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Chapter 13
How Well Am I Doing?
Statement of Cash Flows
Solutions to Questions
13-1 The statement of cash flows highlights
the major activities that have provided and used
cash during a period and shows their effects on
the overall cash balance.
13-2 Cash equivalents are short-term, highly
liquid investments such as Treasury bills, commercial paper, and money market funds. They
are included with cash because investments of
this type are made solely for the purpose of generating a return on temporarily idle funds and
they can be easily converted to cash.
13-3 (1) Operating activities: Transactions
that affect current assets, current liabilities, or
net income.
(2) Investing activities: Transactions that
involve the acquisition or disposition of noncurrent assets.
(3) Financing activities: Transactions
(other than the payment of interest) involving
borrowing from creditors, and any transactions
involving the owners of a company.
13-4 Interest is included as an operating activity since it is part of net income. Financing
activities are narrowly defined to include only
the principal amount borrowed or repaid.
13-5 Since the entire proceeds from a sale of
an asset (including any gain) appear as a cash
inflow from investing activities, the gain must be
deducted from net income to avoid double
counting.
13-6 Transactions involving accounts payable
are not considered to be financing activities because such transactions relate to a companys
day-to-day operating activities rather than to its
financing activities.

13-7 The repayment of $300,000 and the

borrowing of $500,000 must both be shown
gross on the statement of cash flows. That is,
the company would show $500,000 of cash provided by financing activities and then show
$300,000 of cash used by financing activities.
13-8 The direct method reconstructs the income statement on a cash basis by restating
revenues and expenses in terms of cash inflows
and outflows. The indirect method starts with
net income and adjusts it to a cash basis to determine the cash provided by operating activities.
13-9 Depreciation is not really a source of
cash, even though it is listed as a source on
the statement of cash flows. Adding back depreciation charges to net income to compute the
amount of cash provided by operating activities
creates the illusion that depreciation is a source
of cash. It isnt. Charges to the accumulated
depreciation account are added back to net income because they are equivalent to a decrease
in an asset account. [See Exhibit 13-2.]
13-10 An increase in the Accounts Receivable
account must be deducted from net income under the indirect method because this is an increase in a noncash asset.
13-11 A sale of equipment for cash would be
classified as an investing activity. Any transaction involving the acquisition or disposition of
noncurrent assets is classified as an investing
activity.
13-12 Free cash flow is net cash provided by
operating activities minus capital expenditures
and dividends.

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Brief Exercise 13-1 (15 minutes)

a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
m.

Transaction

Equipment was purchased...................

Cash dividends declared and paid ........
Accounts receivable decreased ............
Short-term investments purchased ......
Equipment was sold ............................
Preferred stock was sold to investors ...
A stock dividend was declared and
issued .............................................
Interest was paid to long-term
creditors ..........................................
Salaries and wages payable
decreased........................................
Stock of another company was
purchased .......................................
Bonds were issued ..............................
Rent was received from subleasing
office space, reducing rents receivable ................................................
Common stock was repurchased and
retired .............................................

Activity
Operating Investing Financing
X

X
X

Not
Reported Source Use

X
X*
X

X
X
X

X
X
X

X
X

X
X

X
X

* This would be a cash equivalent and thus not reported separately on the statement of cash flows.

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Brief Exercise 13-2 (15 minutes)

Net income ..............................................................
$35,000
Adjustments to convert net income to a cash basis:
Depreciation charges ............................................. $20,000
Increase in accounts receivable .............................. (19,000)
Increase in inventory ............................................. (33,000)
Decrease in prepaid expenses ................................
1,000
Increase in accounts payable ................................. 15,000
Decrease in accrued liabilities ................................ (2,000)
Increase in deferred income taxes payable .............
4,000 (14,000)
Net cash provided by operating activities...................
$21,000

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Brief Exercise 13-3 (5 minutes)

Free cash flow computation:
Net cash provided by operating activities ..
Capital expenditures ................................
Dividends ...............................................
Free cash flow ...........................................

$110,000
30,000

$34,000
140,000
$(106,000)

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Exercise 13-4 (10 minutes)

Item

Amount

Accounts Receivable.....................
$90,000 decrease
Accrued Interest Receivable .........
$4,000 increase
Inventory .................................... $120,000 increase
Prepaid Expenses.........................
$3,000 decrease
Accounts Payable .........................
$65,000 decrease
Accrued Liabilities ........................
$8,000 increase
Deferred Income Taxes Payable ....
$12,000 increase
Sale of equipment........................
$7,000 gain
Sale of long-term investments ......
$10,000 loss

Add
X
X
X
X
X

Deduct
X
X
X
X

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Exercise 13-5 (30 minutes)

1.
Carmono Company
Statement of Cash Flows
For the Year Ended December 31, 2009

Operating activities:

Net income ..................................................................

Adjustments to convert net income to a cash basis:
Depreciation charges .................................................
Decrease in accounts receivable .................................
Increase in inventory .................................................
Increase in accounts payable .....................................
Net cash provided by operating activities .......................

Investing activities:

Increase in plant and equipment ...................................

Net cash used for investing activities .............................

Financing activities:

Increase in common stock ............................................

Cash dividends.............................................................
Net cash used in financing activities ..............................

$35
$15
2
(10)
4

(40)

5
(14)

Net decrease in cash ....................................................

Cash, beginning of the year ..........................................
Cash, end of the year ...................................................

11
46

(40)

(9)
(3)
6
$ 3

2. Free cash flow computation:

Net cash provided by operating activities..................
Capital expenditures .............................................
Dividends ............................................................
Free cash flow ........................................................

$40
14

$ 46
54
$(8)

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Exercise 13-5 (continued)

Note to the instructor: Although it is not required for part (1) of the exercise, a worksheet may be
helpful.

Change

Source
or use?

2
+10

Source
Use

+2
10

+2
10

Operating
Operating

+40

Use

40

40

Investing

Assets (except cash and cash equivalents)

Current assets:
Accounts receivable ...........
Inventory..........................
Noncurrent assets:
Plant and equipment .........

Cash Flow
Effect

Adjustments

Adjusted
Effect

Classification

Liabilities, Contra-assets, and Stockholders Equity

Contra-assets:
Accumulated depreciation ..
Current liabilities:
Accounts payable ..............
Stockholders equity:
Common stock ..................
Retained earnings:
Net income ....................
Dividends .......................

+15

Source

+15

+15

Operating

+4

Source

+4

+4

Operating

+5

Source

+5

+5

Financing

+35
14

Source
Use

+35
14

+35
14

Operating
Financing

Additional entries

None...................................
Total ...................................

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Exercise 13-6 (30 minutes)

1. Net income ............................................................
Adjustments to convert net income to a cash basis:
Depreciation charges ...........................................
Increase in accounts receivable ............................
Decrease in inventory ..........................................
Increase in prepaid expenses ...............................
Increase in accounts payable ................................
Decrease in accrued liabilities ...............................
Gain on sale of long-term investments ..................
Loss on sale of land .............................................
Increase in deferred income taxes ........................
Net cash provided by operating activities .................
2.

$ 84
$ 60
(110)
70
(9)
35
(4)
(10)
6
8

46
$130

Pavolik Company
Statement of Cash Flows

Operating activities:

Net cash provided by operating activities from part

(1) above ............................................................

$130

Investing activities:

Proceeds from sale of long-term investments ........... $ 16

Proceeds from sale of land ......................................
9
Additions to plant and equipment ............................ (200)
Net cash used for investing activities .......................

Financing activities:

Increase in bonds ...................................................

Decrease in common stock .....................................
Cash dividends .......................................................
Net cash provided by financing activities .................
Net decrease in cash (net cash flow) .......................
Cash balance, beginning of the year ........................
Cash balance, end of the year .................................

150
(80)
(30)

(175)

40
(5)
90
$ 85

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Exercise 13-6 (continued)

Note to the instructor: Although it is not a requirement of the exercise, a worksheet may be helpful.

Change

Source
or use?

+110
70
+9

Use
Source
Use

110
+70
9

6
+200
15

Source
Use
Source

+6
200
+15

Assets (except cash and cash equivalents)

Current assets:
Accounts receivable ...........
Inventory..........................
Prepaid expenses ..............
Noncurrent assets:
Long-term investments ......
Plant and equipment .........
Land.................................

Cash
Flow
Effect

Adjustments

6
15

Adjusted
Effect

Classification

110
+70
9

Operating
Operating
Operating

0
200
0

Investing
Investing
Investing

Liabilities, Contra-assets, and Stockholders Equity

Contra-assets:
Accumulated depreciation ..
Current liabilities:
Accounts payable ..............
Accrued liabilities ..............
Noncurrent liabilities:
Bonds payable ..................
Deferred income taxes.......

+60

Source

+60

+60

Operating

+35
4

Source
Use

+35
4

+35
4

Operating
Operating

+150
+8

Source
Source

+150
+8

+150
+8

Financing
Operating

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Exercise 13-6 (continued)

Stockholders equity:
Common stock ...................
Retained earnings:
Net income .....................
Dividends ........................

Change

Source
or use?

Cash
Flow
Effect

Adjustments

Adjusted
Effect

Classification

80

Use

80

80

Financing

+84
30

Source
Use

+84
30

+84
30

Operating
Financing

+16

+16

Investing

10
+9
+6

10
+9
+6

Operating
Investing
Operating

Additional entries

Proceeds from sale of longterm investments ...............

Gain on sale of long-term
investments .......................
Proceeds from sale of land ....
Loss on sale of land ..............
Total ....................................

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Problem 13-7A (20 minutes)

Transaction

a. Common stock was sold for

cash ......................................
b. Interest was paid on a note
decreasing Interest Payable ....
c. Bonds were retired ...................
d. A long-term loan was made to
a subsidiary ...........................
e. Interest was received on the
loan in (d) .............................
f. A stock dividend was declared
and issued on common stock..
g. A building was acquired by
issuing shares of common
stock .....................................
h. Equipment was sold for cash .....
i. Short-term investments were
sold ......................................
j. Cash dividends were declared
and paid................................
k. Preferred stock was converted
into common stock ................

Source,
Reported
Not on
Use, or
Activity
in Separate
the
Neither Operating Investing Financing Schedule Statement
Source
Use
Use

X
X

Use
Source

X
X

Neither
Neither
Source

X
X

Neither
Use
Neither

X
X
X

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Problem 13-7A (continued)

Transaction

Source,
Reported
Not on
Use, or
Activity
in Separate
the
Neither Operating Investing Financing Schedule Statement

l. Deferred Income Taxes, a

long-term liability, was reduced ...................................
Use
m. Dividends were received on
stock of another company
held as an investment ............ Source
n. Equipment was purchased by
giving a long-term note to
the seller ............................... Neither

X
X
X

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Problem 13-8A (30 minutes)

1. and 2.

Weaver Company
Statement of Cash Flows
For the Year Ended December 31, 2009

Operating activities:

Net income ..........................................................

Adjustments to convert net income to cash basis:
Depreciation charges .........................................
Increase in accounts receivable ..........................
Decrease in inventory ........................................
Increase in prepaid expenses .............................
Increase in accounts payable .............................
Decrease in accrued liabilities.............................
Gain on sale of investments ...............................
Loss on sale of equipment .................................
Increase in deferred income taxes ......................
Net cash provided by operating activities ...............

Investing activities:

Proceeds from sale of long-term investments.........

Proceeds from sale of equipment ..........................
Additions to plant and equipment .........................
Net cash used for investing activities .....................

Financing activities:

Increase in bonds payable ....................................

Decrease in common stock ...................................
Cash dividends ....................................................
Net cash provided by financing activities ...............
Net decrease in cash ............................................
Cash balance, beginning of the year .....................
Cash balance, end of the year ..............................

$ 63
$ 24
(100)
50
(4)
80
(12)
(7)
4
6

10
20
(180)

110
(40)
(30)

41
104

(150)

40
(6)
15
$ 9

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Problem 13-8A (continued)

Note to the instructor: Although it is not a requirement, a worksheet may be helpful.

Change

Source
or use?

Cash
Flow
Effect

+100
50
+4

Use
Source
Use

100
+50
4

3
+140

Source
Use

+3
140

Assets (except cash and cash equivalents)

Current assets:
Accounts receivable ............
Inventory...........................
Prepaid expenses ...............
Noncurrent assets:
Long-term investments .......
Plant and equipment ..........

Adjustments

Adjusted
Effect

Classification

100
+50
4

Operating
Operating
Operating

3
40

0
180

Investing
Investing

+16

+24

Operating

+80
12

Operating
Operating

Liabilities, Contra-assets, and Stockholders Equity

Contra-assets:
Accumulated depreciation ...
Current liabilities:
Accounts payable ...............
Accrued liabilities ...............

+8

Source

+8

+80
12

Source
Use

+80
12

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Problem 13-8A (continued)

Noncurrent liabilities:
Bonds payable ...................
Deferred income taxes........
Stockholders equity:
Common stock ...................
Retained earnings:
Net income .....................
Dividends ........................

Change

Source
or use?

Cash
Flow
Effect

+110
+6

Source
Source

Adjustments

Adjusted
Effect

Classification

+110
+6

+110
+6

Financing
Operating

40

Use

40

40

Financing

+63
30

Source
Use

+63
30

+63
30

Operating
Financing

+10
7

+10
7

Investing
Operating

+20
+4

+20
+4

Investing
Operating

Additional entries

Proceeds from sale of investments ..........................

Gain on sale of investments ...
Proceeds from sale of
equipment .........................
Loss on sale of equipment .....
Total ....................................

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Problem 13-9A (45 minutes)

1. and 2.

Joyner Company
Statement of Cash Flows
For Year 2

Operating activities:

Net income ............................................................

Adjustments to convert net income to cash basis:
Depreciation charges ........................................... $42,000
Increase in accounts receivable ............................ (80,000)
Increase in inventory ........................................... (50,000)
Decrease in prepaid expenses ..............................
7,000
Increase in accounts payable ...............................
60,000
Decrease in accrued liabilities .............................. (10,000)
Gain on sale of equipment ...................................
(8,000)
Increase in deferred income taxes ........................
3,000
Net cash provided by operating activities.................

$ 56,000

(36,000)
20,000

Investing activities:

Proceeds from the sale of equipment ......................

18,000
Loan to Hymas Company........................................ (40,000)
Additions to plant and equipment ........................... (150,000)
Net cash used for investing activities .......................
(172,000)

Financing activities:

Increase in bonds payable ...................................... 120,000

Increase in common stock ......................................
30,000
Cash dividends ...................................................... (15,000)
Net cash provided by financing activities .................
Net decrease in cash ..............................................
Cash balance, beginning of year .............................
Cash balance, end of year ......................................

135,000
(17,000)
21,000
$ 4,000

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Problem 13-9A (continued)

3. Free cash flow computation:
Net cash provided by operating activities..................
Capital expenditures .............................................
$150,000
Dividends ............................................................
15,000
Free cash flow ........................................................

$ 20,000
165,000
$(145,000)

4. A relatively small amount of cash was provided by operating activities

during the year as a result of large increases in accounts receivable and
inventory. Most of the cash that was provided by operating activities was
paid out in dividends. The small amount that remained, combined with
the cash provided by the issue of bonds and the issue of common stock,
was insufficient to purchase a large amount of equipment and make a
loan to another company. As a result, the cash on hand declined sharply
during the year.

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Problem 13-9A (continued)

Note to the instructor: Although it is not a requirement, a worksheet may be helpful.

Change

Source
or use?

Cash
Flow
Effect

+80
+50
7

Use
Use
Source

+40
+110

Use
Use

Assets (except cash and cash equivalents)

Current assets:
Accounts receivable ............
Inventory...........................
Prepaid expenses ...............
Noncurrent assets:
Loan to Hymas Company ....
Plant and equipment ..........

Adjustments

Adjusted
Effect

Classification

80
50
+7

80
50
+7

Operating
Operating
Operating

40
110

40

40
150

Investing
Investing

+30

+42

Operating

Liabilities, Contra-assets, and Stockholders Equity

Contra-assets:
Accumulated depreciation ...
Current liabilities:
Accounts payable ...............
Accrued liabilities ...............
Noncurrent liabilities:
Bonds payable ...................
Deferred income taxes........

+12

Source

+12

+60
10

Source
Use

+60
10

+60
10

Operating
Operating

+120
+3

Source
Source

+120
+3

+120
+3

Financing
Operating

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Problem 13-9A (continued)

Stockholders equity:
Common stock ...................
Retained earnings:
Net income .....................
Dividends ........................

Change

Source
or use?

Cash
Flow
Effect

+30

Source

+56
15

Source
Use

Adjustments

Adjusted
Effect

Classification

+30

+30

Financing

+56
15

+56
15

Operating
Financing

+18
8

Investing
Operating

Additional entries

Proceeds from sale of

equipment .........................
Gain on sale of equipment .....
Total ....................................

+18
8
17

17

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Problem 13-10A (75 minutes)

1. See the worksheet at the end of this solution.
2.

Lomax Company
Statement of Cash Flows
For the Year Ended December 31, 2009

Operating activities:

Net income .......................................................

Adjustments to convert net income to cash basis:
Depreciation charges ......................................
Decrease in patents ........................................
Increase in accounts receivable .......................
Decrease in inventory .....................................
Increase in prepaid expenses ..........................
Increase in accounts payable ...........................
Decrease in accrued liabilities ..........................
Gain on sale of long-term investments .............
Loss on sale of equipment ...............................
Increase in deferred income taxes ...................
Net cash provided by operating activities ............

Investing activities:

Proceeds from sale of long-term investments ......

Proceeds from sale of equipment .......................
Increase in loans to subsidiaries .........................
Additions to plant and equipment .......................
Net cash used for investing activities ..................

$170,000
$ 95,000
6,000
(180,000)
12,000
(5,000)
300,000
(17,000)
(60,000)
20,000
15,000

110,000
70,000
(50,000)
(700,000)

186,000
356,000

(570,000)

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Problem 13-10A (continued)

Financing activities:

Issue of long-term notes...................................

Retire long-term notes ......................................
Increase in common stock ................................
Cash dividends .................................................
Net cash provided by financing activities ...........
Net increase in cash and cash equivalents .........
Cash balance, beginning of the year ..................
Cash balance, end of the year ...........................

600,000
(380,000)
90,000
(75,000)

235,000
21,000
40,000
$ 61,000

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Problem 13-10A (continued)

3. The large amount of cash provided by operating activities is traceable
for the most part to the $300,000 increase in accounts payable. If the
accounts payable had remained basically unchanged, the same as inventory, then operating activities would have provided very little cash and
the company might have experienced serious cash problems.
Note particularly that the cash provided by operating activities was used
to purchase plant and equipment. Thus, the company is using cash derived from a short-term source (buildup of accounts payable) to finance
long-term asset acquisitions. In short, although the company is generating substantial cash from operating activities, the quality of this source
is open to question.
Also, note the substantial increase in accounts receivable. Apparently,
the companys collections from customers are lagging, perhaps because
of sales to customers whose credit is weak. This may be the result of
trying to increase sales so fast that proper credit checks are not being
made. Again, this can lead to serious cash problems if the trend continues.
In the companys financing activities, it appears that long-term debt
sources, rather than equity sources, are being used to provide for
expansion. Although companies frequently use debt to finance expansion,
the level of debt in this company is increasing rapidly. (See Chapter 14 for
a discussion of the Debt-to-Equity ratio and other financial ratios.)

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Problem 13-10A (continued)

Change

Source
or use?

Cash
Flow
Effect

+180
12
+5

Use
Source
Use

180
+12
5

50
+50
+570
6

Source
Use
Use
Source

+50
50
570
+6

Assets (except cash and cash equivalents)

Current assets:
Accounts receivable .............
Inventory............................
Prepaid expenses ................
Noncurrent assets:
Long-term investments ........
Loans to subsidiaries ...........
Plant and equipment ...........
Patents ...............................

Adjustments

50
130

Adjusted
Effect

Classification

180
+12
5

Operating
Operating
Operating

0
50
700
+6

Investing
Investing
Investing
Operating

+95

Operating

+300
17

Operating
Operating

Liabilities, Contra-assets, and Stockholders Equity

Contra-assets:
Accumulated depreciation ....
Current liabilities:
Accounts payable ................
Accrued liabilities ................

+55

Source

+55

+300
17

Source
Use

+300
17

+40

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Problem 13-10A (continued)

Noncurrent liabilities:
Long-term notes .................
Deferred income taxes.........
Stockholders equity:
Common stock ....................
Retained earnings:
Net income ......................
Dividends .........................

Change

Source
or use?

Cash
Flow
Effect

+220
+15

Source
Source

+220
+15

+90

Source

+170
75

Source
Use

Adjustments

Adjusted
Effect

Classification

+380

+600
+15

Financing
Operating

+90

+90

Financing

+170
75

+170
75

Operating
Financing

380

380

Financing

+70
+20

+70
+20

Investing
Operating

+110

+110

Investing

-60

60

Operating

Additional entries

Retire long-term notes ...........

Proceeds from sale of
equipment ..........................
Loss on sale of equipment ......
Proceeds from sale of longterm investments ................
Gain on sale of long-term
investments ........................
Total .....................................

+21

+21

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Problem 13-11A (45 minutes)

1. and 2.

Rusco Products
Statement of Cash Flows
For the Year Ended July 31, 2009

Operating activities:

Net income .......................................................

$ 30,000
Adjustments to convert net income to cash
basis:
Depreciation charges ...................................... $20,000
Increase in accounts receivable ....................... (40,000)
Increase in inventory ...................................... (50,000)
Decrease in prepaid expenses .........................
4,000
Increase in accounts payable ........................... 63,000
Decrease in accrued liabilities ..........................
(9,000)
Gain on sale of investments ............................. (10,000)
Loss on sale of equipment ...............................
2,000
Increase in deferred income taxes ...................
8,000
(12,000)
Net cash provided by operating activities ............
18,000

Investing activities:

Proceeds from sale investments ......................... 30,000

Proceeds from sale of equipment .......................
8,000
Additions to plant and equipment ....................... (150,000)
Net cash used for investing activities ..................
(112,000)

Financing activities:

Increase in bonds payable .................................

Increase in common stock .................................
Cash dividends ..................................................
Net cash provided by financing activities.............
Net decrease in cash .........................................
Cash balance, beginning of the year ...................
Cash balance, end of the year ............................
Schedule of noncash investing and financing
activities:
Preferred stock converted into common stock ...

70,000
20,000
(9,000)

81,000
(13,000)
21,000
$ 8,000
$ 16,000

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Problem 13-11A (continued)

3. Free cash flow computation:
Net cash provided by operating activities..................
$ 18,000
Capital expenditures .............................................
$150,000
Dividends ............................................................
9,000
159,000
Free cash flow ........................................................
$(141,000)
4. Although the company reported a large net income for the year, a relatively small amount of cash was provided by operations due to increases
in both accounts receivable and inventory. The cash provided by operations, when added to the cash provided by the sale of investments, the
issue of bonds, and the sale of common stock, was not sufficient to
cover the purchase of plant and equipment during the year. Note that
the company increased its investment in plant and equipment by almost
50%. More care should have been taken in planning for this major investment in plant assets. Also, the company should get better control
over its accounts receivable and inventory.

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Problem 13-11A (continued)

Note to the instructor: Although it is not a requirement, a worksheet may be helpful.

Change

Source
or use?

Cash
Flow
Effect

+40
+50
4

Use
Use
Source

40
50
+4

20
+130

Source
Use

+20
130

Assets (except cash and cash equivalents)

Current assets:
Accounts receivable ............
Inventory...........................
Prepaid expenses ...............
Noncurrent assets:
Long-term investments .......
Plant and equipment ..........

Adjustments

Adjusted
Effect

Classification

40
50
+4

Operating
Operating
Operating

20
20

0
150

Investing
Investing

+10

+20

Operating

+63
9

Operating
Operating

Liabilities, Contra-assets, and Stockholders Equity

Contra-assets:
Accumulated depreciation ...
Current liabilities:
Accounts payable ...............
Accrued liabilities ...............

+10

Source

+10

+63
9

Source
Use

+63
9

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Problem 13-11A (continued)

Noncurrent liabilities:
Bonds payable ...................
Deferred income taxes........
Stockholders equity:
Preferred stock...................
Common stock ...................
Retained earnings:
Net income .....................
Dividends ........................

Change

Source
or use?

Cash
Flow
Effect

+70
+8

Source
Source

+70
+8

16
+36

Use
Source

16
+36

+30
9

Source
Use

+30
9

Adjustments

Adjusted
Effect

Classification

+70
+8

Financing
Operating

0
+20

Financing

+30
9

Operating
Financing

+30
10

+30
10

Investing
Operating

+8
+2

+8
+2

Investing
Operating

+16
16

Additional entries

Proceeds from sale of

investments .......................
Gain on sale of investments ...
Proceeds from sale of
equipment .........................
Loss on sale of equipment .....
Total ....................................

13

13

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Communicating in Practice
Date:
To:
From:
Subject:

Current Date
Instructors Name
Students Name
Preparing and Interpreting the Statement of Cash Flows

In addition to summarizing general information about the company obtained from the companys web site, each students memorandum should
address the following:
1. Whether the company uses the direct method or the indirect method to
determine the cash flows from operating activities and why that method
is used.
2. A summary of how the information reported on the statement of cash
flows is used for decision-making purposes.

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Research and Application

1. Netflix mentions four competitive strengths on page 3 of its 10-K: comprehensive library of titles, personalized merchandising, scalable business model, and convenience, selection and fast delivery. These
strengths suggest that Netflixs strategy relies on a combination of customer intimacy and operational excellence. Netflix is attempting to
create customer intimacy by using proprietary personalized merchandising software to tailor a comprehensive library of 55,000 titles to the
unique viewing interests of individual customers. The companys operational excellence value proposition is a function of providing customers
with convenient internet-based access to and fast delivery of a large selection of DVD movies. It is also a function of the companys scalable
business model. In other words, Netflixs internet-based business model
allows it to increase sales without the need to build and staff costly retail outlets.
While students can make defensible arguments in favor of either value
proposition, most internet companies attract customers by offering convenient order placement and delivery of products such as books, DVDs,
airline tickets, etc. at low prices. Although these companies seek to increase sales by using software that tailors their offerings to individual
customer preferences, the bedrock of their success hinges on operational excellence.
2. Netflix faces numerous business risks as described on pages 8-20 of the
annual report. Students may appropriately contend that many of these
risks call into question the viability of Netflixs strategy. Here are four
risks faced by Netflix. Two of these risks are largely uncontrollable and
two have suggested control activities:
Risk: Video on Demand (VOD) technology, which enables cable and internet providers to immediately transmit movies to customers on demand, may supplant the Netflix business model. Netflix customers cannot get immediate access to the movies they wish to watch because
they have to wait until they arrive by mail. Netflix does not have a readily available control activity to reduce this risk, which continues to grow
as the quality and speed of VOD content delivery improves.

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Research and Application (continued)

Risk: Studios will alter their filmed entertainment release date practices
in a manner that threatens Netflixs sales. Page 10 of the 10-K says
DVDs currently enjoy a significant competitive advantage over other
distribution channels, such as pay-per-view and VOD, because of the
early distribution window for DVDs. Currently, studios distribute their
filmed entertainment content approximately three to six months after
theatrical release to the home video market, seven to nine months after
theatrical release to pay-per-view and VOD, one year after theatrical release to satellite and cable, and two to three years after theatrical release to basic cable and syndicated networks. If movie studios choose
to shrink or close the window of time that companies such as Netflix can
rent new DVD releases without competition from competing mediums
(such as pay-per-view and VOD), it will lower retailers DVD rental revenues. Netflix does not have a readily available control activity to reduce
this risk.
Risk: Computer viruses could disrupt Netflixs website. In addition, computer hackers could obtain unauthorized accessed to customers credit
card numbers. Either event would damage the companys reputation
and sales growth goals. Control activities: Invest generously in firewalls
and encryption technology to keep website and sensitive customer information secure.
Risk: Inaccurate forecasts may lead to excessive inventory of some
movie titles and stockouts of other titles. Control activities: Create software that allows users to rate movies that they have viewed. The customer feedback helps predict what movie titles will thrive or dive.

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Research and Application (continued)

3. The comparative balance sheet is shown below and on the following page:
Netflix, Inc.
Comparative Balance Sheet
(in thousands)
Beginning
Ending
Balance
Balance

Assets
Current assets:
Cash and cash equivalents .....................
Prepaid expenses ..................................
Prepaid revenue sharing expenses..........
Deferred tax assets ...............................
Other current assets ..............................
Total current assets .................................
DVD library, net.......................................
Intangible assets, net ..............................
Property and equipment, net ....................
Deposits..................................................
Deferred tax assets..................................
Other assets ............................................
Total assets.............................................

$174,461
2,741
4,695
0
5,449
187,346
42,158
961
18,728
1,600
0
1,000
$251,793

$212,256
7,848
5,252
13,666
4,669
243,691
57,032
457
40,213
1,249
21,239
800
$364,681

Change

Source
Or Use?

+37,795
+5,107
+557
+13,666
780

Use
Use
Use
Source

+14,874
504
+21,485
351
+21,239
200

Use
Source
Use
Source
Use
Source

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Research and Application (continued)

Liabilities and Stockholders Equity
Current liabilities:
Accounts payable ..................................
Accrued expenses..................................
Deferred revenue ..................................
Current portion of capital leases .............
Total current liabilities..............................
Deferred rent ..........................................
Total liabilities .........................................

$ 49,775
13,131
31,936
68
94,910
600
95,510

$ 63,491
25,563
48,533
0
137,587
842
138,429

+13,716
+12,432
+16,597
68

Source
Source
Source
Use

+242

Source

Stockholders Equity:
Common stock ......................................
Additional paid-in capital ........................
Deferred stock-based compensation .......
Accumulated other comp. income ...........
Accumulated deficit ...............................
Total stockholders equity.........................
Total liabilities and stockholders equity.....

53
292,843
(4,693)
(222)
(131,698)
156,283
$251,793

55
317,194
(1,326)
0
(89,671)
226,252
$364,681

+2
+24,351
+3,367
+222
+42,027

Source
Source
Source
Source
Source

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Research and Application (continued)

4. The changes shown on the balance sheet are accounted for on the
statement of cash flows as follows (all amounts are in thousands):
The change in the Cash and Cash Equivalents of $37,795 is shown on
the statement of cash flows as the Net Increase in Cash and Cash Equivalents.
The changes in Prepaid Expenses, Prepaid Revenue Sharing Expenses,
and Other Current Assets are accounted for in the operating activities
section of the statement of cash flows under Changes in Prepaid Expenses and Other Current Assets. The reconciliation is as follows:

Balance Sheet:

Prepaid expenses (Use)........................................

Prepaid revenue sharing expenses (Use) ...............
Other current assets (Source) ...............................
Use of cash .........................................................

$(5,107)
(557)
780
$(4,884)

Change in prepaid expenses and other current assets (Use) .........................................................

$(4,884)

Statement of Cash Flows:

The changes in Deferred Tax Assets in the current and noncurrent asset
sections of the balance sheet are accounted for in the operating activities section of the statement of cash flows under Adjustments to Reconcile Net Income to Net Cash Provided by Operating Activities. The reconciliation is as follows:

Balance Sheet:

Deferred tax assetscurrent (Use) .......................

Deferred tax assetsnoncurrent (Use)..................
Use of cash .........................................................

$(13,666)
(21,239)
$(34,905)

Adjustments to net incomeDeferred taxes (Use) .

$(34,905)

Statement of Cash Flows:

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Research and Application (continued)

The change in the DVD Library, Net account on the balance sheet is accounted for in the operating and investing activities sections of the
statement of cash flows. The reconciliation is as follows:

Balance Sheet:

DVD library, net (Use) ..........................................

Statement of Cash Flows:

Adjustment to net incomeamortization of DVD

library (Source) .................................................
Adjustment to net incomegain on disposal of
DVDs (Use).......................................................
Acquisitions of DVD library (Use) ..........................
Proceeds from sale of DVDs (Source) ....................
Use of cash .........................................................

$(14,874)
$96,883
(3,588)
(113,950)
5,781
$(14,874)

The change in the Intangible Assets, Net account on the balance sheet
is accounted for in the operating and investing activities sections of the
statement of cash flows. The reconciliation is as follows:

Balance Sheet:

Intangible assets, net (Source) .............................

$504

Adjustments to net incomeamortization of intangible assets (Source) ....................................

Acquisition of intangible asset (Use)......................
Source of cash.....................................................

$985
(481)
$504

Statement of Cash Flows:

The change in the Property and Equipment, Net account on the balance
sheet is accounted for in the operating and investing activities sections
of the statement of cash flows. The reconciliation is as follows:

Balance Sheet:

Property and equipment, net (Use) .......................

$(21,485)

Adjustments to net incomedepreciation of property and equipment (Source) .............................

Purchases of property and equipment (Use) ..........
Use of cash .........................................................

$ 9,134

Statement of Cash Flows:

(30,619)
$(21,485)

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Research and Application (continued)

The changes in the Deposits and Other Assets balance sheet accounts
are accounted for in the investing activities section of the statement of
cash flows. The reconciliation is as follows:

Balance Sheet:

Deposits (Source) ..................................................

Other assets (Source) ............................................
Source of cash.......................................................

$351
200
$551

Deposits and other assets ......................................

$551

Statement of Cash Flows:

The changes in the Accounts Payable ($13,716), Accrued Expenses

($12,432), Deferred Revenue ($16,597), and Deferred Rent ($242) balance sheet accounts are directly recorded in the operating activities section of the statement of cash flows.
The change in the Current Portion of Capital Leases account on the balance sheet is accounted for in the operating and financing activities sections of the balance sheet. The reconciliation is as follows:

Balance Sheet:

Current portion of capital leases (Use) ....................

$(68)

Adjustments to net incomenon-cash interest expense (Source) ...................................................

Principal payments on notes payable and capital
lease obligations (Use) ........................................
Use of cash ...........................................................

$11

Statement of Cash Flows:

(79)
$68

The Common Stock, Additional Paid-In Capital, and Deferred StockBased Compensation balance sheet accounts are recorded in the operating and financing activities sections of the statement of cash flows. The
reconciliation is as follows:

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Research and Application (continued)

Balance Sheet:

Common stock (Source) .........................................

Additional paid-in capital (Source) ..........................
Deferred stock-based compensation (Source) ..........
Source of cash.......................................................

Statement of Cash Flows:

Adjustments to net incomestock-based compensation expense (Source) ......................................

Proceeds from issuance of commons stock (Source)
Source of cash.......................................................

2
24,351
3,367
$27,720
$14,327
13,393
$27,720

The change in the Accumulated Other Comprehensive Income balance

sheet account ($222) is directly accounted for in the financing activities
section of the statement of cash flows. The change in the Accumulated
Deficit balance sheet account ($42,027) corresponds with the net income reported in the statement of cash flows.

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Appendix 13A
The Direct Method of Determining the Net Cash
Provided by Operating Activities

Brief Exercise 13A-1 (15 minutes)

Sales .............................................................
Adjustments to a cash basis:
Less increase in accounts receivable ..........

$ 350,000

Cost of goods sold .........................................

Adjustments to a cash basis:
Plus increase in inventory ..........................
Less increase in accounts payable ..............

140,000

Selling and administrative expenses ................

Adjustments to a cash basis:
Less decrease in prepaid expenses ............
Plus decrease in accrued liabilities .............
Less depreciation charges .........................
Income taxes.................................................
Adjustments to a cash basis:
Less increase in deferred income taxes ......
Net cash provided by operating activities.........

19,000 $331,000

+ 33,000
15,000

158,000

160,000
1,000
+ 2,000
20,000

141,000

15,000
4,000

11,000
$ 21,000

Note that the $21,000 above agrees with the amount provided by operating activities under the indirect method in the previous exercise.

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Exercise 13A-2 (15 minutes)

Sales .........................................................
Adjustments to a cash basis:
Decrease in accounts receivable ............

$275

Cost of goods sold .....................................

Adjustments to a cash basis:
Increase in inventory ............................
Increase in accounts payable .................

150

Selling and administrative expenses ............

Adjustments to a cash basis:
Depreciation charges ............................
Net cash provided by operating activities.....

+ 2 $277

+ 10
4

156

90
15

75
$ 46

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Exercise 13A-3 (15 minutes)

1. Sales ............................................................. $150,000
Adjustments to a cash basis:
Increase in accounts receivable .................. 10,000 $140,000
Cost of goods sold ..........................................
Adjustments to a cash basis:
Increase in inventory .................................
Increase in accounts payable .....................
Selling and administrative expenses ................
Adjustments to a cash basis:
Increase in prepaid expenses .....................
Decrease in accrued liabilities ....................
Depreciation charges .................................
Income taxes .................................................
Adjustments to a cash basis:
Decrease in income taxes payable
Increase in deferred income taxes ..............
Net cash provided by operating activities .........

90,000
+9,000
7,000

92,000

40,000
+2,000
+3,000
7,500

37,500

8,000
+500
2,000

6,500
$ 4,000

2. Gains and losses on the sale of assets would have no effect on the
computations in (1). The reason is that these items are not part of
sales, cost of goods sold, selling and administrative expenses, or income
taxes. Thus, gains and losses on the income statement are ignored
under the direct method.

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Exercise 13A-4 (15 minutes)

Sales ..........................................................
Adjustments to a cash basis:
Increase in accounts receivable ..............

$700

Cost of goods sold ......................................

Adjustments to a cash basis:
Decrease in inventory ............................
Increase in accounts payable ..................

400

Selling and administrative expenses .............

Adjustments to a cash basis:
Increase in prepaid expenses .................
Decrease in accrued liabilities .................
Depreciation charges .............................

184

Income tax expense....................................

Adjustments to a cash basis:
Increase in deferred income taxes ..........

36

Net cash provided by operating activities......

110 $590

70
35

+9
+4
60

295

137

28
$130

Note that the $130 net cash provided figure agrees with the indirect method in the previous exercise.

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Problem 13A-5A (30 minutes)

1. Sales ....................................................................
Adjustments to a cash basis:
Increase in accounts receivable .........................

$800

Cost of goods sold .................................................

Adjustments to a cash basis:
Decrease in inventory .......................................
Increase in accounts payable ............................

500

Selling and administrative expenses .......................

Adjustments to a cash basis:
Increase in prepaid expenses ............................
Decrease in accrued liabilities ...........................
Depreciation charges ........................................

213

Income taxes ........................................................

Adjustments to a cash basis:
Increase in deferred income taxes .....................
Net cash provided by operating activities ................

100 $700

50
80

+4
+12
24

370

205

27
6

21
$104

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Problem 13A-5A (continued)

2.

Weaver Company
Statement of Cash Flows
For the Year Ended December 31, 2009

Operating activities:

Cash received from customers ...................................

$700
Less cash disbursements for:
Cost of merchandise purchased ............................... $370
Selling and administrative expenses ......................... 205
Income taxes ......................................................... 21
Total cash disbursements ...........................................
596
Net cash provided by operating activities ....................
104

Investing activities:

Proceeds from sale of long-term investments .............. 10

Proceeds from sale of equipment ............................... 20
Additions to plant and equipment ............................... (180)
Net cash used for investing activities ..........................
(150)

Financing activities:

Increase in bonds payable ......................................... 110

Decrease in common stock ........................................ (40)
Cash dividends .......................................................... (30)
Net cash provided by financing activities ....................
Net decrease in cash .................................................
Cash balance, beginning of the year ...........................
Cash balance, end of the year ....................................

40
(6)
15
$ 9

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Problem 13A-6A (45 minutes)

1. Sales ............................................................. $900,000
Adjustments to a cash basis:
Increase in accounts receivable .................. 80,000 $820,000
Cost of goods sold ..........................................
Adjustments to a cash basis:
Increase in inventory .................................
Increase in accounts payable .....................
Selling and administrative expenses ................
Adjustments to a cash basis:
Decrease in prepaid expenses ....................
Decrease in accrued liabilities ....................
Depreciation charges .................................
Income taxes .................................................
Adjustments to a cash basis:
Increase in deferred income taxes ..............
Net cash provided by operating activities .........

500,000
+50,000
60,000

490,000

328,000
7,000
+10,000
42,000

289,000

24,000
3,000

21,000
$ 20,000

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Problem 13A-6A (continued)

2.

Joyner Company
Statement of Cash Flows
For Year 2

Operating activities:

Cash received from customers ..........................

Less cash disbursements for:
Cost of merchandise purchased ...................... $490,000
Selling and administrative expenses ................ 289,000
Income taxes ................................................
21,000
Total cash disbursements ..................................
Net cash provided by operating activities ...........

$820,000

800,000
20,000

Investing activities:

Proceeds from sale of equipment ......................

18,000
Loan to Hymas Company .................................. (40,000)
Additions to plant and equipment ...................... (150,000)
Net cash used for investing activities .................

Financing activities:

Increase in bonds payable ................................

Increase in common stock ................................
Cash dividends .................................................
Net cash provided by financing activities ...........
Net decrease in cash ........................................
Cash balance, beginning of year ........................
Cash balance, end of year.................................

120,000
30,000
(15,000)

(172,000)

135,000
(17,000)
21,000
$ 4,000

3. The decline in cash is explainable largely by the companys inability to

generate a significant amount of cash from operating activities. Note
that the company generated only $20,000 from operating activities, although net income was $56,000 for the year. This small amount of cash
generated is due primarily to the buildup of accounts receivable. Even
though an additional $150,000 was obtained from an issue of bonds and
an issue of common stock ($120,000 + $30,000 = $150,000), the cash
available was not sufficient to expand the plant, make a substantial loan
to another company, and pay a large cash dividend. As a result, cash
declined during the year.
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Problem 13A-7A (45 minutes)

1. The income statement adjusted to a cash basis:
Sales .........................................................
$500,000
Adjustments to a cash basis:
Increase in accounts receivable ..............
40,000 $460,000
Cost of goods sold ......................................
Adjustments to a cash basis:
Increase in inventory .............................
Increase in accounts payable .................
Selling and administrative expenses .............
Adjustments to a cash basis:
Decrease in prepaid expenses ................
Decrease in accrued liabilities .................
Depreciation charges .............................
Income taxes .............................................
Adjustments to a cash basis:
Increase in deferred income taxes ..........
Net cash provided by operating activities .....

300,000
+50,000
63,000

287,000

158,000
4,000
+ 9,000
20,000

143,000

20,000
8,000

12,000
$ 18,000

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Problem 13A-7A (continued)

2.

Rusco Products
Statement of Cash Flows
For the Year Ended July 31, 2009

Operating activities:

Cash received from customers .........................

Less cash disbursements for:
Cost of merchandise purchased .....................
Selling and administrative expenses ...............
Income taxes ...............................................
Total cash disbursements .................................
Net cash provided by operating activities ..........

Investing activities:

Proceeds from sale of investments ...................

Proceeds from sale of equipment .....................
Additions to plant and equipment .....................
Net cash used for investing activities ................

Financing activities:

Increase in bonds payable ...............................

Increase in common stock ...............................
Cash dividends ................................................
Net cash provided by financing activities ..........

$460,000
$287,000
143,000
12,000

30,000
8,000
(150,000)

70,000
20,000
(9,000)

442,000
18,000

(112,000)

81,000

Net decrease in cash .......................................

Cash balance, beginning of the year .................
Cash balance, end of the year ..........................

(13,000)
21,000
$ 8,000

Schedule of noncash investing and financing

activities:
Preferred stock converted into common stock ...

$ 16,000

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Problem 13A-7A (continued)

3. There are two reasons for the sharp decline in cash. First, note that a
relatively small amount of cash was provided by operations during the
year. This is due to a build-up in accounts receivable and inventory,
which together have grown by $90,000; the build-up of receivables reduced the amount of cash received from customers, and the build-up of
inventory increased the amount of cash required to purchase goods.
Second, the company paid out in dividends half of the cash provided by
operations, while at the same time increasing its investment in plant and
equipment by almost 50%. These uses of cash far outstripped the
amount of cash available through operations and the sale of bonds,
common stock, and investments, resulting in a sharp decrease in the
amount of cash available.

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Appendix 13B
The T-Account Approach to Preparing the Statement of Cash Flows
Brief Exercise 13B-1 (30 minutes)
Cash
Provided Used
Increase in accounts re(1)
35 ceivable

Net income
Decrease in prepaid
expenses
(4)
Increase in accounts
payable
(5)
Increase in deferred
income taxes (given)
Depreciation expense
(given)
Net cash provided by
operating activities

1 Increase in inventory
Decrease in accrued liabili15 ties

Bal.
Bal.

(6)

Accrued Liabilities
Bal.
2
Bal.

(3) 33
(6)

4
20
21

Accounts Receivable
Bal.
106
(2)
19
Bal.
125
Prepaid Expenses
7
(4)
6

(2) 19

Bal.
(3)
Bal.

Inventory
180
33
213
Accounts Payable
Bal.
(5)
Bal.

195
15
210

6
4
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705