Chapter 20

Exercise 20.2

a.

b.

Exercise 20.3

a.

Supplemental Disclosures:

1. The purchase of equipment through the issuance of $50,000 of common shares is a significant non-cash financing transaction that would be disclosed in the notes to the financial statements.

   Cash paid interest

   $35,000

2. Note: Had there been cash paid income taxes, this would also be disclosed.

b. Free cash flow:

In the analysis of Carmel’s free cash flow above, we see that it is negative. While including dividends paid is optional, it would not have made a difference in this case. What does make a difference, however, is that the capital expenditures are those needed to sustain the current level of operations. In the case of Carmel Corp., the land was purchased for investment purposes, and not to meet operational requirements. With this in mind, the free cash flow would more accurately be:

This makes intuitive sense and it is supported by the results from one of the coverage ratios.

The current cash debt coverage provides information about how well Carmel Corp. can cover its current liabilities from its net cash flows from operations:

Carmel Corp.’s current cash debt coverage is 1.38 ($181,600 ÷ (87,200 + 176,000) × 50%). The company has adequate cash flows to cover its current liabilities as they come due and so, overall, its financial flexibility looks positive.

In terms of cash flow patterns, we see a positive trend, as Carmel Corp. has managed to more than triple its cash balance in the year, mainly from cash generated from operating activities. They were able to pay $8,000 in dividends, or a 1.7% return. And if dividends are paid several times throughout the year, then the return is more than adequate for investors. Carmel Corp. also sold off its traded investments for a profit, and some idle buildings at a small loss, to obtain sufficient internal funding for some land that they want to purchase as an investment. They also managed to lower their accounts payable levels by close to 60%. All of this supports the assessment that Carmel Corp.’s financial flexibility looks reasonable.

c. The information reported in the statement of cash flows is useful for assessing the amount, timing, and uncertainty of future cash flows. The statement identifies the specific cash inflows and outflows from operating activities, investing activities, and financing activities. This gives stakeholders a better understanding of the liquidity and financial flexibility of the enterprise. Some stakeholders have concerns about the quality of the earnings because of the variety and subjectivity of the bases that can be used to record accruals and estimates. As a result, the higher the ratio of cash provided by operating activities to net income, the more stakeholders can rely on the earnings reported.

Exercise 20.4

*
**
***
****

Disclosures:

Additional land for $37,400 was acquired in exchange for issuing additional common shares.

Exercise 20.5

1. Egglestone Vibe Inc. Statement of Cash Flows
   For the Year Ended December 31, 2021
   Cash flows from operating activities:
   Net income				$24,700
   Adjustments to reconcile net income to
   net cash provided by operating activities
   Depreciation expense (note 1)		$55,900
   Loss on sale of equipment (note 2)		10,100
   Gain on sale of land (note 3)		(38,200)
   Impairment loss – goodwill		63,700
   Increase in accounts receivable		(36,400)
   Increase in inventory		(67,600)
   Decrease in accounts payable		(28,200)		(40,700)
   Net cash used by operating activities				(16,000)
   Cash flows from investing activities
   Purchase of investments – available for sale		(20,000)
   Proceeds from sale of equipment		27,300
   Purchase of land (note 4)		(62,400)
   Proceeds from sale of land		150,000
   Net cash provided by investing activities				94,900
   Cash flows used by financing activities
   Payment of cash dividends (note 5)		(42,600)
   Issuance of notes payable		10,500
   Net cash used by financing activities				(32,100)
   Net increase in cash				46,800
   Cash at beginning of year				37,700
   Cash at end of year				$84,500

   General note: During the year, Egglestone Vibe retired $160,000 in notes payable by issuing common shares.

   Notes to statements:

   1. 
   2. 
   3. 
   4. 
   5. Retained earnings account: ; Dividend declared but not paid = $20,500Dividends payable account:   cash paid dividends
2. Negative cash flows from operating activities may signal trouble ahead with regard to Egglestone’s daily operations, including profitability of operations and management of its current assets, such as accounts receivable, inventory and accounts payable. All three of these increased the cash outflows over the year. In fact, net cash provided by investing activities funded the net cash used by both operating and financing activities. Specifically, proceeds from sale of equipment and land were used to fund operating and financing activities, which may be cause for concern if the assets sold were used to generate significant revenue. Shareholders did receive cash dividends, but investors may wonder if these payments will be sustainable over the long term. Consider that dividends declared were $20,500, which was quite high compared to the net income of $24,700. In addition, the dividends payable account still had a balance payable of $41,600 from prior dividend declarations not yet paid. This creates increased pressure on the company to find sufficient funds to catch-up with the cash payments owed to investors. Egglestone may not be able to sustain payment of cash dividends of this size in the long-term if improvement of its profitability and management of its receivables, payables, and inventory are not implemented quickly.

Exercise 20.6

1. For operating activities, use the steps from earlier in the chapter for the direct method: Step 3 – enter all the line items from the income statement to the most appropriate direct method category so that the total matches the income statement. Step 4 – enter all the changes to the non-cash working capital accounts (except current portion of LT debt) to the most appropriate direct method category, and use the accounting equation technique to determine if the cash flow change for each account is positive or negative. Complete the investing and financing sections as usual.

   Bognar Ltd. Statement of Cash Flows Worksheet – Direct Method
   For the Year Ended December 31, 2020
   	Step 3		Step 4		Step 5
   		I/S Accounts	Changes to W/C +/- add’l adjustments		Net cash flow
   Cash flows from operating activities:
   Cash received from sales – Sales		$1,852,400
   – Accounts receivable				$(108,000)	$1,744,400
   Cash paid for goods and services – COGS		(1,213,300)
   – Other operating expenses		(342,100)
   – Inventory				(146,000)
   – Accounts payable				(37,300)	(1,738,700)
   Cash paid to employees					N/A
   Cash received for interest income					0
   Cash paid for interest for Bonds payable, net of discount ($1,034,250 – 1,089,000) = $54,750 non-cash interest expense		(126,500)		54,750*	(71,750)
   Cash received for income taxes ($69,300 – 26,400)		59,400		(42,900)**	16,500
   Cash received for dividends					0
   Memo Items:
   Depreciation		(121,000)
   Depreciation		(82,500)
   Goodwill impairment		(66,000)
   Loss on Held for Trading investments		(32,500)		32,500***
   Gain on sale of land		24,200
   Loss on sale of machine		(10,800)
   Net cash flows from operating activities		(58,700)			(49,550)
   Cash flows from investing activities:
   Proceeds from sale of land ($430,500 – 363,000 + 24,200 gain)					91,700
   Proceeds from sale of building ($1,176,000 – 1,144,000 = 32,000) less accum. depr.
   ($399,000 + 121,000 – 517,000) = $3,000 accum. depr. for the sold building					29,000
   Sale of machinery					50,000
   Purchase of machinery ($918,750 – 125,000 – 1,188,000) = $394,250 less
   $166,000 = $228,250. $166,000 is a non-cash entry in exchange for shares
   ($199,500 – 60,000 – 305,500) = $166,000					(228,250)
   Net cash flows from investing activities					(57,550)
   Cash flows from financing activities:
   Issuance of preferred shares
   ($885,150 – $1,152,800)					267,650
   Repurchase of common shares					(65,000)
   Dividends paid ($326,550 – 5,000 common shares retirement – $58,700 net loss –
   $151,800) = $111,050 dividends for both preferred and common shares.
   Preferred shares dividend is $40,000. Common shares dividend is $71,050.					(111,050)
   Net cash flows from financing activities					91,600
   Net increase in cash					(15,500)
   Cash, opening					21,000
   Cash, closing					$5,500

   Supplemental Disclosures:

   Cash paid interest and income taxes are already reported as categories in operating activities when using the direct method. Only the non-cash items require supplementary disclosure (below).

   Non-cash:

   Machinery for $394,250 ($918,750 – $125,000 – $1,188,000) was purchased in exchange for $166,000 in common shares and $228,250 in cash.

   Solution Notes:
   * Bond amortization is a non-cash adjusting entry that affects interest expense in the income statement, therefore net income must be adjusted by $54,750 ($1,089,000 – $1,034,250) bond amounts, net of discount.

   ** Deferred tax is a non-cash transaction affecting income tax expense in the income statement, therefore net income must be adjusted by $42,900 ($69,300 – $26,400).

   *** The change in investments held for trading is due to the unrealized loss included in the income statement. This has already been adjusted in step 3, so no further action is required. Memo item only.

2. Bognar Ltd. Statement of Cash Flows
   For the Year Ended December 31, 2020
   Cash flows from operating activities:
   Cash received from sales		$1,744,400
   Cash paid for goods and services		(1,738,700)
   Cash paid for interest		(71,750)
   Cash received for income taxes		16,500
   Net cash flows from operating activities		$(49,550)

3. Indirect Method

   Bognar Ltd. Statement of Cash Flows (Indirect method)
   For the Year Ending December 31, 2020
   Cash flows from operating activities:
   Net loss		$(58,700)
   Non-cash items (adjusted from net income)
   Gain on sale of land		(24,200)
   Depreciation ($121,000 – $82,500)		203,500
   Loss on impairment of goodwill		66,000
   Loss on sale of machine		10,800
   Loss on Held for Trading investment		32,500***
   Interest expense for bond payable		54,750*
   Cash in (out) from operating working capital:
   Increase in accounts receivable		(108,000)
   Increase in inventory		(146,000)
   Decrease in accounts payable		(37,300)
   Decrease in deferred taxes payable		(42,900)**
   Net cash flows from operating activities				$(49,550)

   * Bond amortization is a non-cash adjusting entry that affects interest expense in the income statement and is not included in the adjustments. Net income must, therefore, be adjusted by $54,750 ($1,089,000 – $1,034,250) bond amounts, net of discount.

   ** Deferred tax is a non-cash transaction affecting income tax expense in the income statement and is not included in the adjustments. Net income must, therefore, be adjusted by $42,900 ($69,300 – $26,400).

   *** The change in investments held for trading asset account is due to the unrealized loss included in the income statement.

   Supplemental Disclosures (Indirect Method):

   Interest paid

   $71,750

   ($126,500 interest expense – bonds payable, net of discount of $54,750 ($1,034,250 – $1,089,000))

   Non-cash:

   Machinery for $394,250 ($918,750 – $125,000 – $1,188,000) was purchased in exchange for $166,000 in common shares and $228,250 in cash.

Exercise 20.7

a. Land – Entry #1
Land – Entry #2
Equipment – Entry #1
Equipment – Entry #2
Equipment – Entry #3
Equipment – Entry #4
Lease – Entry #1

Lease – Entry #2

Lease – Entry #3

Lease – Entry #4

b.

c.

Disclosures:

Non-cash items:

Land that originally cost $80,000 was exchanged for another tract of land with a fair value of $100,000 and a cash payment of $5,000.

Equipment worth $99,854 was acquired in exchange for a six year capital lease at an annual interest rate of 8%.

Exercise 20.8

Disclosures:

Non-cash:

Aegean Anchors acquired equipment in exchange for a financing lease of $324,000. (Interest rate is 8%.)

Cash and cash equivalents: