Solution manual intermediate accounting 15e by stice ch05

Chapter 175 CHAPTER QUESTIONS Cash flow from operations can offer a clearer picture of a company's performance than does net income when: • • • instruments purposes not intended for trading Financing activities include transactions and events whereby cash is obtained from or repaid to owners (equity financing) and creditors (debt financing) A company reports large noncash expenses, such as write-offs, depreciation, and provisions for future obligations Earnings may give an overly pessimistic view of the firm A company is growing rapidly Reported earnings may be positive, but operations are actually consuming rather than generating cash A company badly needs to report favorable earnings, as is the case before a major loan application or before a stock offering In these cases, cash flow from operations provides an excellent reality check for reported earnings The normal pattern of cash flow is • • • Operating—positive Investing—negative Financing—either positive or negative The predecessor to the statement of cash flows was called the statement of changes in financial position Preparers of the statement of changes were allowed to use either a cash emphasis or a working capital emphasis In addition, there was no single required format for the statement of changes in financial position The direct method reports all operating cash receipts and cash payments The difference between cash receipts and payments is the net cash flow from operations The indirect method begins with net income as reported on the income statement, adjusts for any noncash items (such as depreciation), and converts the accrual amounts to a cash basis The result of this reconciliation process is net cash flow from operations, which will be exactly the same amount as derived using the direct method To qualify as a cash equivalent when preparing a statement of cash flows, an item must be (a) readily convertible to cash, and (b) so near its maturity that there is insignificant risk of changes in value due to changes in interest rates As a general rule, only investments with original maturities of months or less qualify The original maturity is determined from the date of acquisition of the investment by the entity, not the date of original issuance of the security Many users favor the direct method because it is a straightforward approach that is easy to understand Most accountants prefer the indirect method because it is easy to apply and because it helps explain or reconcile the differences between net cash flow from operations and net income Because accountants already have to report net income, it is easier for them to start with that number and convert it to net cash flow from operations rather than use the direct method Operating activities include those transactions and events that enter into the determination of net income Cash receipts from selling goods or from providing services are the major cash inflow for most businesses Major cash outflows include payments to purchase inventory and to pay wages, taxes, interest, utilities, rent, and similar expenses Investing activities are the purchase and sale of land, buildings, and equipment and the purchase and sale of financial When the direct method is used, depreciation expense is omitted from the calculation of cash from operating 175 176 Chapter activities because it is a noncash expense When the indirect method is used, depreciation expense is added back to net income because depreciation was subtracted in the original computation of net income The statement, “Cash flow is equal to net income plus depreciation” is wrong because it ignores the impact on cash from operating activities of all the changes in current operating assets and current operating liabilities 10 FASB Statement No 95 treats interest payments as an operating activity in order to be consistent with the income statement presentation The FASB defines interest payments as operating activities because interest expense enters into the calculation of net income The FASB considered classifying interest payments as financing activities but ultimately decided on the operating activity classification 11 The “target number” is the net change in the cash balance, as shown in the balance sheet The sum of cash from operating, investing, and financing activities should equal the net change in cash 12 Cost of goods sold, combined with the change in the inventory balance, reveals how much inventory was purchased during the year Inventory purchases, coupled with the change in the accounts payable balance for the year, are used to calculate the amount of cash paid for inventory purchases 13 A loss on the sale of a long-term asset is omitted from the calculation of cash from operating activities when using the direct method When the indirect method is used, the loss is added back to net income because the loss was subtracted in the original computation of net income In both cases, any effects of the sale of the long-term asset are removed from the computation of operating cash flow; cash received from the sale of long-term assets is reported as an investing activity 14 The FASB has defined all transactions involving available-for-sale and held-tomaturity securities as investing activities Transactions involving trading securities are included in the operating activities section 15 If the direct method is used, a separate schedule must be presented to reconcile Chapter 177 net income to net cash provided by (used in) operating activities If a company elects to use the indirect method, the amounts paid during the period for interest and income taxes should be disclosed Regardless of the method used for reporting operating cash flows, companies must disclose any significant noncash investing and financing transactions The supplemental disclosures required by FASB Statement No 95 can be provided in the notes to the financial statements or in separate schedules accompanying the statement of cash flows shortfall in available cash, a company can either use the forecasted information in obtaining additional 16 Significant noncash investing and financing transactions (e.g., the purchase of land by issuing capital stock) are to be reported in the notes to the financial statements or in a separate schedule accompanying the cash flow statement Because these transactions not affect cash, they should not be reported on the statement of cash flows itself 17 Under FASB Statement No 95, interest paid is classified as an operating activity The provisions of IFRS allow interest paid to be classified as either an operating activity or a financing activity 18 The U.K number reported as cash from operating activities excludes items, such as interest and income taxes, that are included in the U.S measure of operating cash flow but that are widely viewed as being nonoperating activities 19 Cash from operations is usually larger than net income This is because of the large number of noncash expenses included in the income statement, such as depreciation, write-downs, and restructuring charges 20 When the value of a company’s cash flow adequacy ratio is less than 1.0, that company is not generating enough cash from operations to pay for all new plant and equipment purchases Accordingly, the company has no cash left over to repay loans or to distribute to investors 21 A forecasted statement of cash flows allows management to see the relationship between forecasted operating cash flow and the cash needed for investing activities If there is an expected 177 178 financing or the company can scale back its expansion plans in order to reduce the drain on cash 22 Lenders can use a forecasted statement of cash flows to see whether it seems likely Chapter that a company can continue to meet its existing debt obligations An investor can use the projected cash flow statement to evaluate the likelihood that a company will be able to continue making dividend payments Chapter 179 PRACTICE EXERCISES PRACTICE 5–1 CASH AND CASH EQUIVALENTS (a) Not cash equivalent because it is an equity investment; no maturity date (b) Cash equivalent of $5,700 because time to maturity at date of purchase was less than three months (c) Cash of $3,400 (d) Not cash equivalent because time to maturity at date of purchase was greater than three months $5,700 + $3,400 = $9,100 PRACTICE 5–2 THREE CATEGORIES OF CASH FLOWS Cash Inflow (Outflow) Operating (d) Cash collected from customers (b) Cash paid for interest (f) Cash paid for income taxes Total $10,000 (450) (1,320) $ 8,230 Investing (a) Cash received from sale of a building $ 5,600 Financing (c) Cash paid to repurchase shares of stock (treasury stock) (1,000) (e) Cash paid for dividends (780) Total $ (1,780) PRACTICE 5–3 Company A Company B Company C PRACTICE 5–4 CASH FLOW PATTERNS start up, high growth cash cow steady state NONCASH INVESTING AND FINANCING ACTIVITIES (a) (b) (c) (d) Investing $(40,000) 0 Total $(40,000) Financing $ 0 56,000 (30,000) $ 26,000 179 Noncash (Disclose only) $ 80,000 67,000 100,000 180 PRACTICE 5–5 Chapter GENERAL FORMAT FOR A STATEMENT OF CASH FLOWS Cash flow from operating activities Cash flow from investing activities Cash flow from financing activities Net decrease in cash Cash balance, beginning of year Cash balance, end of year PRACTICE 5–6 $ 4,300 (15,000) 10,000 $ (700) 3,200 $ 2,500 CASH COLLECTED FROM CUSTOMERS Accounts receivable, beginning $ 1,375 Plus: Sales 10,000 Cash available for collection $11,375 Less: Accounts receivable, ending 1,400 Cash collected from customers $ 9,975 PRACTICE 5–7 CASH PAID FOR INVENTORY PURCHASES Inventory, ending Plus: Cost of goods sold Required inventory Less: Beginning inventory Inventory purchased this year $2,500 5,300 $7,800 2,100 $5,700 Accounts payable, beginning $1,200 Plus: Inventory purchased this year 5,700 Accounts to be paid $6,900 Less: Accounts payable, ending 1,350 Cash paid for inventory purchases $5,550 PRACTICE 5–8 CASH PAID FOR OPERATING EXPENSES Prepaid operating expenses, ending$1,000 Plus: Operating expenses 3,800 Required cash outlay for operating expenses Less: Prepaid operating expenses, beginning Cash paid for operating expenses this year $4,800 700 $4,100 Chapter PRACTICE 5–9 Sales Cost of goods sold 181 DIRECT METHOD Income Statement Interest expense Depreciation expense Net income Adjustments + 290 – 500 – 130 – 60 + 800 $ 4,000 (1,700) (350) (800) $ 1,150 Direct Method: Cash collected from customers Cash paid for inventory purchases Cash paid for interest Net cash flow from operating activities (410) $ 1,550 $ 4,290 (2,330) (410) $ 1,550 PRACTICE 5–10 INDIRECT METHOD Sales Cost of goods sold Income Statement $ 4,000 (1,700) Interest expense Depreciation expense Net income Statement of Cash Flows $ 4,290 (2,330) Adjustments + 290 – 500 – 130 – 60 + 800 (350) (800) $ 1,150 Indirect Method: Net income Plus: Depreciation Plus: Decrease in accounts receivable Less: Increase in inventory Less: Decrease in accounts payable Less: Decrease in interest payable Net cash flow from operating activities $1,150 800 290 (500) (130) (60) $1,550 181 Statement of Cash Flows $ 4,290 (2,330) (410) $ 1,550 182 PRACTICE 5–11 Chapter COMPLETE STATEMENT OF CASH FLOWS FROM DETAILED DATA Operating activities: (f) Cash collected from customers (b) Cash paid to purchase inventory (d) Cash paid for interest (j) Cash paid for income taxes Net cash flow from operating activities $10,000 (7,800) (450) (1,320 ) $ 430 Investing activities: (c) Cash received from sale of a building (k) Cash paid to purchase machinery Net cash flow from investing activities $ 5,600 (1,950) $ 3,650 Financing activities: (e) Cash paid to repay a loan $(1,000) (h) Cash received from issuance of new shares of common stock (i) Cash paid for dividends (780) Net cash flow from financing activities $ (580) Net increase in cash Cash balance, beginning of year Cash balance, end of year PRACTICE 5–12 $ 3,500 1,500 $ 5,000 OPERATING CASH FLOW: GAINS AND LOSSES Net income $ 250 Plus: Depreciation 1,000 Less: Increase in accounts receivable (300) Less: Decrease in income taxes payable(170) Less: Gain on sale of equipment (440) Plus: Loss on sale of building 210 Net cash flow from operating activities$ 550 PRACTICE 5–13 OPERATING CASH FLOW: RESTRUCTURING CHARGES Net income $ 500 Plus: Depreciation 1,000 Plus: Decrease in inventory 300 Plus: Increase in wages payable 170 Plus: Restructuring charge 2,300 Net cash flow from operating activities$4,270 PRACTICE 5–14 OPERATING CASH FLOW: DEFERRED INCOME TAXES Reported income tax expense $20,000 Less: Increase in deferred tax liability 1,250 Taxes owed for current year operations$18,750 Less: Increase in income taxes payable 120 Cash paid for income taxes $18,630 1,200 Chapter PRACTICE 5–15 183 OPERATING CASH FLOW: DEFERRED, OR UNEARNED, SALES REVENUE Sales $10,000 Plus: Accounts receivable, beginning 1,430 Less: Deferred sales revenue, beginning (cash already collected) Cash available for collection this year $10,680 Less: Accounts receivable, ending (1,250) Plus: Deferred sales revenue, ending (collected for future years) 1,000 Total cash collections from customers $10,430 PRACTICE 5–16 (750) OPERATING CASH FLOW: PREPAID OPERATING EXPENSES Cash paid for depreciation $ Cash paid for insurance: Prepaid insurance, ending Plus: Insurance expense Required cash outlay for insurance Less: Prepaid insurance, beginning Cash paid for insurance this year $1,500 7,500 $9,000 1,430 $7,570 Cash paid for wages: Wages payable, beginning Plus: Wage expense this year Wages to be paid Less: Wages payable, ending Cash paid for wages this year $ 750 14,600 $15,350 600 $14,750 Cash paid for operating expenses: $0 + $7,570 + $14,750 = $22,320 PRACTICE 5–17 EQUIPMENT COMPUTING CASH PAID TO PURCHASE PROPERTY, PLANT, AND PPE, beginning Less: PPE sold during the year Ending PPE without purchase of new PPE $106,000 35,000 $ 71,000 PPE, ending $112,000 Less: Ending PPE without purchase of new PPE 71,000 Cash paid to purchase new PPE $ 41,000 This assumes that all PPE purchases were for cash 183 184 Chapter PRACTICE 5–18 COMPUTING CASH RECEIVED FROM THE SALE OF PROPERTY, PLANT, AND EQUIPMENT Accumulated depreciation, beginning $44,000 Plus: Depreciation expense 10,000 Ending accumulated depreciation without PPE sale$54,000 Less: Actual ending accumulated depreciation 31,000 Accumulated depreciation associated with PPE sold$23,000 Original cost of PPE sold $35,000 Accumulated depreciation associated with PPE sold 23,000 Book value of PPE sold $12,000 Book value of PPE sold Plus: Gain on sale of PPE Cash received from sale of PPE PRACTICE 5–19 $12,000 4,500 $16,500 COMPUTING CASH PAID FOR DIVIDENDS Retained earnings, beginning $106,000 Plus: Net income 10,000 Ending retained earnings without dividend declarations$116,000 Less: Actual ending retained earnings 112,000 Dividends declared during the year $ 4,000 Dividends declared during the year Plus: Decrease in dividends payable Cash paid for dividends this year PRACTICE 5–20 $ $ 4,000 250 4,250 STATEMENT OF CASH FLOWS IN THE UNITED KINGDOM (e) (a) (c) (h) U.S approach Cash collected from customers Cash paid to purchase inventory Cash paid for interest Cash paid for income taxes Net cash flow from operating activities $10,000 (7,800) (450) (1,320) $ 430 (e) (a) U.K approach Cash collected from customers Cash paid to purchase inventory Net cash flow from operating activities $ 10,000 (7,800) $ 2,200 Under the U.K approach, cash paid for interest and cash paid for income taxes are not shown as part of operating activities Chapter 223 DISCUSSION CASES Discussion Case 5–57 This case provides an opportunity to clarify several points with respect to the preparation of a statement of cash flows First, no cash is associated with depreciation if taxes are ignored Depreciation is the write-off of the cost of a depreciable asset The entry debiting Depreciation Expense and crediting Accumulated Depreciation does not involve cash Cash was involved when the asset was acquired and will be if the asset is later sold, but the entry to record depreciation is a noncash item Second, depreciation must be added back to cash from operations if net income is used as a beginning point because it has been subtracted as an expense in deriving net income If only expenses involving cash have been subtracted from revenues, depreciation would not need to be considered at all This is also true for other noncash items, such as the cumulative effect of an accounting change The finance professor is probably thinking of depreciation as a source of cash in the sense that depreciation expense reduces taxable income, which conserves cash because less taxes are paid However, even when taxes are considered, depreciation is not a source of cash It may be considered a “conserver” of cash, but the source of cash is revenues from operations Otherwise, if there were no revenues, there would not be any taxable income and, thus, no taxes to be paid The finance professor might also be confused because depreciation is added to net income in calculating cash flow from operations when using the indirect method This would not be the first time that accounting has confused a finance professor Discussion Case 5–58 This case provides an opportunity to contrast income with cash flows and to discuss the importance of the cash flow statement Even if a company is profitable, if it is investing its cash in additional inventory, buildings, and so on, it could find itself in a tight cash position Several factors would have to be examined, especially those dealing with the major inflows and outflows of cash For example, what obligations are outstanding? Is equity financing being used? Has the cash balance increased or decreased significantly during the last year? How was the new store financed? Can profit distributions to the owners be postponed? Also, the timing of cash flows would be important Two specific recommendations might deal with the need for a periodic statement of cash flows and perhaps a cash flow projection statement Such statements are likely to be needed more than annually, especially if the business activity is seasonal Discussion Case 5–59 The accumulation of cash despite paying dividends equal to earnings, could be explained by two factors: Cash from operations and net income will differ to the extent that revenues are not received in cash or expenses are not paid in cash For example, the existence of a large amount of depreciation expense causes cash from operations to be greater than net income Other activities in addition to operations can affect the cash balance For example, cash is increased by borrowing, issuing stock, and selling assets Cash can be decreased by debt repayment, distributions to owners, and purchase of assets This is the reason that a statement of cash flows shows cash inflows and outflows classified by operating, investing, and financing activities 223 224 Chapter Discussion Case 5–60 This case focuses on the most controversial issue the FASB faced when it issued Statement No 95: whether to require the direct method or the indirect method in determining net cash flow from operations The FASB finally decided, by a 4–3 vote, to allow either method In making that decision, the FASB disappointed some financial statement users who argued strongly that the direct method should be required because it is more easily understood Company management, accountants, and other preparers, on the other hand, argued that the indirect method is easier to apply and that it helps explain or reconcile the differences between net income and net cash flow from operations In discussing the case, students should recognize both the pros and cons of the two alternative methods They should also recognize that the two methods produce the same result: the same amount of net cash flow from operations Another point to be made is that the rest of the statement of cash flows, other than the operations section, will be identical regardless of which method is selected A final point to be made is that certain disclosures are required, depending on which method is selected If the direct method is used, a separate schedule must be provided that reconciles net income to net cash flow from operations In effect, this is what the indirect method does If the indirect method is used, the amount of interest and income taxes paid must be disclosed This information is supplied directly when the direct method is used Most preparers would recommend the indirect method because it is easier (and probably less costly) to apply By choosing the indirect method, the reconciliation schedule is already prepared and the additional required disclosures for interest and taxes paid can be supplied without much additional effort In the United States, approximately 95% of large corporations use the indirect method Discussion Case 5–61 Roberts should explain to Dennis that net income and cash flow are not the same thing Net income is measured on an accrual basis, not a cash basis Roberts could prepare a statement of cash flows to support the explanation As shown in the statement, depreciation of $5,000 did not require a cash outlay and is thus added back to net income in determining operating cash flows Changes in the current operating accounts, however, must be subtracted in deriving the amount of cash from operations The increase in receivables indicates that collections from customers were $10,000 less than sales reported in the income statement The $5,000 increase in inventory and the $5,000 decrease in accounts payable indicate that the amount paid to suppliers during the year was $10,000 more than cost of goods sold on the income statement The net effect of depreciation and changes in current operating accounts is net cash provided by operating activities of $5,000 The statement of cash flows also shows that while Dennis obtained $40,000 from borrowing, $32,000 was paid to purchase equipment and $15,000 was used to pay dividends to stockholders When cash flows from operating, investing, and financing activities are combined, the $2,000 net decrease in cash is fully explained Chapter 225 Dennis, Inc Statement of Cash Flows For the Year Ended December 31, 2005 Cash flows from operating activities: Net income Adjustments: Depreciation expense Increase in accounts receivable Increase in inventory Decrease in accounts payable Net cash provided by operating activities Cash flows from investing activities: Purchase of equipment Net cash used in investing activities Cash flows from financing activities: Issuance of long-term note Payment of dividends Net cash provided by financing activities Net decrease in cash Cash at beginning of year Cash at end of year $ 20,000 5,000 (10,000) (5,000) (5,000) $ 5,000 $(32,000) (32,000) $ 40,000 (15,000) 25,000 $ (2,000) 5,000 $ 3,000 Discussion Case 5–62 Examination of the Operating Activities section of a statement of cash flows reveals several other possible sources of cash In general, it is often possible to free up cash by reducing working capital as follows: • Reduce receivables This can be done by increasing collection efforts This strategy is particularly effective for businesses that have previously been lax and have allowed receivables to balloon Of course, care must be taken not to alienate customers • Reduce inventories When cash is short, many companies find that by more carefully monitoring inventory levels they can reduce the need to keep inventory on hand • Reduce prepaid expenses • Delay cash payment of payables Care must be taken not to anger suppliers, and the advisability of losing cash discounts must be considered, but this is probably the most common strategy used by businesses with short-term cash shortages Many businesses are less profitable than they could be because they have too large an investment in working capital Often it requires a cash shortage to make this fact apparent Discussion Case 5–63 Reasons for the prohibition against the reporting of cash flow per share might include the following: • In the entire cash flow area, the FASB was concerned that users would perceive the cash flow numbers as an alternative to earnings data rather than as a supplement to earnings The officially sanctioned reporting of cash flow per share would increase this problem • Computing cash flow per share requires the choice of one particular measure of cash flow Would this be net cash from operating activities? Would an adjustment be made for dividends, for capital expenditures, for interest expense, for repayment of debt? Many definitions of cash flow are used in practice in the investment community • Computation of cash flow per share also requires a measure of the number of shares Extensive authoritative literature explores this issue in relation to earnings per share However, the same concepts of shareholder focus and capital maintenance that guide the computation of number of shares outstanding when computing earnings per share not apply to cash flow 225 226 Chapter Although cash flow per share is not reported in the audited financial statements, it will undoubtedly continue to be computed and reported by interested users It may be that, over time, a common practice and a conceptual framework will evolve that will induce the FASB to reconsider the reporting of cash flow per share Discussion Case 5–64 Atlas Security has gone from a company producing positive cash flows to one using cash to operate the company The negative cash flows from operations preceded the reporting of negative income by year This indicates that perhaps current noncash operating assets, such as accounts receivable, were increasing and producing net income but not producing cash The positive financing cash flows mean that Atlas Security is either borrowing or selling stock to provide cash to run the business Financing inflows can continue only so long If the inflows are from debt, the source of debt will diminish If the inflows are from stock, the decline in income will make the sale of stock less desirable The positive investing cash flows mean that the financing inflows are not being used to make additional investments Instead, the investment assets are being liquidated to provide operating cash In summary, Atlas Security seems to be heading into difficult financial times Cash is being obtained from whatever sources possible to meet operating needs To completely analyze the company, Kara should obtain and review the balance sheet and the income statement These statements can be used to determine the reasonableness of the assumptions made earlier All three statements are useful for analyzing a company Each one provides information that can be used to analyze the health of an organization Discussion Case 5–65 The “net income + depreciation” definition of cash flow has been widely used The W T Grant case illustrates that, in some circumstances, this “cash flow” measure can be very misleading For the fiscal year ended January 31, 1973, W T Grant experienced sharp increases in receivables and inventory These increases combined to cause Grant’s cash flow from operations to be negative even though “net income + depreciation” was positive In general, defining cash flow as “net income + depreciation” ignores the important impact that changes in current operating assets and current operating liabilities can have on cash flow generated by operations When working capital (current assets – current liabilities) is relatively constant, cash from operations is about the same as “net income + depreciation.” Firms that are not growing would be expected to have a stable level of working capital If working capital is increasing, part of the cash generated by operations must be used to finance the additional working capital This will cause cash flow from operations to be less than “net income + depreciation.” Working capital is usually increasing in highgrowth firms and in firms, such as W T Grant, that are having trouble collecting receivables or moving inventory If working capital is decreasing, extra cash is freed up in addition to the cash generated by operations This will cause cash flow from operations to be higher than “net income + depreciation.” Discussion Case 5–66 From the actions taken by Lumpsteak’s CFO, it is clear that reported operating cash flow CAN be manipulated In general, manipulating reported operating cash flow is different from manipulating reported earnings because cash flow manipulation requires actually doing business differently In Lumpsteak’s case, the CFO had to take action to stop payments to vendors, to stop inventory purchases, and to securitize the accounts receivable In contrast, earnings management typically can be done merely by changing accounting assumptions; there is no need to business differently Chapter 227 SOLUTION TO STOP & THINK Stop & Think (p 241): The FASB specifies that a company’s cash flow is to be summarized under three headings: Operating Activities, Investing Activities, and Financing Activities Can you think of any alternatives to this three-way classification? As discussed in the text, the United Kingdom has included eight categories in its statement of cash flows Those eight categories are Operating activities Returns on investments and servicing of finance Taxation Capital expenditure and financial investment Acquisitions and disposals Equity dividends paid Management of liquid resources Financing With such a large percentage of business being done overseas, another way to categorize cash flow is by the currency of the cash: cash flows in U.S dollars, in Japanese yen, and so forth This type of categorization would help users evaluate a company's exposure to foreign currency risk In addition, cash flows can also be categorized by line of business For example, the revenue of PepsiCo is split almost equally between snack foods and soft drinks It would be useful to see how each of these business segments generate and use cash 227 228 Chapter SOLUTIONS TO STOP & RESEARCH Stop & Research (p 241): Locate the most recent cash flow statements for the following three companies and characterize each as having the cash flow pattern of either a start-up company, a steady-state company, or a cash cow: General Electric, Home Depot, and Sears The following comes from the 2001 financial statements of all three companies (numbers in millions): Operating Investing Financing General Electric $32,195 $(40,114) $8,806 Home Depot 5,963 (3,466) (173) Sears 2,262 (1,088) (955) Obviously, all three of these well-known companies have been successful for a number of years So, it isn’t surprising that two of them (Home Depot and Sears) fit the profile of “cash cows.” Because of the continuing expansion efforts of General Electric, the company still needed a net inflow of cash from financing activities in 2001 Thus, General Electric, the most valuable company in the world and a company that has been around for more than 100 years, fits the cash flow profile of a start-up company Stop & Research (p 273): Pfizer and Johnson & Johnson are the two largest pharmaceutical companies in the United States Locate the most recent set of financial statements for both companies and compute the values for the three cash-flow-based ratios explained here Using the 2001 financial statements for Pfizer and Johnson & Johnson, the values for the three cashflow based ratios are computed as follows: From the 2001 financial statements: Net income Cash from operations Cash paid for capex and acquisitions Cash paid for interest Cash paid for income taxes Cash flow-to-net income Cash flow adequacy Cash times interest earned Pfizer $7,752 9,291 Johnson & Johnson $5,668 8,864 2,232 303 1,006 1,793 185 2,090 1.20 4.16 34.98 1.56 4.94 60.21 Chapter 229 SOLUTIONS TO NET WORK EXERCISES Net Work Exercise (p 242): FASB Statement No 95 became effective for fiscal years ending after July 15, 1988 Net Work Exercise (p 269): Diageo owns a large number of brand names for various alcoholic beverages including Captain Morgan, Crown Royal, and Tanqueray The heading of Diageo’s Form 20-F includes the following: “ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.” This Act is administered by the Securities and Exchange Commission of the United States 229 230 Chapter SOLUTIONS TO BOXED ITEMS History of the Cash Flow Statement (p 242) This is actually quite a provocative question Many in the finance community, including most finance professors (it seems), believe that the statement of cash flows is more important than the income statement They point to two things First, from a conceptual standpoint, a company is worth the discounted present value of the future cash flows it will generate This seems to indicate that cash flow is more important than net income Second, members of the finance community point to the item discussed at the beginning of this chapter (under the heading “Sometimes Earnings Fail”) to argue that net income is misleading in some cases, and subject to manipulation in others On the other hand, academic research has demonstrated that net income is the best single measure of a company’s financial performance It is true that net income can be manipulated, but in the large majority of cases, net income is reported fairly, and the resulting information is more informative than is raw cash flow data Background of FASB Statement No 95 (p 261) Arguments in favor of classifying interest paid as a cash outflow from operating activities are as follows: (a) (b) (c) Historically, interest paid has been considered an operating cash flow Most firms classified it as such when preparing statements of changes in financial position under APB Opinion No 19 Interest paid is considered an expense in computing net income, whereas dividends paid are not There is strong support among accountants for maintaining a strong functional relationship between net income and cash flow from operating activities Although both interest and dividends paid can be thought of as costs of obtaining financing, they obviously differ in many respects Interest paid is tax deductible; dividends paid are not Payment of interest is a contractual obligation; payment of dividends is not In formulating Statement No 95, the FASB acknowledged the merit of classifying interest paid as a cash outflow from financing activities However, the Board's conclusion is summarized as follows: “The Board therefore was not convinced that changing the prevalent practice in classifying interest paid would necessarily result in a more meaningful presentation of cash flows This Statement does, however, require that the amount of interest paid during a period … be disclosed, which will permit users of financial statements who wish to consider interest paid as a financing cash outflow to so.” The following items might be useful in deciding whether to require the direct method: (a) (b) (c) The degree to which companies use the direct method in their statements of cash flow Evidence thus far indicates that firms overwhelmingly are choosing the indirect method over the direct method If this were to continue, it could be taken as evidence that the demand from users for the incremental information provided by the direct method is not sufficient to induce firms to provide that information Costs of implementing the direct method After some years of use, it should be possible to better quantify the costs borne by firms in gathering the data necessary to use the direct method Use by financial analysts A study of reports produced by financial analysts can reveal the extent to which the community of sophisticated users is interested in the information provided by the direct method If there is no evidence that analysts are doing extra research to approximate the direct method cash flow disclosures for firms that not provide them, this again can be taken as an indication that market demand for the direct method may not be great enough to justify requiring it Chapter 231 COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 5–1 (The Walt Disney Company) Disney uses the indirect method The statement begins with net income and then makes adjustments for changes in the various accrual accounts Disney has the normal pattern of positive cash from operations and negative cash from investing activities in each of the years In each of the years, Disney's cash from operations was large enough to pay for all investing activities In Note to the financial statements, Disney reports that cash and cash equivalents “consist of cash on hand and marketable securities with original maturities of months or less.” The largest dollar item in the operating activities section of Disney’s 2001 statement of cash flows is the $1.247 billion addition labeled “restructuring and impairment charges.” This item represents losses or expenses included in the computation of net income that did not involve any outflow of cash For example, the impairment charges are write-downs in the carrying values of existing long-term assets; no cash flow is involved in 2001 Operating cash flow for 2001 would have been $4.554 billion ($3.048 + $0.625 + $0.881) if interest and taxes paid were not classified as operating items EBITDA can be computed as follows (in billions): Income before income taxes (from the income statement) $1.283 Add back net interest expense (from the income statement) 0.417 Add back depreciation (from the cash flow statement) 0.987 Add back amortization (from the cash flow statement) 0.767 EBITDA $3.454 The EBITDA of $3.454 billion differs from the $4.554 billion answer in (5) because the computation of EBITDA does not take into consideration many of the accruals associated with the computation of net income Changes in receivables, inventories, and payables are ignored in the computation of EBITDA And in this case, an important difference is that the computation of EBITDA does not include any adjustment for the $1.247 billion noncash restructuring and impairment charge Deciphering 5–2 (Diageo) a Reported cash inflow from operating activities Interest paid (net) Dividends received (from associates) Taxation Management of liquid resources U.S net cash provided by operating activities £ 2,276 (446) 101 (230) (572) £ 1,129 b Reported net cash outflow from capital expenditures Reported net cash outflow from acquisitions and disposals U.S net cash used in investing activities £ (450) (105 ) £ (555) c £ 282 (756) £ (474) Reported cash inflow from financing activities Dividends paid (£31 + £725) U.S net cash used in financing activities Diageo uses the indirect method so there are almost enough data to prepare the operating activities section according to U.S GAAP using the indirect method However, Diageo does not show this information in the cash flow statement itself; the details of the operating activities section are shown in the notes to the financial statements With this detail, the only problem is that Diageo starts with operating profit, whereas in the United States the computation starts with net income Because Diageo uses the indirect method, most of the data needed for the direct method are not available 231 232 Chapter Deciphering 5–3 (Caterpillar) (Amounts in millions) 2001 2000 $ 805 $ 1,053 1,169 153 (130) $ 1,997 1,063 — (57) $ 2,059 Cash flows from investing activities: Capital expenditures—excluding equipment leased to others Expenditures for equipment leased to others, net of disposals Net (increase) decrease in finance receivables Investments and acquisitions (net of cash acquired) Net cash used in investing activities $(1,100) (512) (838) (405) $(2,855) $ (928) (402) (1,197) (115) $ (2,642) Cash flows from financing activities: Net debt proceeds Dividends paid Treasury shares purchased Other $1,529 (474) (43) (88) $ 1,413 (462) (412) (170) Net cash provided by financing activities Increase (decrease) in cash and short-term investments $ 924 $ 66 $ 369 $ (214) Cash flows from operating activities: Profit after tax Adjustments: Depreciation and amortization Nonrecurring charges Changes in working capital Net cash provided by operating activities The term net free cash flow is attempting to measure the cash available from operations after expansion of capital facilities and paying dividends In other words, Caterpillar feels that paying dividends and capital expenditures are required expenditures and therefore are not left to management discretion Deciphering 5–4 (Archer Daniels Midland) During 1999, the change in Archer Daniels Midland’s accounts receivable balance caused an increase in operating cash flow of $56.946 million This means that the receivables balance decreased during 1999 During 2000, accounts receivable increased by $361.391 million This swing from an accounts receivable decrease to a large accounts receivable increase is the primary reason that operating cash flow was lower in 2000 ADM classifies the purchase and sale of some marketable securities as investing activities During 2000, net purchases of these securities used cash of $188 million ($1,101 million – $913 million) During 2001, net proceeds from these securities provided cash of $379 million ($839 million – $460 million) This $567 million decrease in net cash used to purchase securities is the single biggest cause for the decreased cash used in investing activities in 2001 Other contributing factors were the reduction in cash used to purchase property, plant, and equipment and the reduction in cash used to invest in affiliates In 2000, ADM borrowed cash of $317 million under its line of credit agreements In 2001, ADM repaid $674 million under these same agreements This difference from 2000 to 2001 is the major reason for the net cash outflow from financing activities for 2001 The Financing Activities section does indicate substantial net borrowing during 2000 with no new stock issues However, this does not necessarily mean that ADM's debt ratio increased during the year Invested capital can come from two sources—new stock issues and retained earnings Comparison of net income to cash dividends during 2000 shows that ADM's retained earnings increased by over $180 million during the year However, with the treasury stock purchases of Chapter 233 $211 million during the year, total equity decreased Accordingly, ADM’s debt ratio increased during the year Deciphering 5–5 (The Coca-Cola Company) a Increases and decreases in Cash for each year are as follows: 2001 2000 Cash from operating activities $ 4,110 $ 3,585 Cash from investing activities (1,188) (1,165) Cash from financing activities (2,830) (2,072) Net increase (decrease) in cash $ 92 $ 348 1999 $ 3,883 (3,421) (471) $ (9) 1998 $ 3,433 (2,161) (1,333) $ (61) Cash balance at December 31, 2001, approximately equals the balance at January 1, 1998, plus the four yearly changes: $1,648 – $61 – $9 + $348 + $92 = $2,018 b Paid-In Capital from Common Stock at December 31, 2001, approximately equals the balance at January 1, 1998, plus the four yearly amounts of common stock issued: $2,195 + $302 + $168 + $331 + $164 = $3,160 c Retained Earnings at December 31, 2001, equals the balance at January 1, 1998, plus the four yearly net income amounts less the four yearly cash dividend amounts: 4-year net income: $3,533 + $2,431 + $2,177 + $3,969 = $12,110 4-year dividends: $1,480 + $1,580 + $1,685 + $1,791 = $6,536 December 31, 2001, retained earnings: $19,922 + $12,110 – $6,536 = $25,496 d Treasury Stock at December 31, 2001, approximately equals the balance at January 1, 1998, plus the four yearly amounts of treasury stock purchases: $13,145 + $1,563 + $15 + $133 + $277 = $15,133 The December 31, 2001, balance in the treasury stock account exceeds the total paid-in capital from common stock account by approximately $12 billion This means that the amount used to repurchase Coca-Cola shares is almost five times the amount that Coca-Cola shareholders invested in the first place And this is in addition to the cash dividends received by shareholders Another way to think of this is that net Paid-In Capital from Common Stock (Paid-In Capital from Common Stock less Treasury Stock) is a negative $12 billion Deciphering 5–6 (Lockheed Martin Corporation) a Net income plus depreciation b Cash flow from operating activities c Cash flow from operating activities Plus cash paid for interest Plus cash paid for income taxes d Cash flow from operating activities Less capital expenditures Less dividends 2001 $ 504 1,825 2000 82 2,016 1999 $1,243 1,077 3,369 3,212 2,397 1,014 1,333 63 $ In order to maintain its long-run potential, a company must consistently replace property, plant, and equipment and maintain a stable cash dividend level for investors The cash flow number computed in (1)(d)—cash flow from operating activities – capital expenditures – dividends—is a measure of how much free cash flow Lockheed generates after maintaining its long-run potential Someone considering a leveraged buyout (LBO) is interested in the cash flow from the operations of the business before payment of financing costs This is the cash flow before payments for interest and income taxes are subtracted So, an LBO candidate would be particularly interested 233 234 Chapter in the cash flow numbers calculated in (1)(c)—cash flow from operating activities + cash paid for interest + cash paid for income taxes Writing Assignment: Where is your statement of cash flows? TO: President, Moran Auto Sales FROM: Senior Credit Analyst, Far West Bank RE: Need for Statement of Cash Flows Your loan application is being held up while we await the arrival of your statement of cash flows A modern set of financial statements is not complete without a statement of cash flows And, in your case, the statement of cash flows is particularly important because it will reveal exactly why you have been profitable in recent years but are currently running short of cash In a recent memo, your accountant reminded me that most of the information for the statement of cash flows can be deduced from the income statement and from changes in the balance sheet accounts I believe we would all be better off if you were to prepare the statement and send me a copy instead of having me figure out the information from your balance sheet and income statement My reasons for thinking this are as follows: You have access to the raw data and can prepare a much more complete statement of cash flows Offsetting events can hide some cash flows, and the cash flow effects of some complex transactions are difficult to deduce If I am asked to prepare your statement of cash flows myself, I will bill you at my normal consulting rate, which is $500 per hour Research Project: What is in a real cash flow statement? The February 3, 2002, financial statements (fiscal 2001) for Home Depot will be used to discuss possible findings for the research project involving five actual cash flow statements Home Depot uses the indirect method Only about out of 20 large U.S companies uses the direct method For the year ended February 3, 2002, Home Depot has the classic pattern: positive cash from operations and negative cash from investing activities Home Depot's fiscal 2001 net income of $3.044 billion is less than its cash from operations of $5.963 billion For most companies, cash from operations is greater than net income The three largest adjustments for Home Depot are: Increase in accounts payable and accrued liabilities $2.078 billion Depreciation and amortization 0.764 billion Increase in income taxes payable 0.272 billion For many companies, the depreciation and amortization adjustment is the largest Fiscal 2001 was an unusual year for Home Depot because of the large increase in accounts payable and accrued liabilities In most years, a subtraction for an inventory increase is the largest item Home Depot's fiscal 2001 free cash flow is computed as follows: Cash flow from operations $ 5.963 billion Less capital expenditures (3.393 billion) Less cash dividends (0 396 billion) Free cash flow $ 2.174 billion Home Depot's fiscal 2001 net income plus depreciation is computed as follows: Net income $ 3.044 billion Plus depreciation and amortization 0.764 billion Net income plus depreciation $ 3.808 billion For Home Depot in fiscal 2001, this is a poor estimate of cash flow from operations The primary reason is the big increase in accounts payable and accrued liabilities during the year The net income plus depreciation definition of cash flow ignores changes in current operating assets and current operating liabilities Chapter 235 Home Depot's fiscal 2001 operating cash flow is computed as follows: Cash flow from operations billion Plus cash paid for interest Plus cash paid for taxes Operating cash flow billion $ 5.963 0.018 billion 1.685 billion $ 7.666 Total assets $26.394 billion × 0.15 = $3.959 billion So, for Home Depot in fiscal 2001, operating cash flow is almost twice as much as 15% of total assets In its financial summary, Home Depot includes a section called “Statement of Cash Flows Data.” However, only three items are listed: depreciation and amortization, capital expenditures, and cash dividends per share The Debate: Give me the direct method or give me death! FASB MAJORITY: Direct and Indirect Methods (from SFAS No 95, pars 119 and 121) • The indirect method is similar to the old statement of changes in financial position, so it is understood by a generation of preparers and users • Using the direct method requires a determination of what categories of gross cash flows are the most important to disclose It is unclear what these categories should be • The indirect method provides enough information for users to approximate the direct method if they wish Interest Paid as an Operating Activity (from SFAS No 95, par 90) • Interest paid was classified as an operating item in the preparation of the old statement of changes in financial position Why change now? • Operating cash flow should, as far as possible, include all items used in the computation of net income • Cash paid for interest is disclosed separately, so any user who wishes can remove its effect from operating cash flow FASB MINORITY (from the dissent to SFAS No 95): Direct Method • Reporting information about cash collected and cash paid for various activities is more intuitive and informative than reporting accrual adjustments to net income • The whole purpose of the cash flow statement is to report cash flow The direct method does that in a straightforward manner • By sticking with tradition and making the statement of cash flows similar to the old statement of changes in financial position, the progress of financial reporting is hindered Interest Paid as a Financing Activity • Interest paid is a cost of obtaining financing and therefore should be reported as a financing activity • This seems obvious Again, sticking with traditions established with the old statement of changes in financial position results in inconsistencies in the statement of cash flows Ethical Dilemma: Is the price right? This is an ethical dilemma with no neat or tidy solution It seems clear that you cannot give the presentation to the investment bankers Your analysis strongly suggests that the earnings numbers have been manipulated, so you cannot in good conscience present the proposal to the investment bankers without voicing your concerns You should notify the board of directors immediately, so that they can have sufficient time to find someone else to make the presentation You should offer to brief the new presenter on the results of your analysis 235 236 Chapter Chapter 237 Before rendering a harsh judgment against the board for engaging in earnings manipulation, realize that earnings numbers in an IPO serve much the same purpose as advertising does in the selling of cars Everyone knows that the numbers have been puffed up and beautified as much as possible The investment bankers, if they are experienced, will look at all of the financial statement numbers with healthy skepticism Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis solutions CD-ROM, provided with this manual Internet Search a Enron (in millions): Cash from operating activities Net income 2000 $ 4,779 979 1999 $ 1,228 893 1998 $1,640 703 b Xerox (in millions): Cash from operating activities Net income 1999 $ 1,224 1,424 1998 $ (1,165) 585 1997 $ 472 1,452 c MicroStrategy (in thousands): Cash from operating activities Net income 1999 $ 89 (33,743) 1998 $ (2,548) (2,255) 1997 $4,955 (885) Enron In Enron’s case, it appears that the cash flow data were even better than the earnings data The biggest reason for the large increase in operating cash flow in 2000 was attributable to changes in working capital items, primarily a $7.167 billion increase in payables Xerox Xerox also shows a large increase in operating cash flow in the year in which its earnings management was in full swing However, a closer look at the cash flow statement reveals that the reason for the operating cash flow increase in 1999 was a $1.495 billion cash inflow from the securitization of finance receivables This means that Xerox sold some of its long-term receivables during the year to generate cash, the only time in the 3-year period in which Xerox did this MicroStrategy The biggest item in the computation of MicroStrategy’s operating cash flow in 1999 was an increase of $36.720 million in deferred revenue, representing cash collected that could not yet be recognized as revenue Also, the positive $89,000 in operating cash flow is an interesting number; it is so close to zero that one wonders whether MicroStrategy strategically timed the payment of its bills at the end of the year to make sure that the number came out positive The overall lesson from the comparison of net income and operating cash flow for these three companies is that when a company is managing its earnings, it may also be managing its operating cash flow through the timing of transactions In each of these three cases, there is evidence of the management of operating cash flow 237 ... 25,000 (b) No cash is provided or used by depreciation; however, $6,500 is added to net income for yearly depreciation in showing net cash flow provided by operations when using the indirect method... payable Net cash provided by operating activities Cash flows from investing activities: Proceeds from sale of land Purchase of equipment Net cash provided by investing activities ... 167,000 Cash receipts not provided by operations: Cash provided from financing: Notes payable* Common stock ($600,000 – $550,000) Cash receipts not provided by operations $ 125,000