MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

CHAPTER 6

CASH FLOW ANALYSIS

I. Questions
1. Purposes of the Statement of Cash Flows
a. To predict future cash flows
b. To evaluate management decisions
c. To determine the ability to pay dividends to shareholders and
interest and principal to creditors
d. To show the relationship of net income to changes in the
businesss cash.
2. Comparative balance sheets present the financial position of the
enterprise at two points in time. The income statement for the period
between the two balance sheets describes how the income-producing
activities affected the financial position. Because cash flows from
operating activities may differ substantially from net income, and
because numerous other financing and investing activities have an
impact on financial position, the statement of cash flows is necessary.
The statement emphasizes changes in the cash balances that result from
changes in assets, liabilities and equity accounts caused by operating,
investing and financing activities.
3. The most important source of cash for many successful companies is
from operating activities. A large positive operating cash flow is a good
sign because it means funds have been internally generated with no fixed
obligations or commitment to return such to anybody.
4. It is possible for cash to decrease during a year when income is high
because cash may be used not only for operating activities but also for
investing and financing activities.
5. Transactions involving accounts payable are not considered to be
financing activities because such transactions are used to obtain goods
and services rather than to obtain cash. Furthermore, purchases of goods
and services relate to a companys day-to-day operating activities.

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6. The loss is added back to net income to avoid double counting since the
entire proceeds from the sale (net book value minus loss on sale) will
appear as a cash inflow from investing activities.
7. Three categories of transactions that may result in increases in cash are
a. Operating activities
b. Investing activities (e.g., sale of investments or other assets).
c. Financing activities (e.g., borrowing or sale of stock).
These activities are sources of cash when cash is increased as a result of
the particular activity.
8. Three categories of transactions that may result in decreases in cash are
a. Operating activities
b. Investing activities (e.g., purchase of investments or other assets).
c. Financing activities (e.g., repayment of debt or retirement of stock).
These activities are uses of cash when cash is decreased as a result of the
particular activity.
9. Noncash transactions do not provide or consume cash even though they
may result in significant changes in financial position. Examples are the
issuance of share capital for plant assets and the conversion of debt or
preference shares into ordinary shares. Such transactions are not
presented in the body of the statement of cash flows but rather disclosed
in a separate schedule as financing or investing activities.
10. While net loss is usually associated with a decrease in cash, it may be a
source of cash if noncash expenses are greater than the amount of the net
loss. For example, if a net loss of P100,000 included amortization and
depreciation of P125,000 and no noncash revenues existed, cash
provided by operating activities would be P25,000, computed as follows:

Net loss P(100,000)

Add: Expenses not requiring cash depreciation
and amortization 125,000
Net cash provided by operating activities P 25,000
11. The change in cash is the difference between cash at the beginning and
end of the accounting period. The net amount of cash provided by or
used in operating, investing and financing activities must equal this
change in cash. For example, if cash increased by P150,000 during the
year, total sources from operating, investing, and financing activities

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must exceed total uses by P150,000. Also, if cash decreased by P25,000

during the year, total uses of cash must exceed total sources by P25,000.
12. (a) The use of cash does not occur until the cash dividend is actually
paid in the next period. The declaration of the dividend does affect
financial position, however, and should be disclosed as a noncash
financing activity in a separate schedule accompanying the statement
of cash flows.
(b) Because the dividend was declared and paid in the same accounting
period, it appears in the statement of cash flows as a cash decrease in
the financing activities category.
13. Disagree. The refunding of 10% debt by the 8% debt represents a
significant financing activity, even though the net impact of the
exchange on the balance sheet or on the amount of cash is not material.
The issuance of 8% bonds and the retirement of 10% bonds should be
reported as noncash financing transactions in a schedule accompanying
the statement of cash flows.
14. The net income figure includes P150,000 as an expense. Only P112,500
of this amount resulted in a decrease in cash, because P37,500 represents
an increase in the deferred income tax liability account. In determining
cash provided by operating activities, the amount of income tax paid is
P112,500 (direct method). Alternatively, under the indirect method,
P37,500 must be added to net income to determine cash flows from
operating activities.
15. The loss is omitted when listing expenses requiring cash payment (direct
approach) or added back to net income (indirect approach) in
determining cash provided by operating activities. This eliminates the
impact of the transaction from cash provided by operating activities.
Then, the proceeds from the sale are included as a source of cash in the
investing activities category of the statement of cash flows. Any tax
effects of the transaction are included in the tax expense figure and
remain a part of cash flows from operating activities.

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II. Problems

Problem 1

Transaction Operating Investing Financing Source Use

1. Short-term investment
securities were
purchased .................... X X
2. Equipment was
purchased .................... X X
3. Accounts payable
increased ..................... X X
4. Deferred taxes
decreased..................... X X
5. Long-term bonds were
issued .......................... X X
6. Ordinary shares were
sold.............................. X X
7. Interest was paid to
long-term creditors ..... X X
8. A long-term mortgage
was entirely paid off ... X X
9. A cash dividend was
declared and paid ........ X X
10. Inventories decreased ... X X
11. Accounts receivable
increased....................... X X
12. Depreciation charges
totaled P200,000 for
the year ......................... X X

Problem 2 (Analysis of Cash Flow Transactions)

Requirement (a)

The eight items should be presented in the statement of cash flows as

follows:
1. Net income is the basis for the calculation of cash flows from operating
activities by starting with that number and adjusting for noncash revenue
and expense transactions (indirect method) or by computing by the direct
method the positive cash flows from revenues, less the negative cash

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flows from expenses. The cash flows from the transaction giving rise to
the extraordinary loss is reclassified as an investing activity.
2. The acquisition of intangibles is a negative cash flow from investing
activities. The amortization is a noncash expense in determining cash
flows from operating activities.
3. The payment of a cash dividend is a negative cash flow that is presented
in the financing activities section of the statement.
4. The purchase of treasury stock is a negative cash flow in the financing
activities section of the statement.
5. The depreciation expense recognized during the year is a noncash
expense in determining cash flows from operating activities.
6. The conversion of convertible bonds into ordinary shares is a noncash
financing activity that requires disclosure in a separate schedule.
7. The changes in plant asset accounts land, equipment, and building
represent activities whose cash flow effects are presented in the
investing activities section of the statement.
8. The increase in working capital also represents the change in cash
because all other current assets and current liabilities remained constant.
The net of all cash flows from operating, investing and financing
activities must reconcile with the change in cash in the statement of cash
flows.

Requirement (b)

1. Net cash provided by operating activities

Net income P145,000
Noncash expense adjustments:
Depreciation expense 46,250
Amortization expense 6,000
Reclassification of extraordinary loss 15,000
P212,250
2. Net cash used in investing activities
Purchase of intangible assets P (34,000)
Purchase of land (130,000)
Purchase of equipment (60,000)
Purchase of building (100,000)
Sale of land 165,000
P(159,000)

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3. Net cash used in financing activities

Purchase of treasury stock P(31,000)
Payment of dividends (12,500)
P(43,500)
Computations:
Depreciation expense
Change in accumulated depreciation account P35,000
Accumulated depreciation on fully depreciated
assets disposed 11,250
P46,250
Purchase of land
Change in land account P (50,000)
Cost of land sold in condemnation proceedings 180,000
P130,000

Problem 3 (Cash Flow from Operating Activities)

Cash received from customers:

Total revenues P185,000
Less: Note receivable (15,000) P170,000
Cash disbursed for expenses:
Total expenses (P173,000 + P4,200) P177,200
Less: Income taxes deferred (1,260)
Depreciation (25,000)
Amortization (7,000) (143,940)
Net cash provided by operating activities P 26,060

Problem 4 (Cash Flow from Operating Activities)

Cash received from customers (1) P5,237,000

Cash paid for expenses:
Cost of goods sold P3,150,000
Selling 246,000
Salaries and wages (2) 394,400
Interest (3) 65,200
Miscellaneous operating 5,000
Incomes taxes (4) 335,000 4,195,600
Net cash provided by operating activities P1,041,400

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Computations:
1. Revenue from sales P5,432,000
Less: Note receivable (120,000)
Land (75,000)
P5,237,000

2. Salaries and wages expense P 400,000

Less: Increase in accrued salaries and wages
(P45,600 P40,000) (5,600)
P 394,400

3. Interest expense P 72,000

Less: Discount amortization (6,800)
P 65,200

4. Income tax expense P 445,000

Less: Deferred portion (110,000)
P 335,000

Problem 5 (Statement of Cash Flows Preparation Indirect)

Green Tea Company

Statement of Cash Flows
For the Year Ended December 31, 2005

Cash flows from operating activities

Net income* P8,500
Adjustments to reconcile net income to net
cash flows provided by operating
activities:
Depreciation 1,000
Amortization of intangibles 1,000
Increase in current assets (6,000)
Increase in current liabilities 3,000
Net cash provided by operating activities P7,500

*
Increase in retained earnings (P20,000 P13,000) P7,000
Dividends declared 1,500
Net income P8,500

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Cash flows from financing activities

Dividends paid (1,500)
Retirement of long-term liabilities (1,000)
Net cash used in financing activities (2,500)
Net increase in cash P 5,000
Cash, January 1, 2005 10,000
Cash, December 31, 2005 P15,000

Problem 6 (Cash Flow Statement Preparation Direct)

Requirement (a)

Hundred Acre Company

Statement of Cash Flows
For the Year Ended December 31, 2005

Cash flows from operating activities

Cash received from customers P74,000
Cash paid for expense 67,000
Net cash provided by operating activities P7,000
Cash flow from investing activities
Sale of equipment 9,500
Sale of investments 15,000
Acquisition of equipment (53,000)
Net cash used in investing activities (28,500)
Cash flows from financing activities
Sale of ordinary shares 40,000
Payment of cash dividends (8,500)
Net cash used in financing activities 31,500
Net increase in cash P10,000
Cash, January 1, 2005 20,000
Cash, December 31, 2005 P30,000

Reconciliation of net income to net cash

provided by operating activities:
Net income P15,000
Adjustments to reconcile net income to net
cash provided by operating activities:

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Depreciation expense 24,500*

Amortization expense 1,000
Increase in accounts receivable (33,000)
Decrease in accrued expenses (500)
Net cash provided by operating activities P 7,000

Computations:
Cash received from customers:
Revenues P107,000
Deduct: Increase in accounts receivable
(P78,000 P45,000) 33,000
P 74,000
Cash paid for expenses:
Expenses P 92,000
Add: Decrease in accrued expenses
(P7,500 P7,000) 500
Deduct: Depreciation expense
(P33,600 P27,100 + P18,000) (24,500)
Amortization (1,000)
P 67,000
Cash from sale of equipment:
Cost P 27,500
Deduct: Accumulated depreciation (18,000)
Cash received on sale at book value P 9,500
Cash paid to acquire equipment:
Increase in property, plant and equipment
(P118,100 P92,600) P 25,500
Cost of machinery sold 27,500
P 53,000
Cash received on sale of stock:
Increase in ordinary shares amount
(P100,000 P75,000) P 25,000
Increase in additional paid-in capital account
(P55,000 P40,000) 15,000
P 40,000

*
Net increase during 2005 (P33,600 P27,100) P 6,500
Accumulated depreciation on assets sold 18,000
Depreciation expense for 2005 P24,500

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Cash dividends:
Increase in retained earnings (P21,000 P14,500) P 6,500
Net income (P107,000 P92,000) (15,000)
P 8,500

Requirement (b)

The reconciliation of net income to net cash provided by or used in operating

activities is required to be disclosed in order to show more clearly the
relationship and emphasize the differences between the two. Users of
financial statements are often not as aware of the accrual concepts, which
determine net income, as are preparers of those statements. The
reconciliation of net income to net cash flows from operating activities
clearly demonstrates that the two are different and details those events and
transactions that account for the difference.

Problem 7 (Interpretation of Cash Flow Statement)

Requirement (a)

The two companies are similar in the following respects:

1. Overall size.
2. Industry in which they operate.
3. Current ratio (2.4 to 1).
4. Overall peso amounts of cash provided and used:

Range, 2002-2005
Cash Provided Cash Used
Ebony Company P125,000 P168,000 P115,000 P170,000
Ivory Company P135,000 P160,000 P125,000 P165,000

5. Net increase in working capital is identical for each year, 2002

2005.

Requirement (b)

The two companies are dissimilar in the makeup of the sources of cash, as
indicated in the following analysis:

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Sources of Cash in Percentages

2002 2003 2004 2005
Ebony Ivory Ebony Ivory Ebony Ivory Ebony Ivory
Cash provided:
Operations 80 37 77 21 70 (38) 76 7
Long-term debt 8 56 -- 10 -- 44 9 --
Share capital -- -- 16 52 -- 63 -- 56
Asset disposition 12 7 7 17 30 31 15 37
100 100 100 100 100 100 100 100

Ebony Company has relied much more heavily on operations to provide cash
and to a very limited extent on debt and equity financing and asset
disposition. On the other hand, Ivory Company has not been able to provide
cash from operations and has been required to rely on the alternatives of debt
and equity financing and asset disposition.

Requirement (c)

Ebony Company is in a considerably stronger position (as determined by the

data given) and thus should be considered the better investment and credit
risk. The following points are significant:
1. Ebony Company has provided 70%-80% of its cash via operating
activities, supplementing with other means to maintain a current
ratio at the industry average. Ebony has not had to rely consistently
on any alternative source of funding.
2. Ivory Company has apparently been forced to rely continuously on
debt financing except in 2005, perhaps because of the inability to
obtain such financing. The year 2004 is particularly weak for Ivory,
with operations resulting in a P60,000 reduction in cash. The ability
of Ivory to sustain its present financial position (i.e., current ratio,
etc.) is questionable in light of its history.

III. Multiple Choice Questions

1. D 4. D 7. C 10. B
2. C 5. B 8. B 11. A
3. D 6. D 9. A 12. D

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