ACC3820-Financial Accounting Supplementary Course Materials Prof.

Maletta

Practice Problems Problems to Chapter 1 Problem 1 Bestseller Books is a retailer of books and magazines. Indicate the effect of each of the following transactions on Bestseller's balance sheet (i.e., indicate whether assets, liabilities, and owners' equity increased, decreased or stayed the same). Assets Liab. Own. Eq. 1. Investment of capital in business by owner. 2. Loan obtained from bank 3. Books purchased from distributor on credit 4. Furniture purchased on credit 5. Payment made to creditor for furniture 6. Furnishings purchased for cash 7. Rent paid in advance for store premises 8. Wages paid to employees at the end of first week 9. Advance received from customer to supply magazines for one year 10. Books sold to customer for cash

Solution In the following solution, '+' = increase, '-' = decrease, 'O' = no effect, '+/-' = increases in one asset account accompanied by a corresponding decrease in another asset account. Note that the last transaction is in two parts: first, the receipt of cash, next, the outflow of books. Assets Liab. Own. Eq. 1. Investment of capital in business + 0 + by owner 2. Loan obtained from bank + + 0 3. Books purchased from distributor + + 0 on credit 4. Furniture purchased on credit + + 0 5. Payment made to creditor for 0 furniture 6. Furnishings purchased for cash +/ 0 0 7. Rent paid in advance for store +/ 0 0 premises 8. Wages paid to employees at the 0 end of first week 9. Advance received from customer + + 0 to supply magazines for one year 10. Books sold to customer for cash + 0 + 0

Problem 2 Your company, Rome & Hans, has just completed its first year of operations. Irma, the accounting assistant, has just handed you the list of account balances (below). You are pretty sure that she has the right numbers in the right accounts. Prepare a correct balance sheet in good form before you meet with the boss. Rome & Hans Balances as of 12/31/1999 Net income Equipment Inventories Notes payable Prepaid rent Solution: Rome & Hans Balance Sheet as of 12/31/1999 Assets Current: Cash Accounts receivable Inventories Supplies Prepaid rent Total current Noncurrent: Equipment Total Assets Liabilities & Owners' Equity Liabilities: Accounts payable 140,000 Notes payable 50,000 Total liabilities 190,000 Owners' Equity: Capital stock Retained Earnings Total Owners' Total LOE 780,000 195,000 975,000 195,000 800,000 140,000 50,000 15,000 Supplies 6,000 Accounts payable 140,000 Accounts receivable 120,000 Capital stock 780,000 Cash 84,000

84,000 120,000 140,000 6,000 15,000 365,000 800,000 $ 1,165,000

$ 1,165,000

Problem 3 Irma (see problem 2) has found several unposted transactions from the last week of December. Her revised balance sheet appears below. What happened during the period?

Rome & Hans Revised Balance Sheet as of 12/31/1999 Assets Current: Cash Accounts receivable Inventories Supplies Prepaid rent Total current Noncurrent: Equipment Total Assets Solution: Several changes show in comparing the two balance sheets. On the surface, we can see that cash went up $35,000, accounts receivable went down $20,000, inventories went down $20,000, accounts payable went down $15,000 and retained earnings went up $10,000. We do not know the exact details, but it looks like the "missing week" included some sales which reduced inventories, increased cash or accounts receivable and increased net income, which flowed into retained earnings. Also, it seems that R&H received some payments on account since accounts receivable is reduced only by such payments (or by the write-off of a bad account). Finally, it appears that R&H paid off some of its own accounts payable. Liabilities & Owners' Equity Liabilities: 119,000 Accounts payable 100,000 Notes payable 120,000 Total liabilities 6,000 15,000 Owners' Equity: 360,000 Capital stock Retained Earnings 800,000 Total Owners' $ 1,160,000 Total LOE 125,000 50,000 175,000 780,000 205,000 985,000

$ 1,160,000

Problems to Chapter 2 Problem 1: You have been hired recently as the new accountant of the Boston Turncoats Company. Your first responsibility is to prepare financial statements for the year 1999. The former accountant has left you with a sheet of computer printout that contains a complete history of the accounts and balances as on 12-31-99. The history is as follows: Accounts payable Accounts receivable Accumulated depreciation (bldg) Accumulated depreciation (equip) Advances from customers Buildings Capital stock Cash Cost of goods sold Depreciation expense Equipment Insurance expense Land Merchandise inventory (12-31-99) Note payable (due 6-30-02) Prepaid insurance Retained earnings (on 1-1-99) Sales Selling expense $815,000 425,000 820,000 400,000 249,000 1,800,000 1,600,000 179,000 1,520,000 220,000 1,245,000 73,000 2,033,000 675,000 1,200,000 65,000 658,000 2,603,000 110,000

You discover that there are three items yet to be accounted for: (1) Interest on the note payable for the whole year 1999 was paid only on 11-00 and was consequently omitted from the 1999 accounts. The note carries interest at 11 percent per annum and was issued in 1995. (2) Income tax needs to be accrued for the year 1999. The income tax rate is 30 percent. (3) Late in December 1999, the company declared a dividend of $200,000. The dividend is to be paid to stockholders in early 2000. Required Prepare an income statement and a retained earnings statement for the year ended December 31, 1999, and a balance sheet as on December 31, 1999.

Solution: Boston Turncoats Company Income Statement for 1999 Sales Cost of goods sold Gross Margin Depreciation expense Insurance expense Selling expense Interest expense Income before taxes Income tax expense Net Income $ 2,603,000 (1,520,000) 1,083,000 (220,000) (73,000) (110,000) (132,000) 548,000 164,400 $ 383,600

Retained Earnings Statement Retained earnings on 1-1-99 $ 658,000 Net income for 1999 383,600 Dividends declared (200,000) Retained earnings on 12-31-99 $ 841,600 Balance Sheet on December 31, 1999 Assets Cash $179,000 Accounts receivable 425,000 Merchandise inventory 675,000 Prepaid insurance 65,000 Equipment 1245000 less Acc Dep 400000 845,000 Building 1800000 s Acc Dep 820000 980,000 Land 2,033,000 Total assets $5,202,000 Liab & Stock Equity Liabilities: Accounts payable $ 815,000 Advances from cust 249,000 Dividend payable 200,000 Interest payable 132,000 Income tax payable 164,400 Notes payable 1,200,000 $2,760,400 Stockholders' Equity: Capital stock $1,600,000 Retained earnings 841,600 $2,441,000 Total L + SE $5,202,000

Problem 2 Watanabe Clothing Store has the following account balances on January 31, 1999. Cash Accounts receivable Merchandise inventory Equipment Accumulated depreciation Rent payable Accounts payable Capital stock Retained earnings $ 68,400 46,000 120,000 400,000 150,000 6,200 40,700 300,000 137,500

Transactions during February were as follows: 1. 2. 3. 4. 5. 6. Sales (all on account) amounted to $162,000 Credit customers paid $130,000 in cash. Merchandise inventory of $99,000 was purchased on account. Inventory on hand at the end of the month was $159,000. Accounts payable of $85,000 were paid. Rent for January of $6,200 was paid in February. February's rent of $6,300 was unpaid. 7. Miscellaneous expenses of $28,000 were paid in cash. 8. Employee salaries of $45,000 were paid. 9. Depreciation expense for the month was $3,000. 10. The income tax rate is 30 percent. Income tax was not paid. Required: Prepare an income statement for February 1999 and a balance sheet as on February 28, 1999. Solution: Effects of February transactions: 1. 2. 3. 4. 5. 6. 7. Sales revenue Accounts receivable Accounts receivable Cash + 162,000 + 162,000 - 130,000 + 130,000 99,000 99,000 60,000 60,000 85,000 85,000 Rent payable (Feb) Rent expense + 6,300 + 6,300

Merchandise inventory + Accounts payable + Merchandise inventory Cost of goods sold + Accounts payable Cash -

Rent payable (Jan) - 6,200 Cash - 6,200 Miscellaneous expense + Cash 28,000 28,000

8. 9.

Salaries expense Cash Depreciation expense Accumulated depn

+ + + + +

45,000 45,000 3,000 3,000 5,910 5,910 (from income statement)

10. Income tax expense Income tax payable

Watanabe Clothing Store Income Statement for February 1999 Sales Cost of goods sold Gross Margin Depreciation expense Miscellaneous expense Salaries expense Rent expense Income before taxes Income tax expense Net Income $ 162,000 ( 60,000) 102,000 ( 3,000) (28,000) (45,000) ( 6,300) 19,700 5,910 $ 13,790

Retained Earnings Statement Retained earnings on 1-31-99 Net income for Feb. 1999 Dividends declared Retained earnings on 2-28-99 $ 137,500 13,790 ( 0) $ 151,290

Balance Sheet on February 28, 1999 Assets Cash $ 34,200 Accounts receivable 78,000 Merchandise inventory 159,000 Equipment 400,000 - Acc depn 153,000 247,000 Stockholders' Equity: Liab & Stock Equity Liabilities: Accounts payable $ 54,700 Rent payable 6,300 Income tax payable 5,910 Total liab $ 66.910 Capital stock $ Retained earnings $ Total L + SE $ 300,000 151,290 451,290 518,200

Total assets

518,200

Problems to Chapter 3 Problem 1 Toy Town Company is a retailer of toys. The balances of the ledger accounts on January 31, 1999 (the end of Toy Town's fiscal year), prior to the necessary adjustments, were as follows (all amounts in thousands of dollars). (Dr) (Cr) Cash $ 609 Accounts receivable 647 Merchandise inventory 2,923 Store equipment 500 Prepaid insurance 115 Advertising expense 54 Sales salaries expense 180 Administrative salaries 80 Miscellaneous expenses 11 Prepaid rent 240 Rent expense 100 Accumulated depreciation $ 150 Notes payable (due 2002) 360 Accounts payable 386 Common stock 400 Retained earnings 163 Sales 4,000 $ 5,459 $ 5,459 Additional information is given below (figures in thousands). 1. Store equipment is being depreciated on a straight line basis. The average life of the equipment is ten years. 2. As inventory is purchased, it is added to the merchandise inventory account. A physical count at the end of January, 1999, showed inventory of $238. 3. Sales salaries are paid monthly, on the first Friday of the week following the end of the month. Sales salaries for January amounted to $20. 4. Prepaid rent represents one year's rental of store buildings, paid in advance on August 1, 1998. 5. The note payable carries annual interest of ten percent. The note was issued on September 1, 1998. 6. The sales figure includes $100 received as an advance from a major customer. Toy Town has placed an order for these toys with one of its suppliers, and expects delivery to be made in two months. 7. The company declared dividends for the year amounting to $50. 8. The income tax rate is 30 percent. Required A.Prepare the necessary journal entries to account for the additional information items 1-8 above. B.Prepare an income statement, retained earnings statement, and balance sheet for Toy Town, all in good form.

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Solution: A. Journal entries: 1. Depreciation expense 50 Accumulated depreciation 2. 3. 4. 5. 6. 7. 8. B. Cost of goods sold Inventory 2685

50 2685 20 120 15 100 50 176

Sales salaries expense 20 Salaries payable Rent expense Prepaid rent 120

Interest expense 15 Interest payable Sales revenue 100 Advances from customers Dividends 50 Dividends payable Income tax expense 176 Income tax payable

Income Statement for year ended Jan 31, 1999

Sales revenue $ 3,900 Cost of goods sold (2,685) Gross margin 1,215 Advertising expense (54) Sales salaries expense (200) Admin salaries expense (80) Miscellaneous expenses (11) Rent expense (220) Interest expense (15) Depreciation expense (50) Pretax income 585 Income tax expense 176 Net income $ 409

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Retained Earnings Statement for year ended Jan 31, 1999 Beginning balance Net income Dividends Ending balance $ $ 163 409 (50) 522

Balance Sheet on January 31 1999 Assets Current assets Cash $ Accts receivable Merchandise inventory Prepaid insurance Prepaid rent 609 647 238 115 120 1,729 Property Plant & Equipment Store equipment 500 Accumulated depn (200) Liab & St. Equity Current liabilities Accounts payable $ Interest payable Dividend payable Salaries payable Income tax payable Advances to customers Noncurrent liabilities Notes payable Stockholders' equity Common stock Retained earnings Total $ 2,029 Total 400 522 386 15 50 20 176 100

747 360

300

922

$ 2,029

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Problem 2 State Express Inc. provides overnight package and mail delivery services. The balance sheet of the company on December 31, 1999 is given in Exhibit A. Exhibit B provides a listing of cash receipts and expenditures obtained from the company's cash book. Exhibit C contains additional information that should be considered in preparing the required statements. REQUIRED: 1) 2) EXHIBIT A State Express Inc. Balance Sheet as of December 31, 1999 Assets Current Assets: Cash Prepaid Rent Gasoline Inventory Unexpired Insurance Total Noncurrent Assets: Airplanes 2,000,000 Acc. Depn 587,000 Automobiles Acc. Depn Total Total Assets 70,000 13,100 1,413,000 56,900 1,469,900 $ 1,764,586 $ 191,400 15,000 46,286 42,000 294,686 Equities Current Liabilities: Salaries Payable $ Accounts Payable Interest Payable Total 3,300 18,000 30,000 51,300 Prepare an income statement (in good form) for the year 2000. Prepare a balance sheet (in good form) as of December 31, 2000.

Noncurrent liabilities: Note payable (12%, due 1/1/2009) 1,000,000 Stockholders' Equity: Common Stock 500,000 Retained Earnings 213,286 Total 713,286

Total Equities

$1,764,586

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EXHIBIT B

State Express Inc. Cash Receipts and Disbursements for 2000 $ 280,000 14,000 50,000 30,000

Receipts: Cash Sales Collections from credit sales Proceeds from stock issuance Advances from customers Total

$374,000

Disbursements: Gasoline cash purchases $ 13,800 Payments to creditors (for gasoline purchases) 19,000 Wages 86,000 Advertising 5,400 Interest 130,000 Maintenance 7,200 Miscellaneous 5,000 Rent 45,000 Total Increase in cash

311,400 $ 62,600

EXHIBIT C

State Express, Inc. Summary of Notes 1. Unpaid bills for gasoline purchases were $ 5,000. 2. Unpaid salaries at the end of the year amounted to $4,000. 3. Outstanding customer accounts (to be collected) $ 8,000. 4. Advances from customers refers to payment received from a corporate customer for services to be provided in 2001. 5. Gasoline inventory at the end of the year was $ 35,000. 6. Prepaid insurance refers to a four year policy taken out on January 1, 1998. 7. The most recent interest payment was made on October 31, 1999. 8. The estimated life of the aircraft is 20 years and for automobiles is 7 years. 9. Net income, if any, is taxed at a 30 percent rate. 10. There were no prepayments or accrued expenses other than those noted in Exhibit C.3.

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Solution

State Express Inc. Income Statement for year ended Jan 31, 1999 Sales revenue $ 302,000 less Operating expenses Gasoline expense $ (31,086) Advertising expense (5,400) Wages expense (86,700) Maintenance expense (7,200) Insurance expense (21,000) Miscellaneous expenses (5,000) Rent expense (60,000) Interest expense (120,000) Depreciation expense (110,000) (446,386) Net income (loss) $ (144,386) Retained Earnings Statement for year ended Jan 31, 1999 Beginning balance - Net loss - Dividends Ending balance $ $ 213,286 (144,386) 0 68,900

Balance Sheet on January 31 1999 Assets Current assets Cash Accts receivable Gasoline inventory Prepaid insurance Total CA Liabilities & St. Equity Current liabilities Accounts payable $ 5,000 Interest payable 20,000 Advances to customers 30,000 Salaries payable 4,000 Total CL 59,000 Noncurrent liabilities Notes payable $1,000,000 Stockholders' equity Common stock 550,000 Retained earnings 68,900 Total SE 618,900 Total $ 1,677,900

$254,000 8,000 35,000 21,000 318,000

Property Plant & Equipment Airplanes $2,000,000 Accumulated depn (687,000) 1,313,000 Automobiles 70,000 Accumulated depn (23,100) 48,900 Total PP&E 1,359,900 Total $1,677,900

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Recognizing Income (Chp. 3 Continued) Problem 3 Thoroughly Diversified Company (TDC) has a number of operating divisions. In each of the following cases indicate the amount of revenue that you would recommend that TDC should recognize in 1997, briefly providing reasons for your recommendation. 1. The Machine Division signed a contract in 1997 for the sale of $60,000 worth of machinery to the Metal Stamping Company. During 1997, $32,000 worth of machinery were manufactured and delivered under this contract. The Metal Stamping Company has paid $30,000 in 1997. Under the terms of the contract the remaining amount is to be paid in 1998. 2. The Machine Division completed manufacture of $82,000 worth of machinery for which there is no buyer yet. However, this line of machinery has been successful in the past, and the sales department is optimistic about signing a contract with a well-established client in early 1998. 3. The Gas Division entered into a long term contract with Company. The contract provides for Gas Division to provide prices for five years from July 1, 1997. In 1997, $500,000 supplied under the contract. The normal annual supply will Riverbrook gas at fixed worth of gas was be for $1 million.

4. The Military Equipment Division entered into a contract with the US Navy on January 1, 1997. Under the terms of the contract, Military Equipment Division is to supply 30 aircraft to the Navy in 1999. The aircraft are expected to cost the division $300 million to manufacture ($150 million in 1997, $100 million in 1998 and $50 million in 1999), and are being sold to the Navy for $500 million. Actual costs in 1997 were as expected. The Navy made payments amounting to $200 million in 1997 as per the contract. Solution 1. Revenue should be $32,000, based on delivery. The customer has already paid most of this; presumably the collectibility of the remainder is assured. Recognition of the remaining $28,000 of the constract is premature, since the product has not been made or delivered. 2. Revenue should be zero. There is no guarantee that the product will be sold; significant uncertainties remain. 3. Revenue should be $500,000, based on delivery. The product is yet to be produced and delivered for future years and significant uncertainties remain. 4. The two most likely acceptable alternatives are to recognize revenue of $250 million (based on percentage-of-completion) or $200 million (based on collection). The percentage-of-completion amount of $250 million has been calculated by using the proportion of completed cost ($150 million out of expected $300 million or 50 percent) as an indication of the proportion of completed effort. Both methods may be better measures of accomplishment than the completed contract method, under which TDC would have to wait until 1999 to recognize revenue. The completed contract method, which is conservative, would be appropriate if collectibility of payments were not assured.

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Problems for Chapter 7 Problem 1 The 12/31/97 unadjusted trial balance for ABC Co. shows the following balances: Debit Credit Accounts Receivable $800,000 Allowance for Doubtful Accounts $ 3,000

Required: 1. Did the company over or underestimate bad debts at the end of 1996? 2. Assume that this year the company estimates that 8% of accounts receivable will be uncollectible, indicate the necessary adjusting journal entry for bad debts. 3. Assume that on 1/12/98, an account in the amount of $16,000 is deemed uncollectible. Make the necessary journal entry to record this event. 4-6. Answer questions 1-3 assuming that the allowance for doubtful accounts had a $5,000 debit balance prior to adjusting entries instead of the $3,000 credit balance shown above. Solution: 1. Overestimated. 2 3. Bad Debt Expense $61,000 Allowance for Doubtful Accounts Allowance for Doubtful Accounts $16,000 Accounts Receivable $61,000 $16,000

4. Underestimated. 5. 6. Bad Debt Expense $69,000 Allowance for Doubtful Accounts Allowance for Doubtful Accounts $16,000 Accounts Receivable $69,000 $16,000

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Problems to Chapter 8: Problem 1 General Parts Company has only one product line. In 1999 the company began the year with 1,000 units in inventory that had been purchased for $130 each. Purchases and sales in 1999 were as follows: January 17 March 25 May 18 August 7 October 12 December 1 Purchased 3000 units at $125 each Purchased 5000 units at $120 each Sold 4000 units at $180 each Purchased 5000 units at $115 each Sold 8000 units at $180 each Purchased 1000 units at $110 each

General selling and administrative expenses in 1999 amounted to $300,000. The income tax rate was 40 percent. Required 1. Prepare income statements for 1999 in good form, assuming General Parts uses (A) the LIFO method in accounting for inventories, and (B) the FIFO method, in both cases applied on a periodic basis. 2. Would the LIFO method have been acceptable if the company was in the business of selling perishable products? Explain. Solution: 1. LIFO Sales $ 2,160,000 Cost of Goods Sold 1000 X $110 + 5000 X 115 + 5000 X 120 + 1000 X 125 = 1,410,000 Gross Margin 750,000 Sel & Adm Expense 300,000 Pretax Income 450,000 Income Tax Expense 180,000 Net Income $ 270,000 FIFO Sales $ 2,160,000 Cost of Goods Sold 1000 X $130 + 3000 X 125 + 5000 X 120 + 3000 X 115 = 1,450,000 Gross Margin 710,000 Sel & Adm Expense 300,000 Pretax Income 410,000 Income Tax Expense 164,000 Net Income $ 246,000

2. The method used in accounting for the cost of inventory need not correspond to the physical flow of the product. LIFO would be as acceptable for perishable goods as for anything else.

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Problem 2 Rhodes Inc. is a wholesaler of apples. The company's inventory was reported at $150,000 on December 31, 1998, $168,000 on December 31, 1999, and $193,000 on December 31, 2000. The company uses FIFO in accounting for inventory. Cost of goods sold in 2000 was $780,000. The quantity of apples held in inventory was fairly stable over the three years. Required 1. What was the cost of apples purchased by Rhodes in 2000? 2. Would (a) cost of goods sold in 2000, (b) the current ratio at the end of 2000 and (c) income tax expense in 2000 have been higher, the same, or lower if the company had been using LIFO rather than FIFO for inventories? Explain. 3. Ignoring tax effects, would Rhodes Inc.'s cash flow from operations be higher, the same, or lower, if it used LIFO instead of FIFO in 2000? Explain. 4. Considering tax effects, would Rhodes Inc.'s cash flow from operations be higher, the same, or lower, if it used LIFO instead of FIFO in 2000? Explain. Solution 1. Cost of goods sold = Beg. Inv. + Purchases - End. Inv. Purchases = Cost of goods sold - Beg. Inv. + End. Inv. = 780,000 + 193,000 - 168,000 = $805,000 2. Since inventory quantities are stable but value is rising, prices must be rising. Thus: a) LIFO cost of goods sold is higher, since most recently purchased goods are at a higher price. b) LIFO current ratio is lower, since ending inventory goes into current assets which is the numerator of this ratio, and ending inventory in LIFO represents older, lower-priced inventory. c) LIFO income tax expense is lower, since cost of goods sold is higher and income lower. 3. Cash flow from operations will be the same in both cases. LIFO/FIFO are methods to assign cost to inventories, they do not affect the inflow or outflow of cash. 4. LIFO will have higher cash flow from operations because of lower taxes.

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Problem 3 The Oliver Company sells chemical compounds made from fasbium. The company uses LIFO for its inventories. The inventory on January 1, 1998 consists of 3,000 lbs. Using LIFO, this was valued on the balance sheet at $45 per lb. Purchases and ending inventories in subsequent years were as follows: Year 1998 1999 2000 Purchase Price/lb $ 50 50 52 Purchases $384,000 352,000 448,000 Dec 31 Inventory 3,600 lbs 2,600 lbs 4,000 lbs

Because of temporary scarcities, fasbium is expected to cost $62 per lb. in 2001. Sales for 2001 are expected to require 7,000 lbs of fasbium. The purchasing manager suggests that the inventory be allowed to decrease to 600 lbs. at the end of 2001. The controller argues that such a policy is foolish. She says that if inventories are allowed to decrease, the company will pay a very large amount in income taxes (at its current income tax rate of 40 percent). She suggests that the company maintain a 2001 year end inventory of 4,000 lbs. Required 1. Calculate the cost of goods sold and dollar value of ending inventory for the year 2000. 2. Calculate the cost of goods sold and dollar value of ending inventory for 2001, assuming the purchasing manager's advice is followed (Plan A) and the controller's advice is followed (Plan B). 3. Calculate the tax savings for 2001 if the controller's advice is followed rather than the purchasing manager's. If you were making the decision would you agree with the controller or the purchasing manager? Solution: (in lbs) Beginning inventory + Purchases (price/lb) - Sales = Ending inventory 1998 3,000 7,680 ($50) 7,080 3,600 1999 3,600 7,040 ($50) 8,040 2,600 2000 2,600 8,615 ($52) 7,215 4,000 Plan A 2001 4,000 3,600 ($62) 7,000 600 Plan B 2001 4,000 7,000 ($62) 7,000 4,000

Cost of ending inventory: 3000@45 2600@45 2600@45 +600@50 +1400@52

600@45 2600@45 +1400@52

2000 Cost of goods sold = 7,215 X $52 = $375,180 2000 Ending inventory = 1,400 X $52 + 2,600 X $45 = $189,800 Plan A: 2001 Cost of goods sold = 3,600 X $62 + 1,400 X $52 + 2,000 X $45 = $386,000 2001 Ending inventory = 600 X $45 = $27,000

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Plan B: 2001 Cost of goods sold = 7,000 X $62 = $434,000 2001 Ending inventory = 1,400 X $52 + 2,600 X $45 = $189,800 Tax difference under two plans = Income tax rate X (Diff in COGS) = 0.4 X (434,000-386,000) = $19,200 If the company would have to buy the additional quantity at a price close to $62 per pound in any case, then the controller's advice has merit. If the price will return to $52 per pound, then the company is paying $10 extra per pound (a total of $34,000) for the tax savings of $19,200, which is not very clever. Problem 4 International Terrorists Resources (ITR) is a wholesaler of explosives. In 1994, the company adopted a new product line, Blast-X. The table given below shows the quantities of Blast-X purchased in 1994, 1995 and 1996 and the purchase price, along with ending inventory of Blast-X. Year 1994 1995 1996 Price per ton $750 $800 $900 Purchases 800 tons 1,000 tons 1,200 tons Ending Inventory 100 tons 200 tons 400 tons

The selling price of Blast-X was $1,400 in 1996. percent tax rate.

The company has a 30

Blast-X is a product that becomes unstable with age. It is ITR's practice to ship the product to retail customers on a first-in first-out basis. This ensures that inventory does not remain in the warehouse long enough to create an explosive problem. Required 1. What would the company have shown as gross margin in 1996 from Blast-X if it used LIFO? What would the cost of ending inventory be on the December 31, 1996 balance sheet? 2. What would the company have shown as gross margin in 1996 from Blast-X if it used FIFO? What would the cost of ending inventory be on the December 31, 1996 balance sheet? 3. What would the tax savings be under LIFO in 1996?

4. Which inventory method would you recommend to the management of the company. Why? 5. FIFO generally produces a higher income than LIFO. However, the opposite has been the case in recent years for a number of US companies. Indicate two reasons why this might be the case. Solution 1. and 2. LIFO FIFO

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1996 beginning inventory 1996 purchases 1996 cost of goods sold

100 tons @ $750 + 100 tons @ $800 1,200 tons @ $900 1,000 tons @ $900 = $900,000 100 tons @ $750 + 100 tons @ $800 + 200 tons @ $900 = $335,000 $1,400,000 900,000 $ 500,000

200 tons @ $800 1,200 tons @ $900 200 tons @ $800 + 800 tons @ $900 = $880,000 400 tons @ $900 = $360,000

1996 ending inventory

Revenues Cost of goods sold Gross margin 3.

$1,400,000 880,000 $ 520,000

Tax savings = 0.3 X Difference in cost of goods sold = $6,000

5. FIFO would not result in higher income if (1) prices of inputs are decreasing or (2) inventories are decreasing

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Problems to Chapter 10: Problem 1 Conaway Company purchased a machine for cash on January 1, 1998. The price was $31,000. In addition, Conaway incurred costs of $200 in transporting the machine to the factory site and a further $800 in installing the machine. The machine was expected to produce 100 million meters of electric cable over its useful life of 5 years, at the end of which time it was expected to have scrap value of $2,000. 30 million meters of cable were produced in 1998. In early January 1999, the motor of the machine burnt out unexpectedly. Conaway replaced the motor at a cost of $5,000. The useful life of the machine was not expected to be extended by the new motor. In 1999 Conaway produced 20 million meters of cable. On January 1, 2001, Conaway sold the machine to Baril Inc. for $25,000. Conaway's income tax rate is 40 percent. depreciation. Required 1. What was the cost assigned to the machine on Conaway's books when it was purchased? 2, Make the journal entry for the replacement of the motor in 1999. Conaway uses straight line

3. What is the depreciation that Conaway recorded on the machine in 1998 and 1999? 4. 5. Make the journal entry for depreciation of the machine for the year 1998. What is the gain or loss that Conaway recorded on the sale of the machine?

6. What is the depreciation that Conaway would have recorded on the machine in 1998 and 1999 if it had used (a) the units of production method, (b) the sum of the years digits method and (c) the double declining balance method? 7. Assume that when the motor burnt out and the new motor was put in, Conaway reassessed the remaining useful life of the machine to be 3 years rather than 4, with no salvage value. Compute depreciation for 1999, using the straight line method.

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Solution: 1. 2. 3. 4. 5. 6. Cost assigned to machine = $32,000. Repairs expense Cash $5,000 $5,000 (not an asset)

Straight line depreciation in each year is ($32,000 - $2,000)/5 or $6,000. Depreciation expense Accumulated depreciation Gain $6,000 $6,000

= Proceeds from sale - book value = $25,000 - ($32,000 - $12,000) = $5,000

Units of production: Depreciation per million meters = $30,000/100 = $300 1998 depreciation $300 X 30 = $9,000 1999 depreciation $300 X 20 = $6,000 Sum of the years digits: Sum of the years digits = 1 + 2 + 3 + 4 + 5 = 15 1998 depreciation $30,000 X (5/15) = $10,000 1999 depreciation $30,000 X (4/15) = $8,000 Double declining balance: 1998 depreciation $32,000 X 40 % = $12,800 1999 depreciation $19,200 X 40 % = $7,680

7.

Book value at beginning of 1998 = Cost - Accum depn = $32,000 - $6,000 = $26,000 Remaining useful life = 3 years 1999 depreciation = 26000/3 = $8,667

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Problem 2 Basic Research Corporation (BRC) was in the business of developing new products for the pharmaceutical industry. Amounts spent on research and development were expensed as incurred. In 1999, Giant Drug Co (GDC) acquired BRC for $20 million, GDC acquired tangible assets worth $1.2 million and intangible assets valued at $17.8 million (consisting of patents developed by BRC). GDC chooses to amortize the acquired patents over five years and goodwill over forty years, both on a straight line basis. Required: A. Compute the amount assigned to goodwill in GDC's books as a result of the acquisition. B. What is the explanation for GDC's accounting for the patents, considering that these did not appear as assets on BRC's books? C. Compute GDC's amortization expense for 2000, assuming that the only relevant items are the assets acquired in the BRC transaction. Solution A. Goodwill is the excess of acqisition cost over the sum of the values of individual assets obtained in an acquisition. In this case, goodwill = $20 M - ($1.2 M + 17.8 M) = $1 M. B. Patents that are obtained because of internal research cannot be capitalized (treated as assets). However, purchased patents are assets. C. Intangible assets are generally amortized on a straight line basis. Patents are being amortized over 5 years, leading to annual amortization of $17.8 M/5, or $3.56 M. Goodwill is being spread over 40 years, leading to amortization expense of $1 M/40, or $0.025 M. Total amortization expense is $3.585 M. Problem 3 Klaxon Action, Inc. (KA) operates a string of video game arcades. KA is currently revising its policy on depreciating the video game units. KA's experience has shown that the useful economic life of the typical game machine is three years. Although the game will physically last much longer, it generally does not hold enough interest for the clientele to justify occupying the floor space after three years. Given the obsolescence factor, used machines can typically be sold for only five to ten percent of their original purchase price. In general, a new game takes in the most cash, since it takes a while for their "regulars" to learn to master it. Also, once mastered, a game remains popular for a while since the "pros" like to show off and set records. These two phases of a game's life take up about one year and account for about onehalf the game's lifetime (i.e., three-year) revenues. KA's management wishes to establish a depreciation policy that will match the cost of the machine to the revenues produced by the machine on a more-or-less relative basis. However, they want a time-based approach (i.e., not "unitsof-production").

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REQUIRED: (a) KA has just purchased "77 Moebius Strip" for $3200. They expect to use it for three years and then scrap it for $200. Calculate the depreciation expense for year two for this machine under straight-line, double declining balance, and sum-of-years-digits methods. (b) Which method would you recommend to KA? Why? Solution: (a) Straight-line: (original - salvage)/life in years (3200 - 200)/3 = $ 1000 each year is the same Double declining: balance * (2/life in years) year year 1 year 2 S-O-Y-D: beginning balance rate $3200 $1067 .666666 .666666 expense $2133 $ 711 ending balance $1067 $ 356

(original - salvage) * (countdown year)/SOYD year year 1 year 2 depreciable amount $3000 $3000 countdown yr 3 2 SOYD 6 6 expense $1500 $1000

note: countdown year is -(life in years - (year in life -1)) (b) Given the desire to match an accelerated revenue pattern, one of the accelerated depreciation methods is called for. The one that matches KA's expectations most closely seems to be the S-O-Y-D method, since it expenses 1/2 the total in the first year and leaves a scrap value of 200 on the books at the end of three years. The other accelerated method, DDB, expenses 2/3 the total in the first year. Note that KA has a variety of machines, presumably at different ages. Odds are that the simple straight-line total will not be materially different from the total given by S-O-Y-D.

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Problems to Chapter 11: Problem 1 On January 1, 1995, Megafloat Corporation sold 100,000 bonds with the following characteristics: 1. 2. 3. 4. 5. Face value, $1000 each Coupon rate of 13% payment schedule -- 1/1 and 7/1 maturity date -- January 1, 2005 effective interest rate (yield) of 12%

REQUIRED: (1) What was the total amount received for the bonds? (2) What was the total interest expense related to this bond on Megafloat's 1995 income statement? (3) Disregard your answers to parts (1) and (2). Assume that the market rate was not 12% and the issue sold at a discount. Network television financial commentator Flint Buckmeister interpreted the result as follows: "It is evident that the Street doesn't have much confidence in Megafloat. Their bonds wouldn't sell without a discount." Is Flint right? If so, explain what he is talking about. correct explanation. Solution: (1) PVA ($65, 6%, 20 per) + PV (1000, 6%, 20 per) = ($65 * 11.47) + ($1000 * .312) = $1,057.55 per bond 100,000 bonds, total is $105,755,000 (2) 1995, 2 interest expense (1 payment, 1 accrual): 1st: .06 * 105,755,000 = 6,345,300 2nd: .06 * new net bal = .06 * (old bal - amort) old bal = 105,755,000; amort = 6,500,000 - 6,345,300 = 154,700; new net bal = 105,600,300; .06 * 105,600,300 = 6,336,018 Total = 6,345,300 + 6,336,018 = 12,681,318 (3) Flint is confused. The reason that some bonds sell at a discount is that the market interest rate for that level of risk is greater than the face rate. Lack of confidence might affect the market rate. A financially secure bond will sell at a discount if its face rate is lower than the market rate. Conversely, a risky bond will sell at a premium if its face rate is higher than market. For If not, give the

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Problem 2 On June 1, 19x2, Boston Beanery Inc. issued $10 million of 20 year, 10% coupon bonds. The semiannual interest bonds sold at face value. REQUIRED: (1) In 19x4, the prevailing interest rate had increased to 12%. what price could a single bond be purchased on the open market? (2) In 19x6, rates were down to 8%. under those circumstances? How much would a $1000 bond sell for At

(3) How would these changes in the prevailing interest rate affect the interest expense reported by Boston Beanery on its income statement? (4) Bonds are said to be relatively risk-free investments in comparison to common stock. Is this true? Explain your position. Solution: (1) assuming June 2nd: PVA (50,.06,36) + PV (1000,.06,36) = (50*14.621)+(1000*.123) = 731.05 + 122.74 = $853.79 (2) PVA (50,.04,32) + PV (1000,.04,32) = (50*17.87355) + (1000*.28506) = 893.68 + 285.06 = $1178.74 (3) Fluctuations in the market rate will affect the trading price of the bond in the bond market, but Boston Beanery will not be affected. Its liability will remain the same. Thus, market changes, themselves, will not affect how the bonds are reported by the issuing company. (4) Bonds are relatively less risky to the investor, since they are receiving a promise to pay from the issuer. They are not risk-free, however, especially in an environment where the likelihood of bankruptcy is significant. From the issuer's perspective, bonds are quite risky. Whether or not the plans for the proceeds from the issue turn out to be incomeproducing, specific cash outflows are promised. Funding through stock issue is much less risky to the issuer, since no such requirement exists. The issuer's return from using the proceeds need not be as smooth or immediate. Costs to the issuer, on the other hand, follow just the opposite path. The cost of debt is lower to the issuer. Costs of equity funding are high because the investor expects a higher return for exposure to higher risk.

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Problem 3 On January 1, 19x8, SBC issued bonds with face amounts totalling $1 million. The bonds had a 20 year term to maturity and a coupon rate of 10%, with annual payments on December 31. SBC received proceeds such that the effective yield was calculated to be 12%. SBC's fiscal year corresponds to the calendar year. Thus annual financial statements are dated December 31. REQUIRED: (a) How much did SBC receive for the bonds? (b) What interest expense related to the bonds did SBC report in 19x8? (c) What did the net bond liability total on January 1,19x9? (d) SBC had considered issuing zero coupon bonds instead of the standard bonds. Given the same market conditions, what would be the face value of zero coupon bonds that SBC would have had to issue in order to receive $1 million in proceeds? Solution: (a) The proceeds from the bond issue would be: $1,000,000 X 0.104 + $100,000 X 7.469 = $850,900 p.v. of maturity amt p.v. of coupon interest

The interest rate used to compute present values is the market rate of interest at the time of the bond issue, 12 percent. (b)Interest expense = 12 percent of $850,900 = $102,108 Interest expense is computed each period by multiplying the true rate of interest incurred by the company (the market rate at the time of issue, 12 percent) by the value of the liability on the books at the beginning of the period. (c) Bond liability = Bonds Payable + Discount amortization = $850,900 + ($102,108 - $100,000) = $853,008 (d)A zero coupon bond with a face value of $1, due 20 years from now, issued at a market rate of 12 percent, will bring in $0.104 (present value tables, 20 years, 12 percent). In order to receive $1 million in proceeds SBC would need to issue bonds with a face value of $1,000,000/0.104 = $9,615,385.

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Problem 4 "Steel" Wheeler, your obnoxious classmate, was reading the Wall Street Journal the other day in the MBA lounge. He peered over the top of the paper and said, to no one in particular," I see MegaTrump Co just issued its 10 year, 10 percent bonds at 12%. As you know, this will yield them a premium, indicating that the market thinks they are a solid bet in the future. It's a good deal for them, too, because their interest expense will only be 10% while their competitors will have to borrow money in the bond market at the prevailing rate of 12%." REQUIRED:In your most efficient style, avenge yourself for the embarrassment "Steel" caused you in last week's OB class by pointing out three serious misconceptions in his statement in front of the MBA Association president, Stephanie Goodfund, who has just walked in with a cup of coffee. Solution: Cheeses, Steeler old boy, bonds with a coupon rate of 10 percent, issued when the market rate is 12 percent, would be issued at a discount, not a premium. Besides, premiums or discounts do not directly reflect the market's valuation of the future prospects of the company, but rather the relationship between the coupon rate on the bonds and the rate the market requires. Finally, since the market will discount the bonds, they will cost the company the market rate of interest (in this case 12 percent). This is always the case. Isn't that right Stephanie?

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Problems to Chapter 12 & 13 Problem 1 Joyful Company's December 31, 19x6 balance sheet shows the following in the stockholders' equity section: Stockholders' Equity: Paid-in-capital: Preferred stock, 10 percent, $10 par, authorized, issued and outstanding 50,000 shares Common stock, $1 par, authorized and issued 100,000 shares Additional paid in capital Retained earnings less Treasury stock, 10,000 shares Total stockholders' equity

500,000

100,000 1,000,000 1,400,000 (300,000) $2,700,000

Net income in 19x7 was $250,000. At the end of 19x7, Joyful declared a cash dividend of $1 per share on common stock, in addition to the dividend on preferred stock. Required 1. Compute earnings per common share for 19x7.

2. What will Joyful report on its December 31, 19x7 balance sheet as the retained earnings balance? 3. In early 19x8, when the price of Joyful's common stock was about $70, Joyful considered two choices, (1) issuing a 2-for-1 stock split or (2) issuing a 100 percent stock dividend. What is the likely effect of each alternative on (a) the market price per share of Joyful's common stock, (b) the book value per share of Joyful's common stock, (c) total stockholders' equity (d) the retained earnings account. 4. "If the company goes into liquidation, each common shareholder will be paid the following amount: Par value per common share plus the proportionate (per share) amount of additional paid in capital plus the proportionate amount of retained earnings." Do you agree with this statement? Solution 1. Earnings per share = (NI - pref div)/com shares outstanding = (250,000 - 50,000)/90,000 = $2.22

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2.

Retained earnings 12/31/x6 + Net income for 19x7 - Preferred dividend - Common dividend Retained earnings 12/31/x7 (a) (b) (c) (d) mkt price bk value total SE ret earn

$1,400,000 250,000 (50,000) (90,000) $1,510,000 100 % stock dividend Reduced to about half Reduced to half Unchanged Reduced

3.

2-for-1 stock split Reduced to about half Reduced to half Unchanged Unchanged

4. If the company enters liquidation, common stockholders will share the assets remaining after creditors and preferred stockholders are paid off. Only in the unlikely event that the liquidation value of the assets is exactly equal to the book value will the statement be true. Problem 2 On December 31, 19x7, the stockholders' equity section of C'est Ennui, Inc. consisted entirely of the following items: Common stock ($1 par, 15 million shares Additional paid-in capital . . . . . . Retained earnings . . . . . . . . . . . Total stockholders' equity . . . . . . authorized) . . . . . . . . . . . . . . . . . . . 4,500,000 . 96,250,000 . 175,250,000 .$276,000,000

During 19x8, the following events took place (treasury stock policy is to use the cost method): MARKET PRICE DATE: ACTIVITY: PER SHARE: April 1, 19x8: Issued 450,000 shares. $50 August 28, 19x8: Issued 550,000 shares. $75 October 31, 19x8: Declared a two-for-one stock split. Par value split as well. $50 November 10, 19x8: Bought back 20,000 shares from holders $52 December 7, 19x8: Declared dividends of $1.50 per share. $55 (ex dividend) December 31, 19x8: Announced net income of $25.5 million. $58 "Market price per share" refers to the price at which the share was trading on the particular day. REQUIRED Prepare the stockholders' equity section, in good form, of C'est Ennui's December 31, 19x8 balance sheet.

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Solution: In order to prepare the stockholders' equity section it is necessary to know the effect of each transaction during the year. (a) April 1 stock issue: Common stock increases by par value of the shares issued ($450,000). Additional paid in capital (APIC) goes up by the proceeds in excess of the par value ($22,050,000). (b) August 28 stock issue: Common stock increases by par value of the shares issued ($550,000). APIC goes up by the proceeds in excess of the par value ($40,700,000). (c) October 31 stock split: the accounts do not change. The number of shares double. The balances in

(d) November 10 treasury stock buy-back: The decrease in stockholders' equity (the cost of the shares bought back, $52 * 20,000 = $1.04 million) is shown as Treasury Stock, a negative stockholders' equity account. (e) December 7 dividend: The retained earnings balance will be reduced by the dividend declared, which is $1.50 per share times the number of shares outstanding (4,500,000 shares on December 31, 19x7, plus 450,000 shares issued April 1, plus 550,000 shares issued August 28, doubled on October 31 [balance now 11,000,000 million], less 20,000 bought back November 10 [balance 10,980,000]. Total dividend is $16,470,000. (f) December 31 net income: Retained earnings up by $25,500,000. Common stock (((4.5m +.45 +.55)*2)8 $.50) = $5,500,000 APIC (96.25m +(.45*$49) +(.55*$74)= 159,000,000 RE (175.25m +25.5m -(10,980,000*$1.5) = 184,280,000 Treasury Stock (20,000 * $52) = (1,040,000) -----------Total Stockholders' Equity $347,740,000 Problem 3 Prey Inc's common shares were trading at $30 per share in January 19x9. December 31, 19x8 balance sheet of Prey Inc. included the following information in the Stockholders' Equity section: (thousands of dollars) 8% preferred stock, $100 par; 5,000,000 shares authorized; 100,000 issued and outstanding Common stock, $1 par; 10,000,000 shares authorized; 2,000,000 issued Additional paid in capital Retained Earnings Treasury Stock (200,000 shares) Total Stockholders' equity Net Income in 19x8 amounted to $15,200,000 Required 1. Compute Prey Inc's book value per common share. Suggest two reasons why it may not be equal to the market price of the share? $10,000 2,000 21,200 16,000 (7,000) $42,200 The

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2. Prey Company uses LIFO in accounting for its inventories, and additionally uses accelerated depreciation methods. Would the book value of common shares have been higher, lower or unaffected if it had used FIFO and straight line depreciation instead? Explain. 3. Compute Prey's earnings per common share in 19x8. earnings ratio in January 19x9? What is the price-

4. Assume that Prey Inc. declares a 2-for-1 stock split in January 19x9. How would this transaction affect (a) the market price, (b) the book value per share. Solution: 1. Book value per common share = Common stockholders' equity No of common shares outstanding That would be $32,200,000/1,800,000 = $17.89 2. FIFO and straight line depreciation would generally result in higher assets and higher stockholders' equity, so higher book value per common share. 3. Earnings per common share = Net income - preferred dividend Avg no of common shares outstanding That would be (15,200,000 - 800,000)/1,800,000 = $8 Price-Earnings ratio = Market price/EPS = 30/8 = 3.75 4. A 2-for-1 stock split would reduce book value by half. It would also bring the market price to half its value, although the price would go up a little after that because the market generally perceives stock splits to be good news.

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Problems to Chapter 14 Problem 1 Pearson Company supplies parts and products to Fee Line, Inc. and to Kay Nine & Co., manufacturers of pet products. Pearson buys standard parts and products from other sources, adapts them for use in pet products, and then sells them to manufacturers. The market for pet products is experiencing rapid growth, and both Fee Line and Kay Nine, as well as six other large manufacturers of pet products, are expanding their operations. Claus Sharpe, the CEO of Pearson, believes that the time is right for Pearson to expand also. In reviewing the financial statements for Pearson, Sharpe noted that the reported income was $10,000 and yet cash decreased. Being a bit confused by the apparent contradiction, Sharpe asked to see a statement of cash flows. The accountant had not quite finished preparing this statement. The statements prepared by the accountant appear on the next page. REQUIRED: (a) (b) (c) Complete the statement of cash flows in the space provided. How would you explain to Sharpe the "contradiction" he noticed? Comment on Pearson's ability to expand, citing evidence from: (1) operating activities (2) investing activities (3) financing activities

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Pearson Company Income Statement for the year ended December 31, 19x8 -----------------------------------------------------Net Sales $100,000 Cost of Goods Sold (45,000) --------Gross Profit 55,000 Operating Expenses: Depreciation expense $6,000 Other operating expenses 24,000 (30,000) -----------------Income before taxes 25,000 Income Tax Expense (10,000) --------Net Income $15,000

Pearson Company Comparative Balance Sheet as of December 31, 19x8 and December 31, 19x7 -----------------------------------------------------December 31 December 31 1 19x8 19x7 ---------------------------------------------------------------ASSETS Cash $11,000 $15,000 Accounts Receivable 40,000 35,000 Inventories 110,000 100,000 Buildings & Equipment 300,000 260,000 less Accumulated Depreciation (81,000) (75,000) ----------------net Buildings & Equipment 219,000 185,000 Land 25,000 35,000 ----------------Total Assets $405,000 $370,000 ========= ========= LIABILITIES & OWNERS' EQUITY Accounts Payable $68,000 $64,000 Accrued Wages Payable 2,000 1,000 Net Bonds Payable 80,000 90,000 Common Stock 200,000 170,000 Retained Earnings 55,000 45,000 ----------------$405,000 $370,000 ========= =========

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Pearson Company Statement of Cash Flows for the year ended December 31, 19x8 -----------------------------------------------------CASH FLOWS FROM OPERATIONS

CASH FLOWS FROM INVESTING ACTIVITIES Sale of Land Acquisition of Equipment Net Cash Used by Investing Activities CASH FLOWS FROM FINANCING ACTIVITIES Sale of Common Stock Retirement of Bonds Payment of Dividends Net Cash Provided by Financing Activities (DECREASE) IN CASH Beginning Balance (cash) Ending balance (cash)

10,000 (40,000) ---------(30,000) 30,000 (10,000) (5,000) ----------

15,000 ---------

INCREASE

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Solution: (a) Net income $15,000 add depreciation 6,000 less increase in accts rec 5,000 less increase in inventories 10,000 add increase in accts payable 4,000 add increase in wages payable 1,000 Cash flow from operations $11,000

The indirect method has been used here. Note that adding depreciation to net income would give us working capital from operations. In order to get cash flow from operations we need to adjust for changes in working capital items. The problem also required the net increase or decrease in cash to be filled in. This turns out to be a decrease of $4000, obtained by adding the sources of cash (in this case operating and financing activities) and deducting uses of cash (in this case investing activities). The negative $4000 also corresponds necessarily to the change in the cash balances from the 19x7 balance sheet to the 19x8 balance sheet. (b) Income does not equal cash; they are two different concepts. Income computed using accrual accounting includes sales recognized but not yet realized and does not exclude cash spent but not yet expensed. (c) In evaluating the ability of Pearson to expand, some of the factors that one should consider include (i) the cash generated from operations in 19x8 was only a fraction of the amount needed to support the present level of investing activity (which presumably only maintains the current level of operations) (ii) the existing investments have been financed partly by a sale of existing assets and partly by selling common stock. Any further expansion would probably have to be supported by new financing rather than coming from internally generated funds, and would depend on the company's ability to raise money in the capital markets.

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Problem 2 GDM Company has the following balance sheet (in millions) on December 31, 19x7, shown with comparative numbers for 19x6. 19x7 Assets Current assets: Cash $ 25 Accounts receivable 30 Inventory 50 Noncurrent assets: Building and equipment (net of accumulated depreciation) 100 Land 30 Investments 40 $ 275 Liabilities and Stockholders' Equity Current liabilities: Accounts payable Unearned revenue Long term liabilities: Notes payable Stockholders' equity: Common stock Preferred stock Retained earnings 19x6 $ 35 35 35

80 30 80 $ 295

35 10 80 50 40 60 $ 275

25 35 50 50 20 115 $ 295

The company had a net loss in 19x7 of $45 million, but it distributed a dividend of $10 million. Capital was raised by issuing notes for $40 million and preferred stock for $20 million. Payment of $10 million was made to retire long term debt during the period. Proceeds from the capital issues were used in part to acquire a building for $35 million. There was no sale of land or building during the year. Depreciation of $15 million was recorded. Investments were sold at a gain of $5 million. Required 1. Prepare a Statement of Cash Flows, using the indirect method. Be sure to show working capital from operation clearly in computing cash from operations. 2. Briefly comment on the trends revealed by the statement you prepared in part 1.

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Solution: Cash Flow Statement Cash from operations: Net income $ Add/deduct items included in income not adding to/using cash: Depreciation Gain on sale of investments Working capital used in operations Decrease in accounts receivable Increase in inventory Increase in accounts payable Decrease in unearned revenue Cash from operations Cash from investments: Purchase of building Sale of investments Cash from investments Cash from financing: Issuance of notes Issuance of preferred stock Retirement of notes Dividend paid Net change in cash Add beginning balance Ending balance (45) 15 (5) (35) 5 (15) 10 (25)

(60)

(35) 45 10 40 20 (10) (10)

40 $ (10) 35 $ 25

Some of the points worth noting are : (1) the net loss actually understates the extent to which operations are a drain on cash, (2) despite the shortage of cash, the company has paid a dividend, which effectively is being financed by issuing notes, (3) the company has had to finance its operating losses and purchase of building by heavy borrowing and sale of its assets.

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Problem 3 The president of Watertown Wallets Company came to Midstate Bank for a loan. Watertown Wallets had been having a problem with cash. Despite growth in profits, the company had been facing a dwindling cash position, which puzzled the president. The president had prepared an estimate of the amount the company would need to borrow for the coming year, 19x9. The estimate is based on the following schedule. Schedule of Cash Flows: Cash Inflows: Income $20,000 Depreciation 4,000 Gain on sale of old equipment 3,000 Proceeds on sale of old equipment 8,000 Bank Loan 12,000 $47,000 Cash Outflows: Purchase equipment Dividends $30,000 10,000 $40,000

"A loan of $12,000 will increase our cash position by $7,000," said the president. "As you can see from the statement, we plan to sell some of our old equipment for $8,000 to help out. We also plan to acquire some treasury stock for $5,000, but I haven't put that down on the schedule because that really is something that only affects the stockholders." The bank manager determined that the amounts mentioned by the president were correct. However, he also found out that Watertown Wallets Company's accounts receivable and inventory would increase by a total of $10,000 in 19x9, while current liabilities would increase by $5,000 over the same period. "I think that you may require more than $12,000 ," he said. "In that case," said the company president "perhaps we should increase depreciation by $5,000, and increase our funds that way." Required A. Prepare a projected Statement of Cash Flows in proper form, using the indirect method. (Include the amount of bank loan necessary to increase cash by $7,000. Use the old depreciation figure.) B. What percentage of total uses of cash does the company intend to spend on stockholders? What percentage of total sources comes from operations? C. Comment on the company president's suggestion to increase funds by increasing depreciation.

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Solution: A. Cash Flow Statement Operating Activities: Net Income $20,000 Adjust for items not requiring or using cash: Depreciation 4,000 Gain on Sale of PPE <3,000> Working capital from operations 21,000 Increase in AR, Inventory <10,000> Increase in AP 5,000 Cash From Operations $16,000 Investing Activities: Sale of Equipment Purchase of PPE Cash Used in Investments Financing Activities: Purchase of Treasury Stock Payment of Dividend Bank Loan Cash from Financing Net Increase in Cash B. $ 8,000 <30,000> $<22,000> $ <5,000> <10,000> 28,000 $ 13,000 $ 7,000

(PLUG)

Total sources = 16,000 + 8,000 + 28,000 = $ 52,000 Total uses = 30,000 + 10,000 + 5,000 = $45,000 Operations as proportion of total sources = 16,000/52,000 = .31 Payments to stockholders as propportion of total uses is (10,000 + 5,000)/45,000 = 0.33. C. Depreciation is not a source of cash. It appears on the statement as an adjustment to net income in order to compute cash from operations.

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Problem 4 Venture Group, a venture capital organization, is considering whether to provide financing for Minitel Company. You are required to put together a cash flow statement for Minitel on the basis of the company's 19x9 income statement and balance sheet. Minitel's income statement is summarized below: Revenues $380,000 Expenses Cost of goods sold $140,000 Selling and administrative exp 70,000 Depreciation 50,000 Income tax expense 45,000 305,000 Net income $ 75,000 Changes in the balance sheet amounts from the beginning of the year to the end of the year are summarized below: 1. Changes in assets: Increase Increase Increase Increase
*

in in in in

cash other current assets land equipment

$ 12,000 30,000 150,000 15,000

Increase in cost of equipment was $65,000 and increase in accumulated depreciation was $50,000 2. Changes in liabilities: Increase in current liabilities Decrease in note payable 3. Changes in stockholders' equity: Increase in common stock and additional paid in capital Increase in retained earnings $ 47,000 60,000

$145,000 75,000

The cash balance at the end of the year was $18,000. Required Prepare a cash flow statement in proper form, using the indirect method. Briefly comment on any interesting features of the statement.

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Solution Statement of Cash Flows Cash from operations Net income Depreciation Increase in current assets Increase in current liab Cash from operations Cash use in investing Increase in land Increase in equipment Cash used in investing Cash from financing Decrease in notes payable Increase in common stock Cash from financing Net cash flows Beginning balance Ending balance of cash $75,000 50,000 (30,000) 47,000

$ 142,000

$(150,000) (65,000) (215,000) (60,000) 145,000 $ $

85,000 12,000 6,000 18,000

Some points to note: Cash from operations is significantly greater than income for this company; cash from operations is entirely reinvested in the company (no dividends) but is still insufficient for the investing needs; external financing comes mainly from common stock, which has replaced debt financing; the major investment is land.

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