Chapter 5 - Solution PDF

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Summary

Chapter 5: The Statement of Cash FlowsSuggested Time Case 5-1 Aurora Inc. 5-2 Purple Limited 5-3 HUM Products LimitedTechnical Review TR5-1 SCF – Cash Definition..................................... 5 TR5-2 SCF – Cash from Operating Activities............ 5 TR5-3 SCF – Cash from Operating Activities...

Description

Chapter 5: The Statement of Cash Flows Su g g e s t e dTi me Ca s e5 1 5 2 5 3

Au r or aI n c . Pur pl eLi mi t e d HUM Pr o du c t sLi mi t e d

Te c hni c a lRe vi e w TR5 1 TR5 2 TR5 3 TR5 4 TR5 5 TR5 6 TR5 7 TR5 8 TR5 9 TR5 10

SCF–Ca s hDe fini t i o n . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 SCF–Ca s hf r omOp e r a t i n gAc t i vi t i e s . . . . . . . . . . . . . 5 SCF–Ca s hf r omOp e r a t i n gAc t i vi t i e s . . . . . . . . . . . . . 5 SCF–I n v e s t i n gAc t i v i t i e s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 SCF–I n v e s t i n gAc t i v i t i e s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 SCF–Fi na nc i n gAc t i vi t i e s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 SCF–Fi na nc i n gAc t i vi t i e s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 SCF–Fi na nc i n gAc t i vi t i e s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 0 SCF–Ca s hPa i do rCo l l e c t e d. . . . . . . . . . . . . . . . . . . . . . . . . . 5 SCF–Ca s hPa i do rCo l l e c t e d. . . . . . . . . . . . . . . . . . . . . . . . . . 1 0

As s i g nme ntA51 A52 A53 A54 A55 A56 A57 A58

A51 0 A511 A512 A513 A514 A515 A516 A517 A518 A519

Ov e r vi e w–SCFCl a s s i fic a t i on. . . . . . . . . . . . . . . . . . . . . . . . 10 Ov e r vi e w–SCFCl a s s i fic a t i on. . . . . . . . . . . . . . . . . . . . . . . 10 Ov e r vi e w–SCFCl a s s i fic a t i on. . . . . . . . . . . . . . . . . . . . . . . 10 St a t e me n tofCa s hFl o ws( *W) . . . . . . . . . . . . . . . . . . . . . . . . 3 0 St a t e me n tofCa s hFl o ws( *W) . . . . . . . . . . . . . . . . . . . . . . . . 3 0 St a t e me n tofCa s hFl o ws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 0 St a t e me n tofCa s hFl o ws . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 0 Pr e s e n t a t i on–Di r e c t Me t h od , Ope r a t i n g Ac t i vi t i e s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 5 A59 Pr e s e nt a t i on–Di r e c ta n dI n di r e c t , Ope r a t i n g Ac t i vi t i e s( *W) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 0 Pr e s e n t a t i o n–Di r e c t a ndI nd i r e c t , Op e r a t i n g Ac t i vi t i e s. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 0 Pr e s e nt a t i on–Di r e c t a n dI nd i r e c t , Ope r a t i n g Ac t i vi t i e s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 0 I nt e r pr e t a t i o n–Qu a l i t yofEa r ni n g s . . . . . . . . . . . . . . . . 1 5 I nt e r pr e t a t i o n–Qu a l i t yofEa r ni n g s . . . . . . . . . . . . . . . . 1 5 I nt e r pr e t a t i o n–Qu a l i t yofEa r ni n g s . . . . . . . . . . . . . . . . 1 5 St a t e me n tofCa s hFl o ws —I n di r e c tMe t h od ; Ca pi t a lAs s e t s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 St a t e me n tofCa s hFl o ws —Di r e c t a n dI nd i r e c t 45 St a t e me n tofCa s hFl o ws —Op t i on a lSp r e a ds he e t4 0 St a t e me n tofCa s hFl o ws , Pa r t i a l . . . . . . . . . . . . . . . . . . . . . 4 0 St a t e me n tofCa s hFl o ws , Pa r t i a l . . . . . . . . . . . . . . . . . . . . . 4 0

A520 A521 A522 A523 A524 A525 A526 A527 A528 A529 A530 * W

St a t e me n tofCa s hFl o ws( * W) . . . . . . . . . . . . . . . . . . . . . . . . 40 St a t e me n tofCa s hFl o ws —Op t i on a lSp r e a ds he e t3 0 Ca l c ul a t eCa s hFl o w—I n t e r e s ta ndI nc omeTa x 1 0 Op t i o na l Pr e s e n t a t i onAl t e r na t i v e s , Di r e c tMe t h od30 Op t i o na l Pr e s e n t a t i on Al t e r na t i v e s , I n di r e c tMe t ho d 1 5 Pr e s e nt a t i onofI nt e r e s ta ndTa x , I nd i r e c tMe t h od 15 Pr e s e nt a t i onofI nt e r e s ta ndTa x , I nd i r e c tMe t h od 1 5 ASPE—St a t e me n tofCa s hFl o ws . . . . . . . . . . . . . . . . . . . . 15 ASPE—St a t e me n t o fCa s hFl o ws . . . . . . . . . . . . . . . . . . . . . 30 ASPE—St a t e me n tofCa s hFl o ws . . . . . . . . . . . . . . . . . . . . 30 I nt e gr a t i v ePr ob l e m, Ch a p t e r s15. . . . . . . . . . . . . . . . . . . 75

Th es ol u t i ont ot hi sa s s i gn me nt i so nt h et e xtwe bs i t e , Co nn e c t . Th i ss ol u t i o ni sma r k e dWEB.

Cas e s Cas e5 1Aur o r aI nc . Overview The owner of Aurora, Cindy Hickey, has requested advice on cash flow issues. Aurora seems to be a small company, with a profitable history, but is currently in a cash crunch. Users of the financial statements include the bank, as there is a current demand loan, the owner of the company, The statements are presumably used for tax purposes. Issues 1. CFS 2. Advice on cash flow issues Analysis and recommendations 1. CFS A useful first step would be to prepare a Statement of Cash Flows. See Exhibit 1. Although Aurora had $12,000 in net earnings, cash flows from day-to-day, or operating, activities translates into an outflow of $1,200. This was due in part to the increase in accounts receivable and inventory. The company sold investments during the year, a source of cash, but spent $16,000 on machinery and $27,500 on a vehicle. As a result, investing activities represented a cash outflow of $26,300. In the financing area, the bank loan provided $30,000 in cash, but $8,000 of dividends were paid. 2. Advice on cash flow issues

There is a buildup in accounts receivable and inventory. Cindy should review these accounts to ensure that the receivables are collectible and the net realizable value of the inventory is not less than its carrying amount. There is also a major reduction in accounts payable, not consistent with the inventory buildup. Why was payment made so quickly? Are there valid business reasons as to why these balances are increasing? Could the increases to the assets have anything to do with the new manager and his practice of building up the asset base? How do accounts receivable turnover and inventory turnover compare to past years? This is a potential problem area to investigate.

The company has liquidity problem, but still has $20,000 of investments. If these were liquidated, the bank loan could be reduced and the cash flow problem would be addressed. Are there reasons that the investments are still held? This is a solution to investigate. Acquisition of long-term assets should generally not be not financed with cash and demand loans. Financing of the vehicle and machinery should have been through debt that more closely matches the lives of the assets. Why was the machinery and equipment financed in such a way? It might be more efficient for the company to own a vehicle as opposed to renting one, but the financial flexibility of the company has suffered. Using $43,500 to immediately pay for the vehicle and machinery limits Aurora’s cash flow flexibility in the future. In particular, the company has not owned a vehicle in the past. Who is driving the vehicle – Cindy or the new manager? This is a major investment for a small company. Perhaps the vehicle should be sold and another one leased? A review of the Retained Earnings account indicates that $8,000 was taken in dividends during the year. (Net earnings were $12,000, while retained earnings increased by $4,000, so the difference would be attributable to dividends.) While the amount taken out of the company may be in line with past years, it represents a significant drain on Aurora’s cash. Conclusion Aurora has been profitable, as is demonstrated by the relatively high amount of retained earnings. However, the company will need cash in order for the business to remain viable. Cindy should examine various existing financial statement elements with a view to solving the immediate cash problem. Cindy should develop a cash budget to plan for future asset acquisitions. All these issues should be discussed in conjunction with the new manager because Aurora’s liquidity has deteriorated during the year.

Exhibit 1 Aurora Inc. Statement of Cash Flow for the year ended December 31, 20XX Operating activities: Net earnings Depreciation expense Loss on sale of machinery Gain on sale of investments Increase in accounts receivable Increase in inventory Decrease in accounts payable Increase in salaries payable Cash from operating activities

12,000 9,200 2,200 (3,600) (6,500) (7,500) (10,100) 3,100 (1,200)

Investing activities: Sale of investments Sale of machinery Acquisition of machinery Acquisition of vehicle Cash used in investing activities

15,600 1,600 (16,000) (27,500) (26,300)

Financing activities: Increase in demand bank loan Payment of dividends Cash from financing activities

30,000 (8,000) 22,000

Decrease in cash Opening cash Closing cash

(5,500) 6,000 500

Supplemental disclosures: Cash received for interest Cash paid for interest Cash paid for income taxes

1,200 (2,200) (2,750)

Supporting calculations: Cost of investments sold Gain on sale Proceeds from sale

12,000 3,600 15,600

Book value of machinery sold Loss on sale Proceeds from sale

3,800 (2,200) 1,600

Machinery Beginning Cost of machinery sold New machinery purchased Ending

24,000 (9,600) 16,000 30,400

Retained earnings Beginning Net earnings Dividends Ending

45,300 12,000 8,000 49,300

Cas e5 2Pur pl eLi mi t e d Ov e r v i e w Pu r p l eLi mi t e di sa nop e r a t i on wi t hs e v e r ec a s h flo wp r ob l e ms ,f ue l e db y gr o wt h . Ac c o un t i n gp ol i c i e sa n dr e p or t i n go b j e c t i v e sa r eno ts i gn i fic a n t ;t h ei s s uehe r ei st h eus e o fa c c o unt i n gi nf or ma t i o nt os u pp or tma na g e me nt a c t i o n. I s s u e s 1 .An a l y s i sofc a s hflo wsf r omo pe r a t i n ga c t i vi t i e s 2 .Ad vi c eo nc a s hflo wma n a g e me nt Ana l y s i s 1. Analysis of cash flows from operating activities Th ec omp a n yi si n de e di nac a s hc r u nc h ,wi t h$3 20o fc a s ha tt hee n dof20 X3a n d $ 32 , 11 9ofa c c o un t spa y a bl ea nda c c r u e dl i a b i l i t i e s .Sho r t t e r m de bt ,p r e s uma bl y b a n kl o a n s , i s$3 5, 5 66. Ms . Li nha so b v i ou sc on c e r ns . Pe rEx hi b i t1,c a s hflo wsf r om op e r a t i n ga c t i v i t i e sh a v eb e e nc a l c ul a t e db a s e dont he i n f o r ma t i o np r o vi de d .Thi sa n a l y s i sa s s ume st ha tt he r eha v ebe e nnodi s po s i t i o nsof p l a n ta n de q ui p me nt , oro t he rt r a ns a c t i on st ha twoul dt r i g g e rno nc a s hg a i n s . Ca s hflo wf r omo pe r a t i n ga c t i vi t i e sd e mo ns t r a t e swh yt hec ompa n yi si nac ha l l e n gi n g c a s hs i t u a t i on .I n20 X0,t h es t a r t upy e a r ,i n v e n t o r ya nda c c o un t sr e c e i v a b l ei nc r e a s e d f r oms t a r t up-z e r o-t oe n dofy e a rba l a nc e s-a bo ut$ 25 , 00 0, c omb i ne d .Su pp or tof $ 16 , 82 4wa sr e c e i v e df r om c r e d i t o r s ,t hr ou g ht hei nc r e a s ei na c c o un t sp a y a bl ea n d a c c r ue dl i a bi l i t i e s .Ho we v e r ,t h ec a s hs ho r t f a l lwa su nd e r s t a nda bl ea ndp a r to ft he c a p i t a ls t r uc t ur e .I n20 X1 ,mod e s tne ti n c o met r a n s l a t e dt oahe a l t h y$2 , 26 9ofc a s h f r om op e r a t i n ga c t i vi t i e s .Th e r ewa sa ni n c r e a s ei ni n v e n t o r y ,pa r t i a l l yo ffs e tb ya s ma l l e ri nc r e a s ei na c c o un t sp a y a b l e , a n da c c ou nt sr e c e i v a b l ewe r ef a i r l ys t a bl e . Wi t ht hegr o wt hi n20 X2f r o ms a l e st or e t a i lc ha i n s ,t heb us i ne s smode lc ha n g e d. Th e r ewe r el a r g ei nc r e a s e si na c c o un t sr e c e i v a b l e–$1 5, 3 90 ,a ndi n v e n t o r y-$7 , 21 0. Th us ,t h er e v e nu ewa sb oo k e dbu tno tc ol l e c t e d,a n di n v e nt or yha dt ogr o wt ome e t s a l e sd e ma nd s .Ho we v e r ,s up po r tf r o ms up pl i e r s ,i nt e r mso fhi g he rb a l a nc e sof a c c ou nt spa y a bl e , wa si ne x c e s soft h ei n v e n t o r ybu i l d up( $7 , 59 1) . Th ec a s hflo wi s s u e wa sc ol l e c t i onofr e v e nu e . Th ei s s ue sr ol lf or wa r dt o 20 X3.The r ei sa na dd i t i o na l$ 10 , 79 0i na c c o un t s r e c e i v a b l e ,$9 , 00 0i ni n v e nt or y ,bu to nl yac ha n g eof$5, 7 15i na c c o un t spa y a bl e . He r e ,t hei s s ue sa r ec o l l e c t i onofr e v e n ue ,b uta l s ofin a n c i n gofi n v e nt or ybu i l dup . Th es ho r t f a l lh a st ob eme tt hr ou ghbo r r o wi n g .

2. Advice on cash flow management Ms . Li ns ho ul di n v e s t i g a t ea l lo ft hef o l l o wi n ga c t i on s : 1. Speed up collection of accounts receivable. Slow collection is not only a cash timing issue, but bad debts might also be of concern. The company has $29,240 in accounts receivable and it is urgent that the cash flow be sped up. Some alternatives include tightening payment times, offering discounts for early payment, and securitization of accounts receivable. 2. Reduction of inventory. The company has $41,970 in inventory, a risky asset in any business model, but surely exceptionally risky in the fashion industry. If the business model is really based around speedy delivery of edgy fashion, the inventory levels do not reflect this. Inventory obsolescence is a major issue, but so is cash flow – the company is struggling to support inventory levels. 3. Limit growth. Until cash flow stabilizes, additional sales volume that must be supported with accounts receivable and inventory is not feasible 4. Arrange new debt. Bankers should be consulted to see if additional, or restructured, long-term or short-term debt can be arranged. Projected cash flow information should be prepared to support such a request. At present, there is $20 million of long-term debt, which might be supported through the $22.7 million of long-term assets. There is not much room for debt increase. With respect to shortterm loans, there is $36 million of debt, which likely looks to the $70 million of accounts receivable and inventory as collateral. There may not be much opportunity to increase this borrowing, either. Plus, borrowing is expensive. Regardless, borrowing is an option that must be explored. 5. Provide additional capital through equity investment. Either Ms. Lin or other equity investors must be consulted about providing additional money through equity investment. This may raise issues of control over the company, and appropriate pricing. Advice from finance professionals should be sought. Fi na l l y ,Ms .Li ns h ou l de n s u r et h a the rma n a g e me ntt e a mi n c l ud e si n di v i du a l swi t hc l e a r fin a n c i a ls t r e n gt h ,a ndwhoa r ee mp o we r e dt ot a k ea pp r op r i a t ea c t i o n.Thec omp a n yi s p r ofit a bl e ,bu tc l o s et ot h eb r i nki nt e r msofs o l v e n c y .St r on gfin a n c i a lma n a g e me ntwi l l b er e q ui r e df orap e r i o do fy e a r st oa dd r e s st hi sc h a l l e n g e .

Exh i bi t1 Pu r p l eLi mi t e d Ca s hflo wf r o mop e r a t i n ga c t i vi t i e s20 X020 X3

2 0X3

2 0X2

2 0X1

20 X0

Ca s hflo wf r o mop e r a t i n ga c t i vi t i e s Ea r n i n g s Ad dba c k :no nc a s hi t e ms De p r e c i a t i on( 1)

$6, 2 45 $2, 5 80 $ 13 3 2, 9 30

3 , 14 0

3 , 31 0

$( 1, 3 45 ) 1 , 40 0

Ad j u s t me n t :Cha n g e si nwor ki n gc a pi t a l r e l a t e dt oo pe r a t i n ga c t i vi t i e s , r e l a t e dt o Ac c o un t sr e c e i v a b l e ( 1 0, 7 90 ( 1 5, 3 90) ( 12 0) ( 2, 9 40 ) ) I n v e n t or y ( 9 , 00 0) ( 7 , 210 ) ( 2 , 96 0) ( 2 2, 80 0) Pr e p a i da s s e t s ( 3 55 ) ( 1 24 ) ( 8 3) ( 1, 0 04 ) 5 , 71 5 7, 5 91 1 , 9 89 1 6, 82 4 Ac c o un t sp a y a bl ea n da c c r ue d l i a bi l i t i e s Ca s hflo wf r o mop e r a t i n ga c t i vi t i e s

( $ 5, 2 55$ ( 9, 4 13) $ 2, 2 69 $( 9, 8 65) )

(1) 20X0:$16,000 bought vs. $14,600 closing 20X1: $14,600 - $11,290 2 0X2: $1 1, 2 90+$ 9, 5 00bo u gh t-$1 7, 6 50c l o s i n g 2 0X3: $1 7, 6 50+$ 8, 0 00bo u gh t-$2 2, 7 20c l o s i n g

Cas e5 3HUM Pr o duc t sLt d. Ov e r v i e w HUM Pr od uc t s Li mi t e d( HUM) i sa c o ns ume rp r od u c t sc ompa n yt h a td e s i gn s , ma nu f a c t ur e sa ndma r k e t sb r a n de dpr od uc t s .Thec o mp a n yi spu bl i ca n dc omp l i e swi t h I FRS.Va r i ou sa l t e r na t i v e sf orSCF p r e s e n t a t i on a r eb e i n gc o ns i de r e d .Thep r i ma r y fin a n c i a ls t a t e me n tu s e r swo ul db ei n v e s t o r sa n dt h e i ra d vi s o r s .Le nd e r sa r ea l s o i mpo r t a n t ,g i v e nt h el e v e lofde b to nt hes t a t e me ntoffina nc i a lpo s i t i on .Onea s s u me st h a t s t a b l ea ndi mp r o vi n gme t r i c sa r ed e s i r a bl e , a si sr e a di l yun de r s t a n da bl ei nf or ma t i o n. I s s u e s 1 .Pr e s e n t a t i onoft h eSCFu s i n gt hedi r e c tv e r s usi nd i r e c tme t h od si nop e r a t i n g a c t i v i t i e s 2 .I nt e r pr e t a t i onofSCFr e s u l t s 3 .Cl a s s i fic a t i o no fi nt e r e s ta n dd i vi de ndspa i d 4 .Cl a s s i fic a t i o no fde v e l o pme ntc os t s Ana l y s i s 1 . Pr e s e nt at i onof t heSCFus i n gt hedi r e c tv e r s usi nd i r e c tme t h od si nop e r at i n gac t i v i t i e s Th e20 X4SCFus i n gt hei n di r e c tme t h odi ss ho wni nEx hi bi t1,a ndu s i n gt hedi r e c t me t ho d,i nEx hi b i t2.Thei n v e s t i n ga n dfina nc i n gs e c t i on sa r ei d e n t i c a lf o rt h et wo me t ho ds ,a ndt hea mou ntofc a s hu s e di nop e r a t i o nsi si de nt i c a l ,a t$ 17 , 10 0. Ho we v e r ,t h e p r e s e n t a t i o nofo pe r a t i n gc a s hflo wsi sdi ffe r e n ti nt h ei n di r e c tv e r s ust hed i r e c tme t h od s . Th edi r e c tme t h odl i s t sc a s hf r om c us t ome r s ,a ndc a s hp a i df orv a r i o uspu r p os e s .I tma y b ee a s i e rt oi n t e r p r e t . Thi spr e s e n t a t i ona l t e r na t i v ei sno tc ommo ni nCa na dat od a t e . Out s t a n di n gq u e s t i o nsf orr e vi e wwi t ht h eCFO: 1 .TheSCFh a sbe e np r e p a r e da s s umi n gn os a l e so fpr op e r t y , p l a n ta n de q ui pme nto r i n t a n gi bl e s . Th a ti s ,t h ec ha n g ei nt h e s ea c c o un t s wa sa s s u me dt ob e d e p r e c i a t i o n/ a mor t i z a t i ona n da c q ui s i t i o ns . 2 .Al lt r a n s a c t i o nswe r ea s s ume dt ob ec a s ht r a n s a c t i on s–t ha ti s ,t h e r ewe r enon on c a s he x c ha n g e s . 3 .Thea c c o un t st ha tdi dno tc ha n g e( g o od wi l la n dc ommo ns ha r e s )we r ea s s ume dt o b edo r ma n tdu r i n gt h epe r i o d . 4 .An ot h e ra s s umpt i o nwa st h a tl on g t e r m de b twa sn o tr e p a i da ndr e i s s u e d ;t ha ti s , t h a tt h ene ti n c r e a s et ol on g t e r md e b twa st heo nl yt h i n gt ha ta ffe c t e dt h i sa c c o un t ( r e p a y me n t sha v et ob es e p a r a t e l yr e po r t e d )

2 . I nt e r pr e t at i o nof SCFr e s ul t s I n2 0X4 ,t hec ompa n yr e p or t e d$ 96 . 5mi l l i o ni nn e te a r ni n g s ,b utu s e d$1 7. 1mi l l i oni n o pe r a t i n ga c t i v i t i e s .Th e r ewa sal a r g eb ui l d upi ni n v e n t or y( $1 86 . 1)a ndamo r emo de s t b ui l dupi na c c oun t sr e c e i v a b l e( $2 9. 4 ) .Ac c ou nt spa y a bl ei n c r e a s e d,a so newo ul de xp e c t whe ni n v e n t o r yi n c r e a s e s ,bu tt he$ 55i nc r e a s ei na c c ou nt sp a y a bl ei sf a rl e s st ha nt he i n v e n t o r yb ui l dup . Theo v e r a l lr e s ul ti sne g a t i v ec a s hflo wf r omop e r a t i n ga c t i vi t i e s . Th ec o mpa n yi n v e s t e ds i gn i fic a n t l yi np l a n ta s s e t s( $5 5. 2 )a n di nt a n gi b l ea s s e t s( $10 2. 9 ) d ur i n gt hey e a r .The ypa i dou t$ 60mi l l i o ni ndi v i de nd st os ha r e hol de r s . Th e i rma j ...