold, Salaries Expense, etc. Chs. 6“8
except those income statement
items relating to:
• Investing Depreciation, Gains/Losses on Sale of Equipment Ch. 9
• Financing Gains/Losses on Retirement of Debt Ch. 10
Current assets Accounts Receivable Ch. 6
Inventory Ch. 7
Current liabilities Accounts Payable Ch. 7

Investing Long-term assets Property, Plant, and Equipment Ch. 9
Long-term investments Available-for-Sale and Held-to-Maturity Securities Ch. 12

Financing Long-term debt Bonds and Mortgages Ch. 10
Stockholders™ equity (except for Common Stock Ch. 11
net income in Retained Earnings) Dividends Ch. 11
623
f624 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting



Cash Flow Patterns
Most U.S. companies (about 70%) report positive cash flows from operations. That shouldn™t
come as a big surprise because companies need to generate cash from operating activities to sur-
vive in the long term. In addition, about 85% of U.S. companies report negative cash flows
from investing activities. Again, this is expected as companies must expand, enhance, or replace
long-term assets. Predicting whether the sign for cash from financing activities will be positive
or negative is more difficult. That sign depends on whether the company is young, growing,
and in need of cash, or mature, stable, and flush with cash. As a company proceeds through the
normal life cycle of a business, cash from financing typically will vary between positive and neg-
ative. As an example, in fiscal 2000 Home Depot reported positive cash flows from operations
($2.4 billion), negative cash flows from investing ($2.6 billion), and a small positive cash flow
from financing ($281 million).




to summarize
The statement of cash flows is presented in a manner that highlights three ma-
jor categories of cash flows: operating activities, investing activities, and fi-
nancing activities. In addition, the format of the statement should provide a
reconciliation of the beginning and ending balances of cash and cash equiva-
lents (short-term, highly liquid investments). Any significant noncash investing
and financing activities should be disclosed separately, either below the state-
ment of cash flows or in the notes to the financial statements.




3 PREPARING A STATEMENT OF CASH FLOWS”A
SIMPLE EXAMPLE
Prepare a simple statement
of cash flows.
Now that we have reviewed the three types of cash flow activities disclosed on the statement of
cash flows, let™s start with a simple example to see how easy (conceptually) a statement of cash
flows is to prepare. For this example, we will begin with the following trial balance information
for Silmaril, Inc.


Silmaril, Inc.
Trial Balance
January 1, 2002

Debit Credit

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 300
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,900
Property, Plant, and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Accumulated Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700
Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Long-Term Debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000
Retained Earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,560
Totals. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,700 $8,700
624 f625
The Statement Of Cash Flows Chapter 13
The Statement of Cash Flows


The following transactions were conducted by Silmaril, Inc., during 2002:
1. Sales on account, $13,500.
2. Collections on account, $14,000.
3. Purchased inventory on account, $7,900.
4. Cost of goods sold, $8,000.
5. Paid accounts payable, $8,100.
6. Purchased property, plant, and equipment for cash, $1,700.
7. Sold property, plant, and equipment for cash, $500 (original cost, $1,200; accumulated de-
preciation, $800).
8. Paid long-term debt, $200.
9. Issued stock at par value, $450.
10. Recorded depreciation expense, $500.
11. Paid interest on debt, $180.
12. Recorded interest owed (accrued) but not paid, $20.
13. Paid miscellaneous expenses (e.g., wages, supplies, etc.) for the period, $3,200.
14. Recorded tax expense for the period, $450.
15. Paid taxes during the period, $440.

With this information, we can reconstruct the journal entries made by Silmaril, Inc., during the
year:


1. Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,500
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,500
2. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000
Accounts Receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000
3. Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,900
Accounts Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,900
4. Cost of Goods Sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000
5. Accounts Payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,100
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,100
6. Property, Plant, and Equipment . . . . . . . . . . . . . . . . . . . . . . . . . 1,700
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700
7. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800
Property, Plant, and Equipment . . . . . . . . . . . . . . . . . . . . . . . 1,200
Gain on Sale of Equipment. . . . . . . . . . . . . . . . . . . . . . . . . . . 100
8. Long-Term Debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200
9. Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
Common Stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
10. Depreciation Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
Accumulated Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . 500
11. Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 180
12. Interest Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Interest Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
13. Miscellaneous Expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,200
14. Tax Expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450
15. Taxes Payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440
625
f626 Part 4 The Statement Of Cash Flows
Other Dimensions of Financial Reporting




business environment essay


The Statement of Cash Flows”A His- had begun reporting funds flow information several
torical Perspective The statement of years earlier. The funds statement provided useful in-
cash flows is a relatively new financial formation, but it had several limitations. First, APB
statement. In 1987, the Financial Ac- Opinion No. 19 allowed considerable flexibility in how
counting Standards Board (FASB) is- funds could be defined and how they were reported
sued an accounting standard, FASB on the statement. As a result, many companies re-
Statement No. 95, requiring that the ported on a working-capital basis (current assets mi-
statement of cash flows be presented as nus current liabilities), whereas others reported on a
one of the three primary financial state- cash basis or some other basis. Further, in each case,
ments. Previously, companies had been the individual company selected its own format. This
required to present a statement of changes in finan- inconsistency across companies made comparisons
cial position, often called the funds statement. In 1971, difficult.
APB Opinion No. 19 made the funds statement a re- Second, the funds statement, even when prepared

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