week 8 exercises

 

Resources: Ch. 13 & 14 of Financial Accounting

 

Complete Exercises E13-8 & E14-3.

Submit as a Microsoft® Excel or Word® document

612

Chapter

Statement of
Cash Flows
After studying this chapter, you should be
able to:
1 Indicate the usefulness of the statement

of cash flows.
2 Distinguish among operating, investing,

and financing activities.
3 Prepare a statement of cash flows using

the indirect method.
4 Analyze

the statement of cash flows.

S T U D Y O B J E C T I V E S

Feature Story

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13

GOT CASH?

In today’s environment, companies must be ready to respond to changes
quickly in order to survive and thrive. They need to produce new products
and expand into new markets continually. To do this takes cash—lots and
lots of cash. Keeping lots of cash available is a real challenge for a young
company. It requires careful cash management and attention to cash flow.

One company that managed cash successfully in its early years was
Microsoft (www.microsoft.com). During those years the company paid much
of its payroll with stock options (rights to purchase company stock in the
future at a given price) instead of cash. This strategy conserved cash, and
turned more than a thousand of its employees into millionaires during the
company’s first 20 years of business.

In recent years Microsoft has had a different kind of cash problem. Now that
it has reached a more “mature” stage in life, it generates so much cash—
roughly $1 billion per month—that it cannot always figure out what to do
with it. By 2004 Microsoft had accumulated $60 billion.

Scan Study Objectives ■

Read Feature Story ■

Read Preview ■

Read text and answer
p. 617 ■ p. 625 ■ p. 628 ■ p. 632 ■

Work Comprehensive p. 634 ■

Review Summary of Study Objectives ■

Work Comprehensive p. 648 ■

Answer Self-Study Questions ■

Complete Assignments ■

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Do it!

Do it!
Do it!

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613

The company said it was accumu-
lating cash to invest in new oppor-
tunities, buy other companies, and
pay off pending lawsuits. But for
years, the federal government has
blocked attempts by Microsoft to
buy anything other than small firms
because it feared that purchase of
a large firm would only increase
Microsoft’s monopolistic position.
In addition, even the largest esti-
mates of Microsoft’s legal obligations
related to pending lawsuits would use up only about $6 billion in cash.

Microsoft’s stockholders have complained for years that holding all this cash
was putting a drag on the company’s profitability. Why? Because Microsoft
had the cash invested in very low-yielding government securities. Stockhold-
ers felt that the company either should find new investment projects that
would bring higher returns, or return some of the cash to stockholders.

Finally, in July 2004 Microsoft announced a plan to return cash to stockhold-
ers, by paying a special one-time $32 billion dividend in December 2004.
This special dividend was so large that, according to the U.S. Commerce
Department, it caused total personal income in the United States to rise
by 3.7% in one month—the largest monthly increase ever recorded by the
agency. (It also made the holiday season brighter, especially for retailers in
the Seattle area.) Microsoft also doubled its regular annual dividend to $3.50
per share. Further, it announced that it would spend another $30 billion over
the next four years buying treasury stock. In addition, in 2008 Microsoft
offered to buy Yahoo! for $44.6 billion (Yahoo! declined the offer). These
actions will help to deplete some of its massive cash horde, but as you will
see in this chapter, for a cash-generating machine like Microsoft, the company
will be anything but cash-starved.

Source: “Business: An End to Growth? Microsoft’s Cash Bonanza,” The Economist, July 23,
2005, p. 61.

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Inside Chapter 13…

• Net What? (p. 617)

• Cash Flow Isn’t Always What It Seems (p. 619)

• GM Must Sell More Cars (p. 626)

• All About You: Where Does the Money Go? (p. 633)

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 613

THE STATEMENT OF CASH FLOWS: USEFULNESS AND FORMAT

Preview of Chapter 13

The balance sheet, income statement, and retained earnings statement do not always show the whole
picture of the financial condition of a company or institution. In fact, looking at the financial statements of
some well-known companies, a thoughtful investor might ask questions like these: How did Eastman Kodak
finance cash dividends of $649 million in a year in which it earned only $17 million? How could United
Airlines purchase new planes that cost $1.9 billion in a year in which it reported a net loss of over $2 billion?
How did the companies that spent a combined fantastic $3.4 trillion on mergers and acquisitions in a recent
year finance those deals? Answers to these and similar questions can be found in this chapter, which
presents the statement of cash flows.

The content and organization of this chapter are as follows.

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614

Statement of Cash Flows

The Statement of Cash Flows:
Usefulness and Format

• Usefulness
• Classifications
• Significant noncash activities
• Format
• Preparation
• Indirect and direct methods

Preparing the Statement of
Cash Flows—Indirect Method

• Step 1: Operating activities
• Step 2: Investing and financing

activities
• Step 3: Net change in cash

Using Cash Flows to Evaluate
a Company

• Free cash flow

The balance sheet, income statement, and retained earnings statement provide
only limited information about a company’s cash flows (cash receipts and cash pay-
ments). For example, comparative balance sheets show the increase in property,
plant, and equipment during the year. But they do not show how the additions were
financed or paid for. The income statement shows net income. But it does not indi-
cate the amount of cash generated by operating activities. The retained earnings
statement shows cash dividends declared but not the cash dividends paid during
the year. None of these statements presents a detailed summary of where cash
came from and how it was used.

Usefulness of the Statement of Cash Flows
The statement of cash flows reports the cash receipts, cash payments, and
net change in cash resulting from operating, investing, and financing activ-
ities during a period. The information in a statement of cash flows should
help investors, creditors, and others assess:

1. The entity’s ability to generate future cash flows. By examining relationships
between items in the statement of cash flows, investors can make predictions of
the amounts, timing, and uncertainty of future cash flows better than they can
from accrual basis data.

Indicate the usefulness of the
statement of cash flows.

S T U D Y O B J E C T I V E 1

JWCL165_c13_612-673.qxd 8/14/09 7:59 AM Page 614

2. The entity’s ability to pay dividends and meet obligations. If a company does
not have adequate cash, it cannot pay employees, settle debts, or pay dividends.
Employees, creditors, and stockholders should be particularly interested in this
statement, because it alone shows the flows of cash in a business.

3. The reasons for the difference between net income and net cash provided
(used) by operating activities. Net income provides information on the success
or failure of a business enterprise. However, some financial statement
users are critical of accrual-basis net income because it requires many
estimates. As a result, users often challenge the reliability of the number.
Such is not the case with cash. Many readers of the statement of cash
flows want to know the reasons for the difference between net income
and net cash provided by operating activities. Then they can assess for
themselves the reliability of the income number.

4. The cash investing and financing transactions during the period. By
examining a company’s investing and financing transactions, a finan-
cial statement reader can better understand why assets and liabilities
changed during the period.

Classification of Cash Flows

The statement of cash flows classifies cash receipts and cash payments as
operating, investing, and financing activities. Transactions and other events
characteristic of each kind of activity are as follows.

1. Operating activities include the cash effects of transactions that create
revenues and expenses. They thus enter into the determination of net
income.

2. Investing activities include (a) acquiring and disposing of investments and
property, plant, and equipment, and (b) lending money and collecting the
loans.

3. Financing activities include (a) obtaining cash from issuing debt and repaying
the amounts borrowed, and (b) obtaining cash from stockholders, repurchasing
shares, and paying dividends.

The operating activities category is the most important. It shows the cash pro-
vided by company operations. This source of cash is generally considered to be the
best measure of a company’s ability to generate sufficient cash to continue as a
going concern.

Illustration 13-1 (page 616) lists typical cash receipts and cash payments within
each of the three classifications. Study the list carefully. It will prove very useful in
solving homework exercises and problems.

Note the following general guidelines:

1. Operating activities involve income statement items.
2. Investing activities involve cash flows resulting from changes in investments

and long-term asset items.
3. Financing activities involve cash flows resulting from changes in long-term lia-

bility and stockholders’ equity items.

Companies classify as operating activities some cash flows related to invest-
ing or financing activities. For example, receipts of investment revenue (interest
and dividends) are classified as operating activities. So are payments of interest
to lenders. Why are these considered operating activities? Because companies
report these items in the income statement, where results of operations are
shown.

The Statement of Cash Flows: Usefulness and Format 615

E T H I C S N O T E

Though we would discour-
age reliance on cash flows to
the exclusion of accrual account-
ing, comparing cash from opera-
tions to net income can reveal
important information about
the “quality” of reported net
income. Such a comparison can
reveal the extent to which net
income provides a good mea-
sure of actual performance.

Distinguish among operating,
investing, and financing
activities.

S T U D Y O B J E C T I V E 2

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Significant Noncash Activities
Not all of a company’s significant activities involve cash. Examples of significant
noncash activities are:

1. Direct issuance of common stock to purchase assets.
2. Conversion of bonds into common stock.
3. Direct issuance of debt to purchase assets.
4. Exchanges of plant assets.

Companies do not report in the body of the statement of cash flows
significant financing and investing activities that do not affect cash.
Instead, they report these activities in either a separate schedule at the
bottom of the statement of cash flows or in a separate note or supplemen-
tary schedule to the financial statements. The reporting of these noncash
activities in a separate schedule satisfies the full disclosure principle.

In solving homework assignments you should present significant non-
cash investing and financing activities in a separate schedule at the bottom
of the statement of cash flows. (See the last entry in Illustration 13-2, on
page 617, for an example.)

616 Chapter 13 Statement of Cash Flows

Operating
activities

Investing activities

J AVA
TIME

J AVA
TIME

Financing
activities

STOCK
BOND

TYPES OF CASH INFLOWS AND OUTFLOWS
Operating activities—Income statement items

Cash inflows:
From sale of goods or services.
From interest received and dividends received.

Cash outflows:
To suppliers for inventory.
To employees for services.
To government for taxes.
To lenders for interest.
To others for expenses.

Investing activities—Changes in investments and long-term assets
Cash inflows:

From sale of property, plant, and equipment.
From sale of investments in debt or equity securities of other entities.
From collection of principal on loans to other entities.

Cash outflows:
To purchase property, plant, and equipment.
To purchase investments in debt or equity securities of other entities.
To make loans to other entities.

Financing activities—Changes in long-term liabilities and stockholders’ equity
Cash inflows:

From sale of common stock.
From issuance of long-term debt (bonds and notes).

Cash outflows:
To stockholders as dividends.
To redeem long-term debt or reacquire capital stock (treasury stock).

Illustration 13-1
Typical receipt and payment
classifications

INTERNATIONAL NOTE
The statement of cash flows

is very similar under GAAP and
IFRS. One difference is that,
under IFRS, noncash investing
and financing activities are not
reported in the statement of cash
flows but instead are reported in
the notes to the financial
statements.

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before you go on…

Format of the Statement of Cash Flows
The general format of the statement of cash flows presents the results of the three
activities discussed previously—operating, investing, and financing—plus the sig-
nificant noncash investing and financing activities. Illustration 13-2 shows a widely
used form of the statement of cash flows.

The Statement of Cash Flows: Usefulness and Format 617

Net What?

Net income is not the same as net cash provided by operating activities. Below
are some results from recent annual reports (dollars in millions). Note the wide

disparity among these companies, all of which engaged in retail merchandising.

Net Cash Provided by
Company Net Income Operating Activities

Kohl’s Corporation $ 1,083 $ 1,234
Wal-Mart Stores, Inc. 11,284 20,164
J. C. Penney Company, Inc. 1,153 1,255
Costco Wholesale Corp. 1,082 2,076
Target Corporation 2,849 4,125

ACCOUNTING ACROSS THE ORGANIZATION

In general, why do differences exist between net income and net cash provided by
operating activities?

The cash flows from operating activities section always appears first, followed by
the investing activities section and then the financing activities section.

COMPANY NAME
Statement of Cash Flows

Period Covered

Cash flows from

operating activities

(List of individual items)

XX

Net cash provided (used) by operating activities

XXX

Cash flows from investing activities

(List of individual inflows and outflows) XX

Net cash provided (used) by investing activities XXX
Cash flows from financing activities

(List of individual inflows and outflows) XX

Net cash provided (used) by financing activities XXX

Net increase (decrease) in cash XXX
Cash at beginning of period XXX

Cash at end of period XXX

Noncash investing and financing activities
(List of individual noncash transactions) XXX

Illustration 13-2
Format of statement of cash
flows

Do it!
During its first week, Duffy & Stevenson Company had these transactions.

1. Issued 100,000 shares of $5 par value common stock for $800,000 cash.

2. Borrowed $200,000 from Castle Bank, signing a 5-year note bearing 8% interest.

Classification of Cash Flows

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Preparing the Statement of Cash Flows
Companies prepare the statement of cash flows differently from the three
other basic financial statements. First, it is not prepared from an adjusted
trial balance. It requires detailed information concerning the changes in
account balances that occurred between two points in time. An adjusted trial
balance will not provide the necessary data. Second, the statement of cash
flows deals with cash receipts and payments. As a result, the company must
adjust the effects of the use of accrual accounting to determine cash flows.

The information to prepare this statement usually comes from three sources:
• Comparative balance sheets. Information in the comparative balance sheets

indicates the amount of the changes in assets, liabilities, and stockholders’ equi-
ties from the beginning to the end of the period.

• Current income statement. Information in this statement helps determine the
amount of cash provided or used by operations during the period.

• Additional information. Such information includes transaction data that are
needed to determine how cash was provided or used during the period.

Preparing the statement of cash flows from these data sources involves three
major steps, as explained in Illustration 13-3 on the next page.

Indirect and Direct Methods
In order to perform step 1, a company must convert net income from an accrual
basis to a cash basis. This conversion may be done by either of two methods: (1) the
indirect method or (2) the direct method. Both methods arrive at the same total
amount for “Net cash provided by operating activities.” They differ in how they
arrive at the amount.

The indirect method adjusts net income for items that do not affect cash. A
great majority of companies (98.8%) use this method, as shown in the nearby
chart.1 Companies favor the indirect method for two reasons: (1) It is easier and

618 Chapter 13 Statement of Cash Flows

3. Purchased two semi-trailer trucks for $170,000 cash.

4. Paid employees $12,000 for salaries and wages.

5. Collected $20,000 cash for services provided.

Classify each of these transactions by type of cash flow activity.

Solution

1. Financing activity

2. Financing activity

3. Investing activity

4. Operating activity

5. Operating activity

Related exercise material: BE13-1, BE13-2, BE13-3, E13-1, E13-2, E13-3, and 13-1.Do it!

Action Plan

• Identify the three types of
activities used to report all
cash inflows and outflows.

• Report as operating activities
the cash effects of transactions
that create revenues and
expenses and enter into the
determination of net income.

• Report as investing activities
transactions that (a) acquire
and dispose of investments and
long-term assets and (b) lend
money and collect loans.

• Report as financing activities
transactions that (a) obtain
cash from issuing debt and
repay the amounts borrowed
and (b) obtain cash from stock-
holders and pay them dividends.

The Navigator✓

INTERNATIONAL NOTE
Companies preparing finan-

cial statements under IFRS must
prepare a statement of cash
flows as an integral part of the
financial statements.

1
Accounting Trends and Techniques—2007 (New York: American Institute of Certified Public

Accountants, 2007).

1% Direct Method

99%
Indirect Method

Usage of Methods

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 618

less costly to prepare, and (2) it focuses on the differences between net income and
net cash flow from operating activities.

The direct method shows operating cash receipts and payments, making it
more consistent with the objective of a statement of cash flows. The FASB has
expressed a preference for the direct method, but allows the use of either method.

The next section illustrates the more popular indirect method. Appendix 13B
illustrates the direct method.

The Statement of Cash Flows: Usefulness and Format 619

The difference between the beginning
and ending cash balances can be easily
computed from comparative balance
sheets.

+ or –

This step involves analyzing not only
the current year’s income statement
but also comparative balance sheets
and selected additional data.

Step 2: Analyze changes in noncurrent asset and liability accounts and record as
investing and financing activities, or disclose as noncash transactions.

Step 1: Determine net cash provided/used by operating activities by converting
net income from an accrual basis to a cash basis.

Step 3: Compare the net change in cash on the statement of cash flows with the
change in the cash account reported on the balance sheet to make sure
the amounts agree.

This step involves analyzing comparative
balance sheet data and selected additional
information for their effects on cash.

Fina
ncin

gInvesting

Buying & selling
goods

Illustration 13-3
Three major steps in
preparing the statement
of cash flows

For what reasons might managers at WorldCom and at Dynegy take the actions noted
above?

Cash Flow Isn’t Always What It Seems

Some managers have taken actions that artificially increase cash flow from operating
activities. They do this by moving negative amounts out of the operating section and into the
investing or financing section.

For example, WorldCom, Inc. disclosed that it had improperly capitalized expenses: It had
moved $3.8 billion of cash outflows from the “Cash from operating activities” section of the cash
flow statement to the “Investing activities” section, thereby greatly enhancing cash provided by
operating activities. Similarly, Dynegy, Inc. restated its cash flow statement because it had improp-
erly included in operating activities, instead of in financing activities, $300 million from natural gas
trading. The restatement resulted in a drop of 37% in cash flow from operating activities.

SSource: Henny Sender, “Sadly, These Days Even Cash Flow Isn’t Always What It Seems to Be,” Wall Street Journal,
May 8, 2002.

I N V E S T O R I N S I G H T

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620 Chapter 13 Statement of Cash Flows

PREPARING THE STATEMENT OF CASH
FLOWS—INDIRECT METHOD

To explain how to prepare a statement of cash flows using the indirect
method, we use financial information from Computer Services Company.
Illustration 13-4 presents Computer Services’ current and previous-year
balance sheets, its current-year income statement, and related financial in-

formation for the current year.

Prepare a statement of cash
flows using the indirect method.

S T U D Y O B J E C T I V E 3

COMPUTER SERVICES COMPANY
Comparative Balance Sheets

December 31

Change in
Account Balance

Assets 2011 2010

Increase/Decrease

Current assets
Cash $ 55,000 $ 33,000 $ 22,000

Increase

Accounts receivable 20,000 30,000 10,000 Decrease
Merchandise inventory 15,000 10,000 5,000 Increase
Prepaid expenses 5,000 1,000 4,000 Increase

Property, plant, and equipment
Land 130,000 20,000 110,000 Increase
Building 160,000 40,000 120,000 Increase
Accumulated depreciation—building (11,000) (5,000) 6,000 Increase
Equipment 27,000 10,000 17,000 Increase
Accumulated depreciation—equipment (3,000) (1,000) 2,000 Increase

Total assets $398,000 $13

8,000

Liabilities and Stockholders’ Equity

Current liabilities
Accounts payable $ 28,000 $ 12,000 $ 16,000 Increase
Income tax payable 6,000 8,000 2,000 Decrease

Long-term liabilities
Bonds payable 130,000 20,000 110,000 Increase

Stockholders’ equity
Common stock 70,000 50,000 20,000 Increase
Retained earnings 164,000 48,000 116,000 Increase

Total liabilities and stockholders’ equity $398,000 $138,000

COMPUTER SERVICES COMPANY
Income Statement

For the Year Ended December 31, 2011

Revenues

$507,000

Cost of goods sold $150,000
Operating expenses (excluding depreciation) 11

1,000

Depreciation expense 9,000
Loss on sale of equipment 3,000
Interest expense 42,000 315,000

Income before income tax 19

2,000

Income tax expense 47,000

Net income

$145,000

Illustration 13-4
Comparative balance
sheets, income statement,
and additional information
for Computer Services
Company

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We will now apply the three steps to the information provided for Computer
Services Company.

Step 1: Operating Activities
DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY
CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS
To determine net cash provided by operating activities under the indirect method,
companies adjust net income in numerous ways. A useful starting point is to under-
stand why net income must be converted to net cash provided by operating activities.

Under generally accepted accounting principles, most companies use the ac-
crual basis of accounting. This basis requires that companies record revenue when
earned and record expenses when incurred. Earned revenues may include credit
sales for which the company has not yet collected cash. Expenses incurred may in-
clude some items that it has not yet paid in cash. Thus, under the accrual basis, net
income is not the same as net cash provided by operating activities.

Therefore, under the indirect method, companies must adjust net income to
convert certain items to the cash basis. The indirect method (or reconciliation
method) starts with net income and converts it to net cash provided by operating
activities. Illustration 13-5 lists the three types of adjustments.

Preparing the Statement of Cash Flows—Indirect Method 621

Illustration 13-4
(continued)

Illustration 13-5
Three types of adjustments
to convert net income to
net cash provided by
operating activities

H E L P F U L H I N T
Depreciation is similar
to any other expense
in that it reduces net
income. It differs in that
it does not involve a
current cash outflow; that
is why it must be added
back to net income to
arrive at cash provided
by operating activities.

DEPRECIATION EXPENSE
Computer Services’ income statement reports depreciation expense of $9,000.
Although depreciation expense reduces net income, it does not reduce cash. In other
words, depreciation expense is a noncash charge. The company must add it back to
net income to arrive at net cash provided by operating activities. Computer Services
reports depreciation expense in the statement of cash flows as shown on page 622.

Additional information for 2011:
1. The company declared and paid a $29,000 cash dividend.
2. Issued $110,000 of long-term bonds in direct exchange for land.
3. A building costing $120,000 was purchased for cash. Equipment costing $25,000 was also

purchased for cash.
4. The company sold equipment with a book value of $7,000 (cost $8,000, less accumulated

depreciation $1,000) for $4,000 cash.
5. Issued common stock for $20,000 cash.
6. Depreciation expense was comprised of $6,000 for building and $3,000 for equipment.

Net Cash Provided/
Net Income ��� Adjustments � Used by Operating

Activities
• Add back noncash

expenses, such as
depreciation, amortization,
or depletion.

• Deduct gains and add
losses that resulted from
investing and financing
activities.

• Analyze changes to noncash
current asset and current
liability accounts.

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 621

As the first adjustment to net income in the statement of cash flows, companies
frequently list depreciation and similar noncash charges such as amortization of
intangible assets, depletion expense, and bad debt expense.

LOSS ON SALE OF EQUIPMENT
Illustration 13-1 (page 616) states that the investing activities section should report
cash received from the sale of plant assets. Because of this, companies must eliminate
from net income all gains and losses related to the disposal of plant assets, to arrive
at cash provided by operating activities.

In our example, Computer Services’ income statement reports a $3,000 loss on
the sale of equipment (book value $7,000, less $4,000 cash received from sale of
equipment). The company’s loss of $3,000 should not be included in the operating
activities section of the statement of cash flows. Illustration 13-7 shows that the
$3,000 loss is eliminated by adding $3,000 back to net income to arrive at net cash
provided by operating activities.

622 Chapter 13 Statement of Cash Flows

If a gain on sale occurs, the company deducts the gain from its net income in
order to determine net cash provided by operating activities. In the case of either
a gain or a loss, companies report as a source of cash in the investing activities
section of the statement of cash flows the actual amount of cash received from
the sale.

CHANGES TO NONCASH CURRENT ASSET AND CURRENT
LIABILITY ACCOUNTS
A final adjustment in reconciling net income to net cash provided by operating
activities involves examining all changes in current asset and current liability
accounts. The accrual accounting process records revenues in the period earned
and expenses in the period incurred. For example, companies use Accounts
Receivable to record amounts owed to the company for sales that have been
made but for which cash collections have not yet been received. They use the
Prepaid Insurance account to reflect insurance that has been paid for, but which
has not yet expired, and therefore has not been expensed. Similarly, the Salaries
Payable account reflects salaries expense that has been incurred by the company
but has not been paid.

Cash flows from operating activities
Net income $145,000
Adjustments to reconcile net income to net cash

provided by operating activities:
Depreciation expense 9,000

Net cash provided by operating activities $15

4,000

Cash flows from operating activities
Net income $145,000
Adjustments to reconcile net income to net cash

provided by operating activities:
Depreciation expense $9,000
Loss on sale of equipment 3,000 12,000

Net cash provided by operating activities $157,000

Illustration 13-6
Adjustment for depreciation

Illustration 13-7
Adjustment for loss on sale
of equipment

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 622

As a result, we need to adjust net income for these accruals and prepayments
to determine net cash provided by operating activities. Thus we must analyze the
change in each current asset and current liability account to determine its impact
on net income and cash.

CHANGES IN NONCASH CURRENT ASSETS. The adjustments required for changes
in noncash current asset accounts are as follows: Deduct from net income increases
in current asset accounts, and add to net income decreases in current asset ac-
counts, to arrive at net cash provided by operating activities. We can observe these
relationships by analyzing the accounts of Computer Services Company.

Decrease in Accounts Receivable. Computer Services Company’s accounts
receivable decreased by $10,000 (from $30,000 to $20,000) during the period. For
Computer Services this means that cash receipts were $10,000 higher than rev-
enues. The Accounts Receivable account in Illustration 13-8 shows that Computer
Services Company had $507,000 in revenues (as reported on the income statement),
but it collected $517,000 in cash.

Preparing the Statement of Cash Flows—Indirect Method 623

To adjust net income to net cash provided by operating activities, the company
adds to net income the decrease of $10,000 in accounts receivable (see Illustra-
tion 13-9, page 624). If the Accounts Receivable balance increases, cash receipts are
lower than revenue earned under the accrual basis. Therefore, the company deducts
from net income the amount of the increase in accounts receivable, to arrive at net
cash provided by operating activities.

Increase in Merchandise Inventory. Computer Services Company’s
Merchandise Inventory balance increased $5,000 (from $10,000 to $15,000) during
the period. The change in the Merchandise Inventory account reflects the differ-
ence between the amount of inventory purchased and the amount sold. For
Computer Services this means that the cost of merchandise purchased exceeded
the cost of goods sold by $5,000. As a result, cost of goods sold does not reflect
$5,000 of cash payments made for merchandise. The company deducts from net
income this inventory increase of $5,000 during the period, to arrive at net cash
provided by operating activities (see Illustration 13-9, page 624). If inventory de-
creases, the company adds to net income the amount of the change, to arrive at net
cash provided by operating activities.

Increase in Prepaid Expenses. Computer Services’ prepaid expenses in-
creased during the period by $4,000. This means that cash paid for expenses is
higher than expenses reported on an accrual basis. In other words, the company
has made cash payments in the current period, but will not charge expenses
to income until future periods (as charges to the income statement). To adjust
net income to net cash provided by operating activities, the company deducts
from net income the $4,000 increase in prepaid expenses (see Illustration 13-9,
page 624).

If prepaid expenses decrease, reported expenses are higher than the expenses
paid. Therefore, the company adds to net income the decrease in prepaid expenses,
to arrive at net cash provided by operating activities.

Accounts Receivable

1/1/11 Balance 30,000 Receipts from customers 517,000
Revenues 507,000

12/31/11 Balance

20,000

Illustration 13-8
Analysis of accounts
receivable

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 623

CHANGES IN CURRENT LIABILITIES. The adjustments required for changes in current
liability accounts are as follows: Add to net income increases in current liability
accounts, and deduct from net income decreases in current liability accounts, to
arrive at net cash provided by operating activities.

Increase in Accounts Payable. For Computer Services Company, Accounts
Payable increased by $16,000 (from $12,000 to $28,000) during the period. That
means the company received $16,000 more in goods than it actually paid for. As
shown in Illustration 13-10 (below), to adjust net income to determine net cash
provided by operating activities, the company adds to net income the $

16,000

increase in Accounts Payable.

Decrease in Income Tax Payable. When a company incurs income tax expense
but has not yet paid its taxes, it records income tax payable. A change in the Income
Tax Payable account reflects the difference between income tax expense incurred
and income tax actually paid. Computer Services’ Income Tax Payable account de-
creased by $2,000. That means the $47,000 of income tax expense reported on the
income statement was $2,000 less than the amount of taxes paid during the period
of $49,000. As shown in Illustration 13-10, to adjust net income to a cash basis, the
company must reduce net income by $2,000.

624 Chapter 13 Statement of Cash Flows

Illustration 13-10 shows that, after starting with net income of $145,000, the
sum of all of the adjustments to net income was $27,000. This resulted in net cash
provided by operating activities of $172,000.

Cash flows from operating activities
Net income $145,000
Adjustments to reconcile net income to net cash

provided by operating activities:
Depreciation expense $ 9,000
Loss on sale of equipment 3,000
Decrease in accounts receivable

10,000

Increase in merchandise inventory (5,000)
Increase in prepaid expenses (4,000)
Increase in accounts payable 16,000
Decrease in income tax payable (2,000) 27,000

Net cash provided by operating activities $172,000

Illustration 13-10
Adjustments for changes in
current liability accounts

Cash flows from operating activities
Net income $145,000
Adjustments to reconcile net income to net cash

provided by operating activities:
Depreciation expense $ 9,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Increase in merchandise inventory (5,000)
Increase in prepaid expenses (4,000) 13,000

Net cash provided by operating activities $158,000

Illustration 13-9
Adjustments for changes
in current asset accounts

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 624

before you go on…

Summary of Conversion to Net Cash Provided
by Operating Activities—Indirect Method
As shown in the previous illustrations, the statement of cash flows prepared by the in-
direct method starts with net income. It then adds or deducts items to arrive at net
cash provided by operating activities. The required adjustments are of three types:

1. Noncash charges such as depreciation, amortization, and depletion.
2. Gains and losses on the sale of plant assets.
3. Changes in noncash current asset and current liability accounts.

Illustration 13-11 provides a summary of these changes.

Preparing the Statement of Cash Flows—Indirect Method 625

Depreciation expense
Patent amortization expense
Depletion expense

Loss on sale of plant asset
Gain on sale of plant asset

Increase in current asset account
Decrease in current asset account
Increase in current liability account
Decrease in current liability account

Gains
and Losses

Noncash
Charges

Changes in
Current Assets

and
Current Liabilities

Adjustment Required
to Convert Net Income
to Net Cash Provided

by Operating Activities

Add
Add
Add

Add

Deduct

Deduct
Add
Add

Deduct

⎫
⎬
⎭

⎫
⎬
⎭
⎫
⎬
⎭

Illustration 13-11
Adjustments required to
convert net income to net
cash provided by operating
activities

Do it!
Josh’s PhotoPlus reported net income of $73,000 for 2011. Included in the in-

come statement were depreciation expense of $7,000 and a gain on sale of equipment of $2,500.
Josh’s comparative balance sheets show the following balances.

12/31/10 12/31/11

Accounts receivable $17,000 $21,000
Accounts payable 6,000 2,200

Calculate net cash provided by operating activities for Josh’s PhotoPlus.

Solution

Cash from Operating
Activities

Cash flows from operating activities
Net income $73,000

Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense $7,000
Gain on sale of equipment (2,500)
Increase in accounts receivable (4,000)
Decrease in accounts payable (3,800) (3,300)

Net cash provided by operating activities $69,700

The Navigator✓

Related exercise material: BE13-4, BE13-5, BE13-6, BE13-7, E13-4, E13-5, E13-6, E13-7, E13-8, and
13-2.

Do it!
Action Plan

• Add noncash charges such as
depreciation back to net income
to compute net cash provided
by operating activities.

• Deduct from net income gains
on the sale of plant assets, or
add losses back to net income,
to compute net cash provided
by operating activities.

• Use changes in noncash current
asset and current liability
accounts to compute net cash
provided by operating activities.

JWCL165_c13_612-673.qxd 8/14/09 7:59 AM Page 625

Step 2: Investing and Financing Activities
ANALYZE CHANGES IN NONCURRENT ASSET
AND LIABILITY ACCOUNTS AND RECORD AS INVESTING
AND FINANCING ACTIVITIES, OR AS NONCASH INVESTING
AND FINANCING ACTIVITIES
Increase in Land. As indicated from the change in the Land account and the
additional information, the company purchased land of $110,000 through the
issuance of long-term bonds. The issuance of bonds payable for land has no effect
on cash. But it is a significant noncash investing and financing activity that merits
disclosure in a separate schedule. (See Illustration 13-13 on page 628.)

Increase in Building. As the additional data indicate, Computer Services
Company acquired an office building for $120,000 cash. This is a cash outflow
reported in the investing section. (See Illustration 13-13 on page 628.)

Increase in Equipment. The Equipment account increased $17,000. The addi-
tional information explains that this was a net increase that resulted from two

626 Chapter 13 Statement of Cash Flows

GM Must Sell More Cars

Market share matters—and it shows up in the accounting numbers. Just ask
General Motors. In recent years GM has seen its market share erode until, at

25.6% of the market, the company reached the point where it actually consumed more cash
than it generated. It isn’t time to panic yet—GM has about $20 billion in cash on hand—but it
is time to come up with a plan.

To address immediate cash needs, GM management reduced its annual dividend and sold
off some assets and businesses. Even these measures were not enough to avoid bankruptcy.
GM is now in the process of shrinking its operations to fit its sales figures. The following table
shows net income and cash provided by operating activities at various market-share levels.

ACCOUNTING ACROSS THE ORGANIZATION

Why does GM’s cash provided by operating activities drop so precipitously when the
company’s sales figures decline?

Source: David Welch and Dan Beucke, “Why GM’s Plan Won’t Work,” Business Week, May 9, 2005, pp. 85–93.

Data: Merrill Lynch & Co. *Net income and cash flow figures in billions of dollars, including GMAC.

$3.0

$1.5

$0

�$1.5

�$3.0

�$4.5

28% 27% 26%
25% 24% 23% 22% 21% 20%

U.S. market share

Cash flow*Net income

*

GM’S current U.S.
market share = 25.6%

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 626

transactions: (1) a purchase of equipment of $25,000, and (2) the sale for $4,000 of
equipment costing $8,000. These transactions are investing activities. The com-
pany should report each transaction separately. Thus it reports the purchase of
equipment as an outflow of cash for $25,000. It reports the sale as an inflow of cash
for $4,000. The T account below shows the reasons for the change in this account
during the year.

Preparing the Statement of Cash Flows—Indirect Method 627

Equipment

1/1/11 Balance 10,000 Cost of equipment sold 8,000
Purchase of equipment 25,000

12/31/11 Balance 27,000

The following entry shows the details of the equipment sale transaction.

Cash 4,000
Accumulated Depreciation 1,000
Loss on Sale of Equipment 3,000

Equipment 8,000

Increase in Bonds Payable. The Bonds Payable account increased $110,000. As
indicated in the additional information, the company acquired land from the
issuance of these bonds. It reports this noncash transaction in a separate schedule
at the bottom of the statement.

Increase in Common Stock. The balance sheet reports an increase in Common
Stock of $20,000. The additional information section notes that this increase re-
sulted from the issuance of new shares of stock. This is a cash inflow reported in the
financing section.

Increase in Retained Earnings. Retained earnings increased $116,000
during the year. This increase can be explained by two factors: (1) Net income
of $145,000 increased retained earnings. (2) Dividends of $29,000 decreased
retained earnings. The company adjusts net income to net cash provided by op-
erating activities in the operating activities section. Payment of the dividends
(not the declaration) is a cash outflow that the company reports as a financing
activity.

STATEMENT OF CASH FLOWS—2011
Using the previous information, we can now prepare a statement of cash flows for
2011 for Computer Services Company as shown in Illustration 13-13 (page 628).

Step 3: Net Change in Cash
COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH
FLOWS WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON
THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE
Illustration 13-13 indicates that the net change in cash during the period was an
increase of $22,000. This agrees with the change in Cash account reported on the
balance sheet in Illustration 13-4 (page 620).

Illustration 13-12
Analysis of equipment

Cash Flows
�4,000

A SEL�

�

�4,000
�1,000

�3,000 Exp
�8,000

H E L P F U L H I N T
When companies issue
stocks or bonds for cash,
the actual proceeds will
appear in the statement
of cash flows as a
financing inflow (rather
than the par value of the
stocks or face value of
bonds).

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 627

before you go on…

628 Chapter 13 Statement of Cash Flows

H E L P F U L H I N T
Note that in the invest-
ing and financing activi-
ties sections, positive
numbers indicate cash
inflows (receipts), and
negative numbers
indicate cash outflows
(payments).

COMPUTER SERVICES COMPANY
Statement of Cash Flows—Indirect Method

For the Year Ended December 31, 2011
Cash flows from operating activities
Net income $145,000
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation expense $ 9,000
Loss on sale of equipment 3,000
Decrease in accounts receivable 10,000
Increase in merchandise inventory (5,000)
Increase in prepaid expenses (4,000)
Increase in accounts payable 16,000
Decrease in income tax payable (2,000) 27,000

Net cash provided by operating activities 172,000
Cash flows from investing activities

Purchase of building (120,000)
Purchase of equipment (25,000)
Sale of equipment 4,000

Net cash used by investing activities (141,000)
Cash flows from financing activities

Issuance of common stock 20,000
Payment of cash dividends (29,000)

Net cash used by financing activities (9,000)

Net increase in cash

22,000

Cash at beginning of period 33,000

Cash at end of period $ 55,000

Noncash investing and financing activities
Issuance of bonds payable to purchase land $

110,000

Do it!
Use the information below and on the next page to prepare a statement of

cash flows using the indirect method.
Indirect Method

Action Plan

• Determine net cash provided/
used by operating activities by
adjusting net income for items
that did not affect cash.

• Determine net cash
provided/used by investing
activities and financing activities.

• Determine the net increase/
decrease in cash.

REYNOLDS COMPANY
Comparative Balance Sheets

December 31

Change
Assets 2011 2010 Increase/Decrease

Cash $ 54,000 $ 37,000 $ 17,000 Increase
Accounts receivable 68,000 26,000 42,000 Increase
Inventories 54,000 –0– 54,000 Increase
Prepaid expenses 4,000 6,000 2,000 Decrease
Land 45,000 70,000 25,000 Decrease
Buildings 200,000 200,000 –0–
Accumulated depreciation—buildings (21,000) (11,000) 10,000 Increase
Equipment 193,000 68,000 125,000 Increase
Accumulated depreciation—equipment (28,000) (10,000) 18,000 Increase

Totals $569,000 $386,000

Illustration 13-13
Statement of cash flows,
2011—indirect method

JWCL165_c13_612-673.qxd 8/14/09 7:59 AM Page 628

Preparing the Statement of Cash Flows—Indirect Method 629

Liabilities and Stockholders’ Equity

Accounts payable $ 23,000 $ 40,000 $ 17,000 Decrease
Accrued expenses payable 10,000 –0– 10,000 Increase
Bonds payable 110,000 150,000 40,000 Decrease
Common stock ($1 par) 220,000 60,000 160,000 Increase
Retained earnings 206,000 136,000 70,000 Increase

Totals $569,000 $386,000

REYNOLDS COMPANY
Income Statement

For the Year Ended December 31, 2011

Revenues $890,000
Cost of goods sold $465,000
Operating expenses 221,000
Interest expense 12,000
Loss on sale of equipment 2,000 700,000

Income before income taxes 190,000
Income tax expense 65,000

Net income $125,000

Additional information:

1. Operating expenses include depreciation expense of $33,000 and charges from prepaid

expenses of $2,000.
2. Land was sold at its book value for cash.
3. Cash dividends of $55,000 were declared and paid in 2011.
4. Interest expense of $12,000 was paid in cash.
5. Equipment with a cost of $166,000 was purchased for cash. Equipment with a cost of

$41,000 and a book value of $36,000 was sold for $34,000 cash.
6. Bonds of $10,000 were redeemed at their face value for cash. Bonds of $30,000 were

converted into common stock.
7. Common stock ($1 par) of $130,000 was issued for cash.
8. Accounts payable pertain to merchandise suppliers.

Solution

REYNOLDS COMPANY
Statement of Cash Flows—Indirect Method

For the Year Ended December 31, 2011

Cash flows from operating activities
Net income $125,000
Adjustments to reconcile net income to net cash

provided by operating activities:
Depreciation expense $ 33,000
Loss on sale of equipment 2,000
Increase in accounts receivable (42,000)
Increase in inventories (54,000)
Decrease in prepaid expenses 2,000
Decrease in accounts payable (17,000)
Increase in accrued expenses payable 10,000 (66,000)

Net cash provided by operating activities 59,000

H E L P F U L H I N T
1. Determine net cash

provided/used by
operating activities,
recognizing that
operating activities
generally relate to
changes in current
assets and current
liabilities.

2. Determine net cash
provided/used by
investing activities,
recognizing that
investing activities
generally relate to
changes in noncurrent
assets.

3. Determine net cash
provided/used by
financing activities,
recognizing that
financing activities
generally relate to
changes in long-term
liabilities and stock-
holders’ equity
accounts.

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 629

630 Chapter 13 Statement of Cash Flows

Cash flows from investing activities
Sale of land 25,000
Sale of equipment 34,000
Purchase of equipment (166,000)

Net cash used by investing activities (107,000)
Cash flows from financing activities

Redemption of bonds (10,000)
Sale of common stock 130,000
Payment of dividends (55,000)

Net cash provided by financing activities 65,000

Net increase in cash 17,000
Cash at beginning of period 37,000

Cash at end of period $ 54,000

Noncash investing and financing activities
Conversion of bonds into common stock $ 30,000

Related exercise material: BE13-4, BE13-5, BE13-6, BE13-7, E13-4, E13-5, E13-6, E13-7, E13-8, and E13-9.

The Navigator✓

USING CASH FLOWS TO EVALUATE A COMPANY

Traditionally, investors and creditors have most commonly used ratios
based on accrual accounting. These days, cash-based ratios are gaining in-
creased acceptance among analysts.

Free Cash Flow
In the statement of cash flows, cash provided by operating activities is intended
to indicate the cash-generating capability of the company. Analysts have noted,
however, that cash provided by operating activities fails to take into account that
a company must invest in new fixed assets just to maintain its current level of
operations. Companies also must at least maintain dividends at current levels to
satisfy investors. The measurement of free cash flow provides additional insight
regarding a company’s cash-generating ability. Free cash flow describes the
cash remaining from operations after adjustment for capital expenditures and
dividends.

Consider the following example: Suppose that MPC produced and sold
10,000 personal computers this year. It reported $100,000 cash provided by oper-
ating activities. In order to maintain production at 10,000 computers, MPC
invested $15,000 in equipment. It chose to pay $5,000 in dividends. Its free cash
flow was $80,000 ($100,000 � $15,000 � $5,000). The company could use this
$80,000 either to purchase new assets to expand the business or to pay an $80,000
dividend and continue to produce 10,000 computers. In practice, free cash flow is
often calculated with the formula in Illustration 13-14. (Alternative definitions
also exist.)

Analyze the statement of cash
flows.

S T U D Y O B J E C T I V E 4

Free Cash Cash Provided by Capital Cash
Flow

�
Operating Activities

�
Expenditures

�
Dividends

Illustration 13-14
Free cash flow

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 630

Illustration 13-15 provides basic information (in millions) excerpted from the
2008 statement of cash flows of Microsoft Corporation.

Using Cash Flows to Evaluate a Company 631

MICROSOFT CORPORATION
Statement of Cash Flows (partial)

2008

Cash provided by operating activities $21,612
Cash flows from investing activities

Additions to property and equipment $ (3,182)
Purchases of investments (20,954)
Sales of investments 25,132
Acquisitions of companies (8,053)
Maturities of investments 2,597
Other (127)

Cash used by investing activities (4,587)
Cash paid for dividends (4,015)

Microsoft’s free cash flow is calculated as shown in Illustration 13-16.

Cash provided by operating activities $21,612
Less: Expenditures on property and equipment 3,182

Dividends paid 4,015

Free cash flow $14,415

This is a tremendous amount of cash generated in a single year. It is available
for the acquisition of new assets, the retirement of stock or debt, or the payment of
dividends. As indicated in the Feature Story, for example, Microsoft is attempting
to buy Yahoo! for over $44 billion as part of its acquisition strategey.

Oracle Corporation is one of the world’s largest sellers of database software and
information management services. Like Microsoft, its success depends on continuing
to improve its existing products while developing new products to keep pace with
rapid changes in technology. Oracle’s free cash flow for 2008 was $7,159 million. This
is impressive, but significantly less than Microsoft’s amazing ability to generate cash.

Illustration 13-15
Microsoft cash flow
information ($ in millions)

Illustration 13-16
Calculation of Microsoft’s
free cash flow ($ in millions)

Where Does
the Money Go?
on page 633 for

information on how topics
in this chapter apply

to you.

all about Y U*
Be sure to read

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 631

before you go on…

632 Chapter 13 Statement of Cash Flows

(a) Free cash flow � $29,300 � $19,000 � $9,000 � $1,300
(b) Cash provided by operating activities fails to take into account that a company must invest

in new plant assets just to maintain the current level of operations. Companies must also
maintain dividends at current levels to satisfy investors. The measurement of free cash flow
provides additional insight regarding a company’s cash-generating ability.

Solution

Related exercise material: BE13-8, BE13-9, BE13-10, BE13-11, E13-7, E13-9, and 13-3.Do it!

The Navigator✓
Action Plan

• Compute free cash flow as:
Cash provided by operating
activities � Capital
expenditures � Cash dividends.

Chicago Corporation issued the following statement of cash flows for 2011.Free Cash Flow
Do it!

CHICAGO CORPORATION
Statement of Cash Flows—Indirect Method

For the Year Ended December 31, 2011

Cash flows from operating activities
Net income $19,000
Adjustments to reconcile net income to net cash

provided by operating activities:
Depreciation expense $ 8,100
Loss on sale of equipment 1,300
Decrease in accounts receivable 6,900
Increase in inventory (4,000)
Decrease in accounts payable (2,000) 10,300

Net cash provided by operating activities 29,300

Cash flows from investing activities
Sale of investments 1,100
Purchase of equipment (19,000)

Net cash used by investing activities (17,900)

Cash flows from financing activities
Issuance of stock 10,000
Payment on long-term note payable (5,000)
Payment for dividends (9,000)

Net cash used by financing activities (4,000)

Net increase in cash 7,400
Cash at beginning of year 10,000

Cash at end of year $17,400

(a) Compute free cash flow for Chicago Corporation. (b) Explain why free cash flow often
provides better information than “Net cash provided by operating activities.”

JWCL165_c13_612-673.qxd 8/13/09 6:15 PM Page 632

all about Y U*all about Y U*
Where Does the Money Go?

*

Some Facts*

About the Numbers*

* College students spend about $200 billion per year
on consumer products. Of that amount, $41 billion
is “discretionary” in nature.

* More than 70% of college students own a cell phone,
and 71% own a car.

* College students spend more than $8 billion per
year purchasing DVDs, CDs, music downloads, and
video games.

* Annual spending on travel by college students is
about $4.6 billion.

* 78% of college students work, earning an average
of $821 per month.

College students spend an average of $287 per month on discretionary items
(defined as anything other than tuition, room/board, rent, books, and school fees).
A large chunk of that—more than $11 billion—is spent on beverages and snack
foods. Maybe this would be a good place to start cutting your expenditures.

The authors’ comments on this situation appear on page 672.

WWhen a company’s cash flow from operatingactivities does not cover its cash needs, it must
borrow money. In the short term this is OK, but in
the long-term it can spell disaster. Sooner or later the
company needs to increase its cash from operations
or cut back on its expenditures, or it will go broke.
Guess what? The same is true for you and me.

Where do you spend your cash? Most of us know
how much we spend each month on rent and car
payments. But how much do you spend each month
on soda, coffee, pizza, video rentals, music downloads,
and your cell phone service? Don’t think it matters?
Suppose you spend an average of only $4 per day on
unneeded “incidentals.” That’s $120 a month, or
almost $1,500 per year.

Source: “College Students Spend $200 Billion per Year,” HarrisInteractive,
www.harrisinteractive.com/news/allnewsbydate.asp?NewsID�480 (accessed May 2006).

What Do You Think?*
Let’s say that you live on campus and own a car. You use the car for pleasure
and to drive to a job that is three miles away. Suppose your annual cash flow
statement includes the following items.

Cash inflows:
Wages $ 9,000
Student loans 5,000
Credit card debt 4,000

Cash outflows:
Tuition, books, room, and board 13,000
Vehicle costs 2,000
Vacation 2,000
Cell phone service 500
Snacks and beverages 500

Should you get rid of your car and cell phone, quit eating snacks, and give up
the idea of a vacation?

YES: At this rate you will accumulate nearly $40,000 in debts by the time
you graduate. It is not fun to spend most of the paycheck of your post-
graduation job paying off the debts you accumulated while in school.

NO: Give me a break. A person has to have some fun. Life wouldn’t be
worth living if I couldn’t be drinking a Starbucks while cruising down the
road talking on my cell phone.

Sources: Becky Ebenkamp, “College Communications 101,” Brandweek, August 22-29, 2005, p. 16.

633

Annual Spending by College Students on Beverages and Snacks

$0 $1,000 $2,000 $3,000 $4,000

Sports drinks

Chip snacks

Coffee

Bottled water

Bottled juice

Soda

Dollars in millions

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 633

634 Chapter 13 Statement of Cash Flows

The income statement for the year ended December 31, 2011, for Kosinski Manufacturing
Company contains the following condensed information.

KOSINSKI MANUFACTURING COMPANY
Income Statement

For the Year Ended December 31, 2011

Revenues $6,583,000
Operating expenses (excluding depreciation) $4,920,000
Depreciation expense 880,000 5,800,000

Income before income taxes 783,000
Income tax expense 353,000

Net income $ 430,000

Included in operating expenses is a $24,000 loss resulting from the sale of machinery for $270,000
cash. Machinery was purchased at a cost of $750,000.

The following balances are reported on Kosinski’s comparative balance sheets at December 31.

KOSINSKI MANUFACTURING COMPANY
Comparative Balance Sheets (partial)

2011 2010

Cash $672,000 $130,000
Accounts receivable 775,000 610,000
Inventories 834,000 867,000
Accounts payable 521,000 501,000

Income tax expense of $353,000 represents the amount paid in 2011. Dividends declared
and paid in 2011 totaled $200,000.

Instructions
Prepare the statement of cash flows using the indirect method.

Solution to Comprehensive Do it!

Do it!

KOSINSKI MANUFACTURING COMPANY
Statement of Cash Flows—Indirect Method

For the Year Ended December 31, 2011
Cash flows from operating activities

Net income $ 430,000
Adjustments to reconcile net income to net cash

provided by operating activities:
Depreciation expense $ 880,000
Loss on sale of machinery 24,000
Increase in accounts receivable (165,000)
Decrease in inventories 33,000
Increase in accounts payable 20,000 792,000

Net cash provided by operating activities 1,222,000

Cash flows from investing activities

Sale of machinery 270,000
Purchase of machinery (750,000)

Net cash used by investing activities (480,000)

Cash flows from financing activities

Payment of cash dividends (200,000)

Net increase in cash 5

42,000

Cash at beginning of period 130,000

Cash at end of period $ 672,000

The Navigator✓
Action Plan

• Determine net cash from oper-
ating activities. Operating
activities generally relate to
changes in current assets and
current liabilities.

• Determine net cash from invest-
ing activities. Investing activities
generally relate to changes in
noncurrent assets.

• Determine net cash from
financing activities. Financing
activities generally relate to
changes in long-term liabilities
and stockholders’ equity
accounts.

Comprehensive

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Appendix 13A Using a Worksheet to Prepare the Statement of Cash Flows—Indirect Method 635

1 Indicate the usefulness of the statement of cash flows.
The statement of cash flows provides information about
the cash receipts, cash payments, and net change in cash
resulting from the operating, investing, and financing activ-
ities of a company during the period.

2 Distinguish among operating, investing, and financing
activities. Operating activities include the cash effects of
transactions that enter into the determination of net in-
come. Investing activities involve cash flows resulting from
changes in investments and long-term asset items. Financing
activities involve cash flows resulting from changes in long-
term liability and stockholders’ equity items.

3 Prepare a statement of cash flows using the indirect
method. The preparation of a statement of cash flows
involves three major steps: (1) Determine net cash

provided/used by operating activities by converting net
income from an accrual basis to a cash basis. (2) Analyze
changes in noncurrent asset and liability accounts and
record as investing and financing activities, or disclose as
noncash transactions. (3) Compare the net change in cash
on the statement of cash flows with the change in the cash
account reported on the balance sheet to make sure the
amounts agree.

4 Analyze the statement of cash flows. Free cash flow
indicates the amount of cash a company generated during
the current year that is available for the payment of addi-
tional dividends or for expansion.

SUMMARY OF STUDY OBJECTIVES

The Navigator✓

Direct method A method of determining net cash provided
by operating activities by adjusting each item in the income
statement from the accrual basis to the cash basis and
which shows operating cash recipts and payments. (p. 619).

Financing activities Cash flow activities that include (a) ob-
taining cash from issuing debt and repaying the amounts
borrowed and (b) obtaining cash from stockholders, repur-
chasing shares, and paying dividends. (p. 615).

Free cash flow Cash provided by operating activities
adjusted for capital expenditures and dividends paid.
(p. 630).

Indirect method A method of preparing a statement of
cash flows in which net income is adjusted for items that do

not affect cash, to determine net cash provided by operat-
ing activities. (pp. 618, 621).

Investing activities Cash flow activities that include
(a) purchasing and disposing of investments and property,
plant, and equipment using cash and (b) lending money
and collecting the loans. (p. 615).

Operating activities Cash flow activities that include the
cash effects of transactions that create revenues and expenses
and thus enter into the determination of net income. (p. 615).

Statement of cash flows A basic financial statement that
provides information about the cash receipts, cash pay-
ments, and net change in cash during a period, resulting
from operating, investing, and financing activities. (p. 614).

GLOSSARY

APPENDIX 13A Using a Worksheet to Prepare the
Statement of Cash Flows—Indirect Method
When preparing a statement of cash flows, companies may need to
make numerous adjustments of net income. In such cases, they often use a
worksheet to assemble and classify the data that will appear on the state-
ment. The worksheet is merely an aid in preparing the statement. Its use is
optional. Illustration 13A-1 (page 636) shows the skeleton format of the
worksheet for preparation of the statement of cash flows.

The following guidelines are important in preparing a worksheet.

1. In the balance sheet accounts section, list accounts with debit balances separately
from those with credit balances. This means, for example, that Accumulated
Depreciation appears under credit balances and not as a contra account under
debit balances. Enter the beginning and ending balances of each account in the
appropriate columns. Enter as reconciling items in the two middle columns the
transactions that caused the change in the account balance during the year.

After all reconciling items have been entered, each line pertaining to a
balance sheet account should “foot across.” That is, the beginning balance plus

Explain how to use a worksheet
to prepare the statement of cash
flows using the indirect method.

S T U D Y O B J E C T I V E 5

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636 Chapter 13 Statement of Cash Flows

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A B C D E

XYZ COMPANY
Worksheet

Statement of Cash Flows For the Year Ended . . .

XX

End of
Last Year

Balances

XX
XX

XX
XXX

XXX

End of
Current Year

Balances
XX
XX

XXX
XX
XX

XXX

Balance Sheet Accounts

Debit balance accounts

Operating activities
Net income
Adjustments to net income
Investing activities
Receipts and payments
Financing activities
Receipts and payments
Totals
Increase (decrease) in cash
Totals

Credit balance accounts
Totals

Totals
Statement of Cash

Flows Effects

Debit

(XX)
XXX

XXX
XX
XX
XX
XX
XX
XX
XX
XX

Credit

XX
XX
XX
XX
XX
XX
XX
XX
XXX
XXX

Reconciling Items

XYZ Company.xlsIllustration 13A-1
Format of worksheet

or minus the reconciling item(s) must equal the ending balance. When this
agreement exists for all balance sheet accounts, all changes in account balances
have been reconciled.

2. The bottom portion of the worksheet consists of the operating, investing, and
financing activities sections. It provides the information necessary to prepare
the formal statement of cash flows. Enter inflows of cash as debits in the recon-
ciling columns. Enter outflows of cash as credits in the reconciling columns.
Thus, in this section, the sale of equipment for cash at book value appears as a
debit under investing activities. Similarly, the purchase of land for cash appears
as a credit under investing activities.

3. The reconciling items shown in the worksheet are not entered in any journal or
posted to any account. They do not represent either adjustments or corrections
of the balance sheet accounts. They are used only to facilitate the preparation
of the statement of cash flows.

Preparing the Worksheet
As in the case of worksheets illustrated in earlier chapters, preparing a worksheet
involves a series of prescribed steps. The steps in this case are:

1. Enter in the balance sheet accounts section the balance sheet accounts and
their beginning and ending balances.

2. Enter in the reconciling columns of the worksheet the data that explain the
changes in the balance sheet accounts other than cash and their effects on the
statement of cash flows.

3. Enter on the cash line and at the bottom of the worksheet the increase or
decrease in cash. This entry should enable the totals of the reconciling columns
to be in agreement.

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 636

To illustrate the preparation of a worksheet, we will use the 2011 data for
Computer Services Company. Your familiarity with these data (from the chapter)
should help you understand the use of a worksheet. For ease of reference, the
comparative balance sheets, income statement, and selected data for 2011 are
presented in Illustration 13A-2 (on page 638).

DETERMINING THE RECONCILING ITEMS
Companies can use one of several approaches to determine the reconciling items.
For example, they can first complete the changes affecting net cash provided by
operating activities, and then can determine the effects of financing and investing
transactions. Or, they can analyze the balance sheet accounts in the order in which
they are listed on the worksheet. We will follow this latter approach for Computer
Services, except for cash. As indicated in step 3, cash is handled last.

Accounts Receivable. The decrease of $10,000 in accounts receivable means
that cash collections from revenues are higher than the revenues reported in the
income statement.To convert net income to net cash provided by operating activities,
we add the decrease of $10,000 to net income. The entry in the reconciling columns
of the worksheet is:

(a) Operating—Decrease in Accounts Receivable 10,000
Accounts Receivable 10,000

Merchandise Inventory. Computer Services Company’s Merchandise Inventory
balance increases $5,000 during the period. The Merchandise Inventory account
reflects the difference between the amount of inventory that the company purchased
and the amount that it sold. For Computer Services this means that the cost of mer-
chandise purchased exceeds the cost of goods sold by $5,000. As a result, cost of
goods sold does not reflect $5,000 of cash payments made for merchandise. We
deduct this inventory increase of $5,000 during the period from net income to
arrive at net cash provided by operating activities. The worksheet entry is:

(b) Merchandise

Inventory 5,000

Operating—Increase in Merchandise

Inventory 5,000

Prepaid Expenses. An increase of $4,000 in prepaid expenses means that ex-
penses deducted in determining net income are less than expenses that were paid
in cash. We deduct the increase of $4,000 from net income in determining net cash
provided by operating activities. The worksheet entry is:

(c) Prepaid Expenses 4,000
Operating—Increase in Prepaid Expenses 4,000

Land. The increase in land of $110,000 resulted from a purchase through the
issuance of long-term bonds. The company should report this transaction as a sig-
nificant noncash investing and financing activity. The worksheet entry is:

(d) Land 110,000
Bonds Payable 110,000

Building. The cash purchase of a building for $120,000 is an investing activity
cash outflow. The entry in the reconciling columns of the worksheet is:

(e) Building 120,000
Investing—Purchase of Building 120,000

Equipment. The increase in equipment of $17,000 resulted from a cash purchase
of $25,000 and the sale of equipment costing $8,000. The book value of the equipment

Appendix 13A Using a Worksheet to Prepare the Statement of Cash Flows—Indirect Method 637

H E L P F U L H I N T
These amounts are
asterisked in the
worksheet to indicate
that they result from a
significant noncash
transaction.

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 637

638 Chapter 13 Statement of Cash Flows

Additional information for 2011:
1. The company declared and paid a $29,000 cash dividend.
2. Issued $110,000 of long-term bonds in direct exchange for land.
3. A building costing $120,000 was purchased for cash. Equipment costing $25,000 was also
purchased for cash.
4. The company sold equipment with a book value of $7,000 (cost $8,000, less accumulated
depreciation $1,000) for $4,000 cash.
5. Issued common stock for $20,000 cash.
6. Depreciation expense was comprised of $6,000 for building and $3,000 for equipment.

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A B C D

$ 22,000
10,000

5,000
4,000

110,000
120,000

6,000
17,000
2,000

$ 16,000
2,000

110,000

20,000
116,000

Change in
Account Balance

Increase/Decrease

Increase
Decrease

Increase
Increase

Increase
Increase
Increase
Increase
Increase

Increase
Decrease
Increase
Increase
Increase

Assets
Current assets
Cash
Accounts receivable
Merchandise inventory
Prepaid expenses
Property, plant, and equipment
Land
Building
Accumulated depreciation—building
Equipment
Accumulated depreciation—equipment
Total

Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable
Income tax payable
Long-term liabilities
Bonds payable
Stockholders’ equity
Common stock
Retained earnings
Total liabilities and stockholders’ equity

$ 33,000
30,000
10,000
1,000

20,000

40,000
(5,000)
10,000
(1,000)

$138,000

$ 12,000
8,000

20,000

50,000
48,000

$138,000

20102011

$ 55,000
20,000
15,000
5,000

130,000

160,000
(11,000)
27,000
(3,000)

$398,000

$ 28,000
6,000

130,000

70,000
164,000

$398,000

COMPUTER SERVICES COMPANY
Comparative Balance Sheets

December 31

Computer Services Company.xls

Sheet 1 Sheet 2

File Edit View Insert Format Tools Data Window Help

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A B C D

Revenues
Cost of goods sold
Operating expenses (excluding depreciation)
Depreciation expense
Loss on sale of equipment
Interest expense
Income before income tax
Income tax expense
Net income

COMPUTER SERVICES COMPANY
Income Statement

For the Year Ended December 31, 2011
$507,000

315,000
192,000
47,000

$145,000

$150,000
111,000

9,000
3,000

42,000

File Edit View Insert Format Tools Data Window Help

Computer Services Company.xls
Sheet 1 Sheet 2

Illustration 13A-2
Comparative balance
sheets, income statement,
and additional information
for Computer Services
Company

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 638

was $7,000, the cash proceeds were $4,000, and a loss of $3,000 was recorded. The
worksheet entries are:

(f) Equipment 25,000
Investing—Purchase of Equipment 25,000

(g) Investing—Sale of Equipment 4,000
Operating—Loss on Sale of Equipment 3,000
Accumulated Depreciation—Equipment 1,000

Equipment 8,000

Accounts Payable. We must add the increase of $16,000 in accounts payable to net
income to determine net cash provided by operating activities.The worksheet entry is:

(h) Operating—Increase in Accounts Payable 16,000
Accounts Payable 16,000

Income Tax Payable. When a company incurs income tax expense but has not
yet paid its taxes, it records income tax payable. A change in the Income Tax
Payable account reflects the difference between income tax expense incurred
and income tax actually paid. Computer Services’ Income Tax Payable account
decreases by $2,000. That means the $47,000 of income tax expense reported on the
income statement was $2,000 less than the amount of taxes paid during the period
of $49,000. To adjust net income to a cash basis, we must reduce net income by
$2,000. The worksheet entry is:

(i) Income Tax

Payable 2,000

Operating—Decrease in Income Taxes

Payable 2,000

Bonds Payable. The increase of $110,000 in this account resulted from the is-
suance of bonds for land. This is a significant noncash investing and financing activ-
ity. Worksheet entry (d) above is the only entry necessary.

Common Stock. The balance sheet reports an increase in Common Stock of
$20,000. The additional information section notes that this increase resulted from
the issuance of new shares of stock. This is a cash inflow reported in the financing
section. The worksheet entry is:

(j) Financing—Issuance of Common Stock 20,000
Common Stock 20,000

Accumulated Depreciation—Building, and Accumulated Depreciation—
Equipment. Increases in these accounts of $6,000 and $3,000, respectively,
resulted from depreciation expense. Depreciation expense is a noncash charge that
we must add to net income to determine net cash provided by operating activities.
The worksheet entries are:

(k) Operating—Depreciation Expense—Building 6,000
Accumulated Depreciation—Building 6,000

(l) Operating—Depreciation Expense—Equipment 3,000
Accumulated Depreciation—Equipment 3,000

Retained Earnings. The $116,000 increase in retained earnings resulted from
net income of $145,000 and the declaration and payment of a $29,000 cash divi-
dend. Net income is included in net cash provided by operating activities, and the
dividends are a financing activity cash outflow. The entries in the reconciling
columns of the worksheet are:

(m) Operating—Net Income 145,000
Retained Earnings 145,000

(n) Retained Earnings

29,000

Financing—Payment of Dividends 29,000

Appendix 13A Using a Worksheet to Prepare the Statement of Cash Flows—Indirect Method 639

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 639

Disposition of Change in Cash. The firm’s cash increased $22,000 in 2011. The
final entry on the worksheet, therefore, is:

(o) Cash 22,000
Increase in Cash 22,000

As shown in the worksheet, we enter the increase in cash in the reconciling credit
column as a balancing amount. This entry should complete the reconciliation of the
changes in the balance sheet accounts. Also, it should permit the totals of the rec-
onciling columns to be in agreement. When all changes have been explained and
the reconciling columns are in agreement, the reconciling columns are ruled to
complete the worksheet. The completed worksheet for Computer Services
Company is shown in Illustration 13A-3.

640 Chapter 13 Statement of Cash Flows

Balance
12/31/10

33,000
30,000
10,000
1,000

20,000
40,000
10,000

144,000

12,000
8,000

20,000
5,000
1,000

50,000
48,000

144,000

55,000
20,000
15,000
5,000

130,000
160,000
27,000

412,000

28,000
6,000

130,000
11,000
3,000

70,000
164,000
412,000

22,000
5,000
4,000

110,000

120,000
25,000

2,000
1,000
29,000

145,000
10,000

16,000

6,000
3,000
3,000

4,000
20,000

525,000

525,000
10,000
8,000
16,000

110,000
6,000
3,000

20,000
145,000

5,000
4,000
2,000
120,000
25,000

29,000
503,000
22,000

525,000

Reconciling Items
Debit

* Significant noncash investing and financing activity.

*
*
Credit

(o)

(b)
(c)

(d)

(e)
(f)

(i)

(g)

(n)

(m)

(a)

(h)

(k)
(l)
(g)

(g)

(j)

(a)
(g)
(h)

(d)
(k)
(l)
(j)
(m)

(b)
(c)
(i)
(e)
(f)
(n)
(o)

Balance
12/31/11

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A B C D E

Balance Sheet Accounts
Debits
Cash
Accounts receivable
Merchandise inventory
Prepaid expenses
Land
Building
Equipment
Total

Accounts payable
Income tax payable
Bonds payable
Accumulated depreciation—building
Accumulated depreciation—equipment
Common stock
Retained earnings
Total
Statement of Cash Flows Effects
Operating activities
Net income
Decrease in accounts receivable
Increase in merchandise inventory
Increase in prepaid expenses
Increase in accounts payable
Decrease in income tax payable
Depreciation expense—building
Depreciation expense—equipment
Loss on sale of equipment
Investing activities
Purchase of building
Purchase of equipment
Sale of equipment
Financing activities
Issuance of common stock
Payment of dividends
Totals
Increase in cash
Totals

Credits

COMPUTER SERVICES COMPANY
Worksheet

Statement of Cash Flows For the Year Ended December 31, 2011

Computer Services Company.xls
File Edit View Insert Format Tools Data Window Help

Illustration 13A-3
Completed worksheet—
indirect method

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 640

Appendix 13B Statement of Cash Flows—Direct Method 641

SUMMARY OF STUDY OBJECTIVE FOR APPENDIX 13A

5 Explain how to use a worksheet to prepare the state-
ment of cash flows using the indirect method. When
there are numerous adjustments, a worksheet can be a
helpful tool in preparing the statement of cash flows. Key
guidelines for using a worksheet are: (1) List accounts with
debit balances separately from those with credit balances.
(2) In the reconciling columns in the bottom portion of the
worksheet, show cash inflows as debits and cash outflows as

credits. (3) Do not enter reconciling items in any journal or
account, but use them only to help prepare the statement of
cash flows.

The steps in preparing the worksheet are: (1) Enter be-
ginning and ending balances of balance sheet accounts.
(2) Enter debits and credits in reconciling columns. (3) Enter
the increase or decrease in cash in two places as a balancing
amount.

APPENDIX 13B Statement of Cash Flows—Direct Method
To explain and illustrate the direct method, we will use the transactions of
Juarez Company for 2011, to prepare a statement of cash flows. Illustration
13B-1 presents information related to 2011 for Juarez Company.

Prepare a statement of cash
flows using the direct method.

S T U D Y O B J E C T I V E 6

JUAREZ COMPANY
Comparative Balance Sheets

December 31
Change
Assets 2011 2010 Increase/Decrease

Cash $191,000 $159,000 $ 32,000 Increase
Accounts receivable 12,000 15,000 3,000 Decrease
Inventory 170,000 160,000 10,000 Increase
Prepaid expenses 6,000 8,000 2,000 Decrease
Land 140,000 80,000 60,000 Increase
Equipment 160,000 –0– 160,000 Increase
Accumulated depreciation—equipment (16,000) –0– 16,000 Increase

Total $663,000 $422,000

Liabilities and Stockholders’ Equity

Accounts payable $ 52,000 $ 60,000 $ 8,000 Decrease
Accrued expenses payable 15,000 20,000 5,000 Decrease
Income tax payable 12,000 –0– 12,000 Increase
Bonds payable 130,000 –0– 130,000 Increase
Common stock 360,000 300,000 60,000 Increase
Retained earnings 94,000 42,000 52,000 Increase

Total $663,000 $422,000

JUAREZ COMPANY
Income Statement

For the Year Ended December 31, 2011

Revenues $975,000
Cost of goods sold $660,000
Operating expenses (excluding depreciation) 176,000
Depreciation expense 18,000
Loss on sale of store equipment 1,000 855,000

Income before income taxes 120,000
Income tax expense 36,000

Net income $ 84,000

Illustration 13B-1
Comparative balance
sheets, income statement,
and additional information
for Juarez Company

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 641

To prepare a statement of cash flows under the direct approach, we will apply
the three steps outlined in Illustration 13-3 (page 619).

Step 1: Operating Activities
DETERMINE NET CASH PROVIDED/USED BY OPERATING ACTIVITIES BY
CONVERTING NET INCOME FROM AN ACCRUAL BASIS TO A CASH BASIS
Under the direct method, companies compute net cash provided by operating activi-
ties by adjusting each item in the income statement from the accrual basis to the cash
basis.To simplify and condense the operating activities section, companies report only
major classes of operating cash receipts and cash payments. For these major classes,
the difference between cash receipts and cash payments is the net cash provided by
operating activities. These relationships are as shown in Illustration 13B-2.

642 Chapter 13 Statement of Cash Flows

Additional information:
1. In 2011, the company declared and paid a $32,000 cash dividend.
2. Bonds were issued at face value for $130,000 in cash.
3. Equipment costing $180,000 was purchased for cash.
4. Equipment costing $20,000 was sold for $17,000 cash when the book value of the equipment

was $18,000.
5. Common stock of $60,000 was issued to acquire land.

From sales of
goods and services

to customers

Cash Receipts – Cash Payments = Net Cash Providedby Operating Activities

To suppliers

To employees

For operating
expenses

Net cash
provided by

operating activities

For interest

For taxes

From receipts
of interest and

dividends on loans
and investments

Illustration 13B-1
(continued)

An efficient way to apply the direct method is to analyze the items reported in
the income statement in the order in which they are listed. We then determine cash
receipts and cash payments related to these revenues and expenses. The following
pages present the adjustments required to prepare a statement of cash flows for
Juarez Company using the direct approach.

Illustration 13B-2
Major classes of cash
receipts and payments

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 642

Cash Receipts from Customers. The income statement for Juarez Company re-
ported revenues from customers of $975,000. How much of that was cash receipts?
To answer that, companies need to consider the change in accounts receivable
during the year. When accounts receivable increase during the year, revenues on an
accrual basis are higher than cash receipts from customers. Operations led to
revenues, but not all of these revenues resulted in cash receipts.

To determine the amount of cash receipts, the company deducts from sales
revenues the increase in accounts receivable. On the other hand, there may be a
decrease in accounts receivable. That would occur if cash receipts from customers
exceeded sales revenues. In that case, the company adds to sales revenues the
decrease in accounts receivable.

For Juarez Company, accounts receivable decreased $3,000. Thus, cash receipts
from customers were $978,000, computed as shown in Illustration 13B-3.

Appendix 13B Statement of Cash Flows—Direct Method 643

Revenues from sales $975,000
Add: Decrease in accounts receivable 3,000

Cash receipts from customers $978,000

Juarez can also determine cash receipts from customers from an analysis of the
Accounts Receivable account, as shown in Illustration 13B-4.

Accounts Receivable

1/1/11 Balance 15,000 Receipts from customers 978,000
Revenues from sales 975,000

12/31/11 Balance 12,000 H E L P F U L H I N T
The T account shows that
revenue plus decrease in
receivables equals cash
receipts.

Illustration 13B-5 shows the relationships among cash receipts from customers,
revenues from sales, and changes in accounts receivable.

Cash Receipts Revenues � Decrease in Accounts Receivable
from � from or

Customers Sales � Increase in Accounts Receivable

⎫⎪
⎬
⎪⎭

Cash Payments to Suppliers. Juarez Company reported cost of goods sold of
$660,000 on its income statement. How much of that was cash payments to suppliers?
To answer that, it is first necessary to find purchases for the year. To find purchases,
companies adjust cost of goods sold for the change in inventory. When inventory
increases during the year, purchases for the year have exceeded cost of goods sold.
As a result, to determine the amount of purchases, the company adds to cost of
goods sold the increase in inventory.

In 2011, Juarez Company’s inventory increased $10,000. It computes purchases
as follows.

Illustration 13B-3
Computation of cash
receipts from customers

Illustration 13B-4
Analysis of accounts
receivable

Illustration 13B-5
Formula to compute cash
receipts from customers—
direct method

Cost of goods sold $660,000
Add: Increase in inventory 10,000

Purchases $670,000

Illustration 13B-6
Computation of purchases

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 643

After computing purchases, a company can determine cash payments to suppliers.
This is done by adjusting purchases for the change in accounts payable. When ac-
counts payable increase during the year, purchases on an accrual basis are higher than
they are on a cash basis. As a result, to determine cash payments to suppliers, a com-
pany deducts from purchases the increase in accounts payable. On the other hand, if
cash payments to suppliers exceed purchases, there will be a decrease in accounts
payable. In that case, a company adds to purchases the decrease in accounts payable.

For Juarez Company, cash payments to suppliers were $678,000, computed as
follows.

644 Chapter 13 Statement of Cash Flows

Purchases $670,000
Add: Decrease in accounts payable 8,000
Cash payments to suppliers $678,000

Illustration 13B-7
Computation of cash
payments to suppliers

Juarez also can determine cash payments to suppliers from an analysis of the
Accounts Payable account, as shown in Illustration 13B-8.

Accounts

Payable

Payments to suppliers 678,000 1/1/11 Balance 60,000
Purchases 670,000

12/31/11 Balance 52,000

Illustration 13B-9 shows the relationships among cash payments to suppliers, cost
of goods sold, changes in inventory, and changes in accounts payable.

�

⎫
⎪
⎪
⎬
⎪
⎪
⎭

⎫
⎪
⎪
⎬
⎪
⎪
⎭

Cash
Payments

to
Suppliers

Cost
of

Goods
Sold

� Increase in Inventory
or

� Decrease in Inventory

� Decrease in
Accounts Payable

or
� Increase in Accounts

Payable
⎫
⎪
⎪
⎬
⎪
⎪
⎭
⎫
⎪
⎪
⎬
⎪
⎪
⎭

Cash Payments for Operating Expenses. Juarez reported on its income state-
ment operating expenses of $176,000. How much of that amount was cash paid for
operating expenses? To answer that, we need to adjust this amount for any changes
in prepaid expenses and accrued expenses payable. For example, if prepaid ex-
penses increased during the year, cash paid for operating expenses is higher than
operating expenses reported on the income statement. To convert operating ex-
penses to cash payments for operating expenses, a company adds the increase to
operating expenses. On the other hand, if prepaid expenses decrease during the
year, it deducts the decrease from operating expenses.

Companies must also adjust operating expenses for changes in accrued ex-
penses payable. When accrued expenses payable increase during the year, operat-
ing expenses on an accrual basis are higher than they are in a cash basis. As a result,
to determine cash payments for operating expenses, a company deducts from oper-
ating expenses an increase in accrued expenses payable. On the other hand, a com-
pany adds to operating expenses a decrease in accrued expenses payable because
cash payments exceed operating expenses.

H E L P F U L H I N T
The T account shows
that purchases plus
decrease in accounts
payable equals payments
to suppliers.

Illustration 13B-8
Analysis of accounts
payable

Illustration 13B-9
Formula to compute cash
payments to suppliers—
direct method

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 644

Juarez Company’s cash payments for operating expenses were $179,000,
computed as follows.

Appendix 13B Statement of Cash Flows—Direct Method 645

Operating expenses $176,000
Deduct: Decrease in prepaid expenses 2,000
Add: Decrease in accrued expenses payable 5,000

Cash payments for operating expenses $179,000

Illustration 13B-11 shows the relationships among cash payments for operating
expenses, changes in prepaid expenses, and changes in accrued expenses payable.

Cash
Payments

for
Operating
Expenses

�
Operating
Expenses

� Increase in

Prepaid Expense

or
� Decrease in

Prepaid Expense

� Decrease in Accrued

Expenses Payable

or
� Increase in Accrued

Expenses Payable
⎫
⎪
⎪
⎬
⎪
⎪
⎭
⎫
⎪
⎪
⎬
⎪
⎪
⎭
⎫
⎪
⎪
⎬
⎪
⎪
⎭
⎫
⎪
⎪
⎬
⎪
⎪
⎭

Depreciation Expense and Loss on Sale of Equipment. Companies show
operating expenses exclusive of depreciation. Juarez’s depreciation expense in
2011 was $18,000. Depreciation expense is not shown on a statement of cash flows
because it is a noncash charge. If the amount for operating expenses includes
depreciation expense, the company must reduce operating expenses by the amount
of depreciation to determine cash payments for operating expenses.

The loss on sale of equipment of $1,000 is also a noncash charge. The loss on
sale of equipment reduces net income, but it does not reduce cash. Thus, companies
do not report on a statement of cash flows the loss on sale of equipment.

Other charges to expense that do not require the use of cash, such as the amor-
tization of intangible assets, depletion expense, and bad debt expense, are treated
in the same manner as depreciation.

Cash Payments for Income Taxes. Juarez reported income tax expense of
$36,000 on the income statement. Income tax payable, however, increased $12,000.
This increase means that the company has not yet paid $12,000 of the income
taxes. As a result, income taxes paid were less than income taxes reported in the in-
come statement. Cash payments for income taxes were, therefore, $24,000 as shown
below.

Income tax expense $36,000
Deduct: Increase in income tax payable 12,000

Cash payments for income taxes $24,000

Illustration 13B-13 shows the relationships among cash payments for income taxes,
income tax expense, and changes in income tax payable.

Cash
Payments for
Income Taxes

�
Income Tax

Expense
� Decrease in Income Tax Payable

or
� Increase in Income Tax Payable

⎫⎪
⎬
⎪⎭

Illustration 13B-10
Computation of cash
payments for operating
expenses

Illustration 13B-11
Formula to compute cash
payments for operating
expenses—direct method

Illustration 13B-12
Computation of cash
payments for income taxes

Illustration 13B-13
Formula to compute cash
payments for income
taxes—direct method

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 645

The operating activities section of the statement of cash flows of Juarez
Company is shown in Illustration 13B-14.

646 Chapter 13 Statement of Cash Flows

Cash flows from operating activities
Cash receipts from customers $978,000
Less: Cash payments:

To suppliers $678,000
For operating expenses 179,000
For income taxes 24,000 881,000

Net cash provided by operating activities $ 97,000

When a company uses the direct method, it must also provide in a separate schedule
(not shown here) the net cash flows from operating activities as computed under
the indirect method.

Step 2: Investing and Financing Activities
ANALYZE CHANGES IN NONCURRENT ASSET AND LIABILITY
ACCOUNTS AND RECORD AS INVESTING AND FINANCING
ACTIVITIES, OR AS SIGNIFICANT NONCASH TRANSACTIONS
Increase in Land. Juarez’s land increased $60,000. The additional information
section indicates that the company issued common stock to purchase the land. The
issuance of common stock for land has no effect on cash. But it is a significant
noncash investing and financing transaction. This transaction requires disclosure in
a separate schedule at the bottom of the statement of cash flows.

Increase in Equipment. The comparative balance sheets show that equipment
increased $160,000 in 2011. The additional information in Illustration 13B-1
indicated that the increase resulted from two investing transactions: (1) Juarez
purchased for cash equipment costing $180,000. And (2) it sold for $17,000 cash
equipment costing $20,000, whose book value was $18,000. The relevant data for
the statement of cash flows is the cash paid for the purchase and the cash proceeds
from the sale. For Juarez Company, the investing activities section will show the
following: The $180,000 purchase of equipment as an outflow of cash, and the
$17,000 sale of equipment as an inflow of cash. The company should not net the two
amounts. Both individual outflows and inflows of cash should be shown.

The analysis of the changes in equipment should include the related
Accumulated Depreciation account. These two accounts for Juarez Company are
shown in Illustration 13B-15.

Equipment

1/1/11 Balance –0– Cost of equipment sold 20,000
Cash purchase 180,000

12/31/11 Balance 160,000

Accumulated Depreciation—Equipment

Sale of equipment 2,000 1/1/11 Balance –0–
Depreciation expense 18,000

12/31/11 Balance 16,000

Illustration 13B-14
Operating activities section
of the statement of cash
flows

Illustration 13B-15
Analysis of equipment
and related accumulated
depreciation

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 646

Increase in Bonds Payable. Bonds Payable increased $130,000. The additional
information in Illustration 13B-1 indicated that Juarez issued, for $130,000 cash,
bonds with a face value of $130,000. The issuance of bonds is a financing activity. For
Juarez Company, there is an inflow of cash of $130,000 from the issuance of bonds.

Increase in Common Stock. The Common Stock account increased $60,000.
The additional information indicated that Juarez acquired land from the issuance
of common stock. This transaction is a significant noncash investing and financing
transaction which the company should report separately at the bottom of the statement.

Increase in Retained Earnings. The $52,000 net increase in Retained Earnings
resulted from net income of $84,000 and the declaration and payment of a cash
dividend of $32,000. Companies do not report net income in the statement of cash
flows under the direct method. Cash dividends paid of $32,000 are reported in the
financing activities section as an outflow of cash.

STATEMENT OF CASH FLOWS—2011
Illustration 13B-16 shows the statement of cash flows for Juarez.

Appendix 13B Statement of Cash Flows—Direct Method 647

JUAREZ COMPANY
Statement of Cash Flows—Direct Method
For the Year Ended December 31, 2011

Cash flows from operating activities
Cash receipts from customers $ 978,000
Less: Cash payments:

To suppliers $ 678,000
For operating expenses 179,000
For income taxes 24,000 881,000

Net cash provided by operating activities 97,000
Cash flows from investing activities

Purchase of equipment (180,000)
Sale of equipment 17,000

Net cash used by investing activities (163,000)
Cash flows from financing activities

Issuance of bonds payable 130,000
Payment of cash dividends (32,000)

Net cash provided by financing activities 98,000

Net increase in cash 32,000
Cash at beginning of period 159,000

Cash at end of period $ 191,000

Noncash investing and financing activities
Issuance of common stock to purchase land $ 60,000

Illustration 13B-16
Statement of cash flows,
2011—direct method

Step 3: Net Change in Cash
COMPARE THE NET CHANGE IN CASH ON THE STATEMENT OF CASH
FLOWS WITH THE CHANGE IN THE CASH ACCOUNT REPORTED ON
THE BALANCE SHEET TO MAKE SURE THE AMOUNTS AGREE
Illustration 13B-16 indicates that the net change in cash during the period was an
increase of $32,000. This agrees with the change in balances in the cash account
reported on the balance sheets in Illustration 13B-1 (page 641).

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 647

648 Chapter 13 Statement of Cash Flows

6 Prepare a statement of cash flows using the direct
method. The preparation of the statement of cash flows
involves three major steps: (1) Determine net cash provided/
used by operating activities by converting net income from
an accrual basis to a cash basis. (2) Analyze changes in non-
current asset and liability accounts and record as investing
and financing activities, or disclose as noncash transactions.

(3) Compare the net change in cash on the statement of
cash flows with the change in the cash account reported on
the balance sheet to make sure the amounts agree. The
direct method reports cash receipts less cash payments to
arrive at net cash provided by operating activities.

SUMMARY OF STUDY OBJECTIVE FOR APPENDIX 13B

GLOSSARY FOR APPENDIX 13B

Direct method A method of determining net cash pro-
vided by operating activities by adjusting each item in the

income statement from the accrual basis to the cash basis.
(pp. 619, 642)

Do it!Comprehensive

The income statement for Kosinski Manufacturing Company contains the following condensed
information.

KOSINSKI MANUFACTURING COMPANY
Income Statement
For the Year Ended December 31, 2011

Revenues $6,583,000
Operating expenses, excluding depreciation $4,920,000
Depreciation expense 880,000 5,800,000

Income before income taxes 783,000
Income tax expense 353,000
Net income $ 430,000
KOSINSKI MANUFACTURING COMPANY
Comparative Balance Sheets (partial)
2011 2010
Cash $672,000 $130,000
Accounts receivable 775,000 610,000
Inventories 834,000 867,000
Accounts payable 521,000 501,000

Included in operating expenses is a $24,000 loss resulting from the sale of machinery for $270,000
cash. Machinery was purchased at a cost of $750,000. The following balances are reported on
Kosinski’s comparative balance sheet at December 31.

Income tax expense of $353,000 represents the amount paid in 2011. Dividends declared and
paid in 2011 totaled $200,000.

Instructions
Prepare the statement of cash flows using the direct method.

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 648

Self-Study Questions 649

Solution to Comprehensive Do it! Action Plan

• Determine net cash from
operating activities. Each item
in the income statement must
be adjusted to the cash basis.

• Determine net cash from
investing activities. Investing
activities generally relate to
changes in noncurrent assets.

• Determine net cash from
financing activities. Financing
activities generally relate to
changes in long-term liabilities
and stockholders’ equity
accounts.

The Navigator✓

KOSINSKI MANUFACTURING COMPANY
Statement of Cash Flows—Direct Method
For the Year Ended December 31, 2011

Cash flows from operating activities
Cash collections from customers $6,418,000*
Cash payments:

For operating expenses $4,843,000**
For income taxes 353,000 5,196,000

Net cash provided by operating activities 1,222,000

Cash flows from investing activities
Sale of machinery 270,000
Purchase of machinery (750,000)

Net cash used by investing activities (480,000)

Cash flows from financing activities
Payment of cash dividends (200,000)

Net cash used by financing activities (200,000)
Net increase in cash 542,000
Cash at beginning of period 130,000
Cash at end of period $ 672,000

Direct-Method Computations:

*Computation of cash collections from customers:
Revenues per the income statement $6,583,000
Deduct: Increase in accounts receivable (165,000)

Cash collections from customers $6,418,000

**Computation of cash payments for operating
expenses:
Operating expenses per the income statement $4,920,000
Deduct: Loss from sale of machinery (24,000)
Deduct: Decrease in inventories (33,000)
Deduct: Increase in accounts payable (20,000)

Cash payments for operating expenses $4,843,000

*Note: All Questions, Exercises, and Problems marked with an asterisk relate to material in the appendices to the chapter.

Answers are at the end of the chapter.

1. Which of the following is incorrect about the statement of
cash flows?
a. It is a fourth basic financial statement.
b. It provides information about cash receipts and cash

payments of an entity during a period.
c. It reconciles the ending cash account balance to the

balance per the bank statement.
d. It provides information about the operating, investing,

and financing activities of the business.
2. Which of the following will not be reported in the state-

ment of cash flows?

a. The net change in plant assets during the year.
b. Cash payments for plant assets during the year.
c. Cash receipts from sales of plant assets during the year.
d. How acquisitions of plant assets during the year were

financed.

3. The statement of cash flows classifies cash receipts and
cash payments by these activities:
a. operating and nonoperating.
b. investing, financing, and operating.
c. financing, operating, and nonoperating.
d. investing, financing, and nonoperating.

SELF-STUDY

QUESTIONS

(SO 1)

(SO 1)

(SO 2)

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 649

4. Which is an example of a cash flow from an operating
activity?
a. Payment of cash to lenders for interest.
b. Receipt of cash from the sale of capital stock.
c. Payment of cash dividends to the company’s stock-

holders.
d. None of the above.

5. Which is an example of a cash flow from an investing
activity?
a. Receipt of cash from the issuance of bonds payable.
b. Payment of cash to repurchase outstanding capital

stock.
c. Receipt of cash from the sale of equipment.
d. Payment of cash to suppliers for inventory.

6. Cash dividends paid to stockholders are classified on the
statement of cash flows as:
a. operating activities.
b. investing activities.
c. a combination of (a) and (b).
d. financing activities.

7. Which is an example of a cash flow from a financing
activity?
a. Receipt of cash from sale of land.
b. Issuance of debt for cash.
c. Purchase of equipment for cash.
d. None of the above

8. Which of the following is incorrect about the statement of
cash flows?
a. The direct method may be used to report cash provided

by operations.
b. The statement shows the cash provided (used) for

three categories of activity.
c. The operating section is the last section of the statement.
d. The indirect method may be used to report cash pro-

vided by operations.

Questions 9 through 11 apply only to the indirect method.

9. Net income is $132,000, accounts payable increased
$10,000 during the year, inventory decreased $6,000 dur-
ing the year, and accounts receivable increased $12,000
during the year. Under the indirect method, what is net
cash provided by operating activities?
a. $102,000.
b. $112,000.
c. $124,000.
d. $136,000.

10. Items that are added back to net income in determining
cash provided by operating activities under the indirect
method do not include:
a. depreciation expense. b. an increase in inventory.
c. amortization expense. d. loss on sale of equipment.

11. The following data are available for Allen Clapp
Corporation.

Net income $200,000
Depreciation expense 40,000
Dividends paid 60,000
Gain on sale of land 10,000
Decrease in accounts receivable 20,000
Decrease in accounts payable 30,000

Net cash provided by operating activities is:
a. $160,000.
b. $220,000.
c. $240,000.
d. $280,000.

12. The following data are available for Orange Peels
Corporation.
Sale of land $100,000
Sale of equipment 50,000
Issuance of common stock 70,000
Purchase of equipment 30,000
Payment of cash dividends 60,000
Net cash provided by investing activities is:
a. $120,000.
b. $130,000.
c. $150,000.
d. $190,000.

13. The following data are available for Something Strange!
Increase in accounts payable $40,000
Increase in bonds payable 100,000
Sale of investment 50,000
Issuance of common stock 60,000
Payment of cash dividends 30,000
Net cash provided by financing activities is:
a. $90,000.
b. $130,000.
c. $160,000.
d. $170,000.

14. The statement of cash flows should not be used to eval-
uate an entity’s ability to:
a. earn net income.
b. generate future cash flows.
c. pay dividends.
d. meet obligations.

15. Free cash flow provides an indication of a company’s
ability to:
a. generate net income.
b. generate cash to pay dividends.
c. generate cash to invest in new capital expenditures.
d. Both (b) and (c).

*16. In a worksheet for the statement of cash flows, a decrease
in accounts receivable is entered in the reconciling columns
as a credit to Accounts Receivable and a debit in the:
a. investing activities section.
b. operating activities section.
c. financing activities section.
d. None of the above.

*17. In a worksheet for the statement of cash flows, a work-
sheet entry that includes a credit to accumulated de-
preciation will also include a:
a. credit in the operating section and a debit in

another section.
b. debit in the operating section.
c. debit in the investing section.
d. debit in the financing section.

Questions 18 and 19 apply only to the direct method.
*18. The beginning balance in accounts receivable is

$44,000, the ending balance is $42,000, and sales during

(SO 2)
(SO 2)
(SO 2)
(SO 2)
(SO 2)

(SO 3)

(SO 3)
(SO 3)
(SO 3)
(SO 3)

(SO 4)

(SO 4)

(SO 5)

(SO 5)

(SO 6)

650 Chapter 13 Statement of Cash Flows

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 650

Brief Exercises 651

the period are $129,000. What are cash receipts from
customers?
a. $127,000.
b. $129,000.
c. $131,000.
d. $141,000.

*19. Which of the following items is reported on a cash flow
statement prepared by the direct method?

a. Loss on sale of building.
b. Increase in accounts receivable.
c. Depreciation expense.
d. Cash payments to suppliers.

Go to the book’s companion website,
www.wiley.com/college/weygandt,
for Additional Self-Study Questions. The Navigator✓

QUESTIONS

1. (a) What is a statement of cash flows?
(b) John Norris maintains that the statement of cash

flows is an optional financial statement. Do you
agree? Explain.

2. What questions about cash are answered by the statement
of cash flows?

3. Distinguish among the three types of activities reported in
the statement of cash flows.

4. (a) What are the major sources (inflows) of cash in a
statement of cash flows?

(b) What are the major uses (outflows) of cash?
5. Why is it important to disclose certain noncash transac-

tions? How should they be disclosed?
6. Wilma Flintstone and Barny Rublestone were discussing

the format of the statement of cash flows of Hart Candy
Co. At the bottom of Hart Candy’s statement of cash flows
was a separate section entitled “Noncash investing and
financing activities.” Give three examples of significant
noncash transactions that would be reported in this section.

7. Why is it necessary to use comparative balance sheets, a
current income statement, and certain transaction data in
preparing a statement of cash flows?

8. Contrast the advantages and disadvantages of the direct
and indirect methods of preparing the statement of cash
flows. Are both methods acceptable? Which method is
preferred by the FASB? Which method is more popular?

9. When the total cash inflows exceed the total cash outflows
in the statement of cash flows, how and where is this ex-
cess identified?

10. Describe the indirect method for determining net cash
provided (used) by operating activities.

11. Why is it necessary to convert accrual-based net income to
cash-basis income when preparing a statement of cash flows?

12. The president of Ferneti Company is puzzled. During the
last year, the company experienced a net loss of $800,000,
yet its cash increased $300,000 during the same period of
time. Explain to the president how this could occur.

13. Identify five items that are adjustments to convert net in-
come to net cash provided by operating activities under
the indirect method.

14. Why and how is depreciation expense reported in a state-
ment prepared using the indirect method?

15. Why is the statement of cash flows useful?
16. During 2011 Doubleday Company converted $1,700,000

of its total $2,000,000 of bonds payable into common
stock. Indicate how the transaction would be reported on
a statement of cash flows, if at all.

*17. Why is it advantageous to use a worksheet when prepar-
ing a statement of cash flows? Is a worksheet required to
prepare a statement of cash flows?

*18. Describe the direct method for determining net cash
provided by operating activities.

*19. Give the formulas under the direct method for computing
(a) cash receipts from customers and (b) cash payments to
suppliers.

*20. Garcia Inc. reported sales of $2 million for 2011. Accounts
receivable decreased $200,000 and accounts payable in-
creased $300,000. Compute cash receipts from customers,
assuming that the receivable and payable transactions
related to operations.

*21. In the direct method, why is depreciation expense not re-
ported in the cash flows from operating activities section?

22. In its 2008 statement of cash flows, what amount
did PepsiCo report for net cash (a) provided by operating
activities, (b) used for investing activities, and (c) used for
financing activities?

BE13-1 Each of these items must be considered in preparing a statement of cash flows for
Kiner Co. for the year ended December 31, 2011. For each item, state how it should be shown in
the statement of cash flows for 2011.

(a) Issued bonds for $200,000 cash.
(b) Purchased equipment for $150,000 cash.
(c) Sold land costing $20,000 for $20,000 cash.
(d) Declared and paid a $50,000 cash dividend.

BRIEF

EXERCISES

Indicate statement presentation
of selected transactions.

(SO 2)
(SO 6)

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 651

BE13-2 Classify each item as an operating, investing, or financing activity. Assume all items
involve cash unless there is information to the contrary.

(a) Purchase of equipment. (d) Depreciation.
(b) Sale of building. (e) Payment of dividends.
(c) Redemption of bonds. (f) Issuance of capital stock.

BE13-3 The following T account is a summary of the cash account of Edmonds Company.

Cash (Summary Form)

Balance, Jan. 1 8,000
Receipts from customers 364,000 Payments for goods 200,000
Dividends on stock investments 6,000 Payments for operating expenses 140,000
Proceeds from sale of equipment 36,000 Interest paid 10,000
Proceeds from issuance of Taxes paid 8,000

bonds payable 300,000 Dividends paid 50,000

Balance, Dec. 31 306,000

What amount of net cash provided (used) by financing activities should be reported in the
statement of cash flows?

BE13-4 Martinez, Inc. reported net income of $2.5 million in 2011. Depreciation for the year
was $160,000, accounts receivable decreased $350,000, and accounts payable decreased $280,000.
Compute net cash provided by operating activities using the indirect method.

BE13-5 The net income for Adcock Co. for 2011 was $280,000. For 2011 depreciation on plant
assets was $70,000, and the company incurred a loss on sale of plant assets of $12,000. Compute
net cash provided by operating activities under the indirect method.

BE13-6 The comparative balance sheets for Goltra Company show these changes in noncash
current asset accounts: accounts receivable decrease $80,000, prepaid expenses increase $28,000,
and inventories increase $30,000. Compute net cash provided by operating activities using the
indirect method assuming that net income is $200,000.

BE13-7 The T accounts for Equipment and the related Accumulated Depreciation for
Pettengill Company at the end of 2011 are shown here.

In addition, Pettengill Company’s income statement reported a loss on the sale of equip-
ment of $4,500. What amount was reported on the statement of cash flows as “cash flow from
sale of equipment”?

BE13-8 In a recent year, Cypress Semiconductor Corporation reported cash provided by
operating activities of $155,793,000, cash used in investing of $207,826,000, and cash used in
financing of $33,372,000. In addition, cash spent for fixed assets during the period was
$132,280,000. No dividends were paid.

Calculate free cash flow.

BE13-9 Lott Corporation reported cash provided by operating activities of $360,000, cash
used by investing activities of $250,000, and cash provided by financing activities of $70,000. In
addition, cash spent for capital assets during the period was $200,000. No dividends were paid.
Calculate free cash flow.

BE13-10 In a recent quarter, Alliance Atlantis Communications Inc. reported cash provided
by operating activities of $45,600,000 and revenues of $264,800,000. Cash spent on plant asset ad-
ditions during the quarter was $1,600,000. Calculate free cash flow.

BE13-11 The management of Radar Inc. is trying to decide whether it can increase its divi-
dend. During the current year it reported net income of $875,000. It had cash provided by oper-
ating activities of $734,000, paid cash dividends of $70,000, and had capital expenditures of
$280,000. Compute the company’s free cash flow, and discuss whether an increase in the dividend
appears warranted. What other factors should be considered?

Equipment Accumulated Depreciation

Beg. bal. 80,000 Disposals 22,000 Disposals 5,500 Beg. bal. 44,500
Acquisitions 41,600 Depr. exp. 12,000

End. bal. 99,600 End. bal. 51,000

Classify items by activities.

(SO 2)

Identify financing activity
transactions.

(SO 2)

Compute cash provided by
operating activities—indirect
method.

(SO 3)
Compute cash provided by
operating activities—indirect
method.
(SO 3)

Compute net cash provided by
operating activities—indirect
method.

(SO 3)

Determine cash received from
sale of equipment.

(SO 3)
Calculate free cash flow.
(SO 4)
Calculate free cash flow.
(SO 4)
Calculate free cash flow.
(SO 4)

Calculate and analyze free cash
flow.

(SO 4)

652 Chapter 13 Statement of Cash Flows

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Do it! Review 653

*BE13-12 During the year, prepaid expenses decreased $6,600, and accrued expenses increased
$2,400. Indicate how the changes in prepaid expenses and accrued expenses payable should be
entered in the reconciling columns of a worksheet. Assume that beginning balances were:
Prepaid expenses $18,600 and Accrued expenses payable $8,200.

*BE13-13 Columbia Sportswear Company had accounts receivable of $206,024,000 at the be-
ginning of a recent year, and $267,653,000 at year-end. Sales revenues were $1,095,307,000 for the
year. What is the amount of cash receipts from customers?

*BE13-14 Young Corporation reported income taxes of $340,000,000 on its 2011 income state-
ment and income taxes payable of $277,000,000 at December 31, 2010, and $522,000,000 at
December 31, 2011. What amount of cash payments were made for income taxes during 2011?

*BE13-15 Flynn Corporation reports operating expenses of $80,000 excluding depreciation
expense of $15,000 for 2011. During the year prepaid expenses decreased $6,600 and accrued
expenses payable increased $4,400. Compute the cash payments for operating expenses in
2011.

Compute receipts from
customers—direct method.

(SO 6)

Indicate entries in worksheet.

(SO 5)

Compute cash payments for
income taxes—direct method.

(SO 6)

Compute cash payments for
operating expenses—direct
method.

(SO 6)

13-1 Rapture Corporation had the following transactions.

1. Issued $200,000 of bonds payable.
2. Paid utilities expense.
3. Issued 500 shares of preferred stock for $45,000.
4. Sold land and a building for $250,000.
5. Lent $30,000 to Dead End Corporation, receiving Dead End’s 1-year, 12% note.

Classify each of these transactions by type of cash flow activity (operating, investing, or financing).

13-2 JMB Photography reported net income of $100,000 for 2011. Included in the
income statement were depreciation expense of $6,000, patent amortization expense of $2,000,
and a gain on sale of equipment of $3,600. JMB’s comparative balance sheets show the follow-
ing balances.

12/31/10 12/31/11

Accounts receivable $27,000 $21,000
Accounts payable 6,000 9,200

Calculate net cash provided by operating activities for JMB Photography

13-3 Grinders Corporation issued the following statement of cash flows for 2011.

GRINDERS CORPORATION
Statement of Cash Flows—Indirect Method

For the Year Ended December 31, 2011

Cash flows from operating activities
Net income $59,000
Adjustments to reconcile net income to net cash

provided by operating activities:
Depreciation expense $9,100
Loss on sale of equipment 3,300
Decrease in accounts receivable 9,500
Increase in inventory (5,000)
Decrease in accounts payable (2,200) 14,700

Net cash provided by operating activities 73,700
Cash flows from investing activities

Sale of investments 3,100
Purchase of equipment (27,000)

Net cash used by investing activities (23,900)

Do it!
Do it!
Do it!

ReviewDo it!
Classify transactions by type of
cash flow activity.

(SO 2)

Calculate net cash from
operating activities.

(SO 3)

Compute and discuss free cash
flow.

(SO 4)

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 653

Cash flows from financing activities
Issuance of stock 20,000
Payment on long-term note payable (10,000)
Payment for dividends (15,000)

Net cash used by financing activities (5,000)

Net increase in cash 44,800
Cash at beginning of year 13,000

Cash at end of year $57,800

(a) Compute free cash flow for Grinders Corporation. (b) Explain why free cash flow often
provides better information than “Net cash provided by operating activities.”

E13-1 Pioneer Corporation had these transactions during 2011.

(a) Issued $50,000 par value common stock for cash.
(b) Purchased a machine for $30,000, giving a long-term note in exchange.
(c) Issued $200,000 par value common stock upon conversion of bonds having a face value of

$200,000.
(d) Declared and paid a cash dividend of $18,000.
(e) Sold a long-term investment with a cost of $15,000 for $15,000 cash.
(f) Collected $16,000 of accounts receivable.
(g) Paid $18,000 on accounts payable.

Instructions
Analyze the transactions and indicate whether each transaction resulted in a cash flow from
operating activities, investing activities, financing activities, or noncash investing and financing
activities.

E13-2 An analysis of comparative balance sheets, the current year’s income statement, and
the general ledger accounts of Gagliano Corp. uncovered the following items. Assume all items
involve cash unless there is information to the contrary.

(a) Payment of interest on notes payable.
(b) Exchange of land for patent.
(c) Sale of building at book value.
(d) Payment of dividends.
(e) Depreciation.
(f) Receipt of dividends on investment in

stock.
(g) Receipt of interest on notes receivable.

EXERCISES

(h) Issuance of capital stock.
(i) Amortization of patent.
(j) Issuance of bonds for land.
(k) Purchase of land.
(l) Conversion of bonds into common stock.
(m) Loss on sale of land.
(n) Retirement of bonds.

Instructions
Indicate how each item should be classified in the statement of cash flows using these four major
classifications: operating activity (indirect method), investing activity, financing activity, and sig-
nificant noncash investing and financing activity.

E13-3 Rachael Ray Corporation had the following transactions.

1. Sold land (cost $12,000) for $15,000.
2. Issued common stock for $20,000.
3. Recorded depreciation of $17,000.
4. Paid salaries of $9,000.
5. Issued 1,000 shares of $1 par value common stock for equipment worth $8,000.
6. Sold equipment (cost $10,000, accumulated depreciation $7,000) for $1,200.

Instructions
For each transaction above, (a) prepare the journal entry, and (b) indicate how it would affect the
statement of cash flows.

Classify transactions by type
of activity.

(SO 2)
Classify transactions by type
of activity.
(SO 2)

Prepare journal entry and
determine effect on cash flows.

(SO 2)

654 Chapter 13 Statement of Cash Flows

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Exercises 655

E13-4 Villa Company reported net income of $195,000 for 2011. Villa also reported deprecia-
tion expense of $45,000 and a loss of $5,000 on the sale of equipment. The comparative balance
sheet shows a decrease in accounts receivable of $15,000 for the year, a $17,000 increase in
accounts payable, and a $4,000 decrease in prepaid expenses.

Instructions
Prepare the operating activities section of the statement of cash flows for 2011. Use the indirect
method.

E13-5 The current sections of Bellinham Inc.’s balance sheets at December 31, 2010 and 2011,
are presented here.

Bellinham’s net income for 2011 was $153,000. Depreciation expense was $24,000.

Prepare the operating activities
section—indirect method.

(SO 3)
Prepare the operating activities
section—indirect method.
(SO 3)
Equipment

Date Debit Credit Balance

Jan. 1 Balance 160,000
July 31 Purchase of equipment 70,000 230,000
Sept. 2 Cost of equipment constructed 53,000 283,000
Nov. 10 Cost of equipment sold 49,000 234,000

Accumulated Depreciation—Equipment
Date Debit Credit Balance

Jan. 1 Balance 71,000
Nov. 10 Accumulated depreciation on

equipment sold 30,000 41,000
Dec. 31 Depreciation for year 28,000 69,000

Retained Earnings

Date Debit Credit Balance

Jan. 1 Balance 105,000
Aug. 23 Dividends (cash) 14,000 91,000
Dec. 31 Net income 67,000 158,000

2011 2010

Current assets
Cash $105,000 $ 99,000
Accounts receivable 110,000 89,000
Inventory 158,000 172,000
Prepaid expenses 27,000 22,000

Total current assets $400,000 $382,000

Current liabilities
Accrued expenses payable $ 15,000 $ 5,000
Accounts payable 85,000 92,000

Total current liabilities $100,000 $ 97,000

Instructions
Prepare the net cash provided by operating activities section of the company’s statement of cash
flows for the year ended December 31, 2011, using the indirect method.

E13-6 The three accounts shown below appear in the general ledger of Cesar Corp. during
2011.

Instructions
From the postings in the accounts, indicate how the information is reported on a statement
of cash flows using the indirect method. The loss on sale of equipment was $5,000. (Hint: Cost of
equipment constructed is reported in the investing activities section as a decrease in cash of
$53,000.)

Prepare partial statement of
cash flows—indirect method.

(SO 3)

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 655

E13-7 Scully Corporation’s comparative balance sheets are presented below.

Prepare statement of cash flows
and compute free cash flow.

(SO 3, 4)

Additional information:

1. Net income was $22,630. Dividends declared and paid were $19,500.
2. All other changes in noncurrent account balances had a direct effect on cash flows, except the

change in accumulated depreciation. The land was sold for $4,900.

Instructions
(a) Prepare a statement of cash flows for 2011 using the indirect method.
(b) Compute free cash flow.

E13-8 Here are comparative balance sheets for Taguchi Company.

SCULLY CORPORATION
Comparative Balance Sheets

December 31
2011 2010

Cash $ 14,300 $ 10,700
Accounts receivable 21,200 23,400
Land 20,000 26,000
Building 70,000 70,000
Accumulated depreciation (15,000) (10,000)

Total $110,500 $120,100

Accounts payable $12,370 $31,100
Common stock 75,000 69,000
Retained earnings 23,130 20,000

Total $110,500 $120,100

TAGUCHI COMPANY
Comparative Balance Sheets

December 31

Assets 2011 2010

Cash $ 73,000 $ 22,000
Accounts receivable 85,000 76,000
Inventories 170,000 189,000
Land 75,000 100,000
Equipment 260,000 200,000
Accumulated depreciation (66,000) (32,000)

Total $597,000 $555,000

Liabilities and Stockholders’ Equity

Accounts payable $ 39,000 $ 47,000
Bonds payable 150,000 200,000
Common stock ($1 par) 216,000 174,000
Retained earnings 192,000 134,000

Total $597,000 $555,000
Additional information:

1. Net income for 2011 was $103,000.
2. Cash dividends of $45,000 were declared and paid.
3. Bonds payable amounting to $50,000 were redeemed for cash $50,000.
4. Common stock was issued for $42,000 cash.
5. No equipment was sold during 2011, but land was sold at cost.

Prepare a statement of cash
flows—indirect method.

(SO 3)

656 Chapter 13 Statement of Cash Flows

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Exercises 657

Instructions
Prepare a statement of cash flows for 2011 using the indirect method.

E13-9 Muldur Corporation’s comparative balance sheets are presented below.

EDDIE MURPHY COMPANY
Comparative Balance Sheets

December 31
Assets 2011 2010

Cash $ 63,000 $ 22,000
Accounts receivable 85,000 76,000
Inventories 180,000 189,000
Land 75,000 100,000
Equipment 260,000 200,000
Accumulated depreciation (66,000) (42,000)

Total $597,000 $545,000

Liabilities and Stockholders’ Equity

Accounts payable $ 34,000 $ 47,000
Bonds payable 150,000 200,000
Common stock ($1 par) 214,000 164,000
Retained earnings 199,000 134,000

Total $597,000 $545,000

MULDUR CORPORATION
Comparative Balance Sheets

December 31
2011 2010

Cash $ 15,200 $ 17,700
Accounts receivable 25,200 22,300
Investments 20,000 16,000
Equipment 60,000 70,000
Accumulated depreciation (14,000) (10,000)

Total $106,400 $116,000

Accounts payable $ 14,600 $ 11,100
Bonds payable 10,000 30,000
Common stock 50,000 45,000
Retained earnings 31,800 29,900

Total $106,400 $116,000
Additional information:

1. Net income was $18,300. Dividends declared and paid were $16,400.
2. Equipment which cost $10,000 and had accumulated depreciation of $1,200 was sold for

$3,300.
3. All other changes in noncurrent account balances had a direct effect on cash flows, except

the change in accumulated depreciation.

Instructions
(a) Prepare a statement of cash flows for 2011 using the indirect method.
(b) Compute free cash flow.

*E13-10 Comparative balance sheets for Eddie Murphy Company are presented below.

Additional information:

1. Net income for 2011 was $125,000.
2. Cash dividends of $60,000 were declared and paid.

Prepare statement of cash flows
and compute free cash flow.
(SO 3, 4)

Prepare a worksheet.

(SO 5)

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 657

3. Bonds payable amounting to $50,000 were redeemed for cash $50,000.
4. Common stock was issued for $50,000 cash.
5. Depreciation expense was $24,000.
6. Sales for the year were $978,000.

Instructions
Prepare a worksheet for a statement of cash flows for 2011 using the indirect method. Enter the
reconciling items directly on the worksheet, using letters to cross-reference each entry.

*E13-11 Hairston Company completed its first year of operations on December 31, 2011. Its
initial income statement showed that Hairston had revenues of $192,000 and operating expenses
of $78,000. Accounts receivable and accounts payable at year-end were $60,000 and $23,000, re-
spectively. Assume that accounts payable related to operating expenses. Ignore income taxes.

Instructions
Compute net cash provided by operating activities using the direct method.

*E13-12 A recent income statement for McDonald’s Corporation shows cost of goods sold
$4,852.7 million and operating expenses (including depreciation expense of $1,201 million)
$10,671.5 million. The comparative balance sheet for the year shows that inventory increased
$18.1 million, prepaid expenses increased $56.3 million, accounts payable (merchandise suppli-
ers) increased $136.9 million, and accrued expenses payable increased $160.9 million.

Instructions
Using the direct method, compute (a) cash payments to suppliers and (b) cash payments for
operating expenses.

*E13-13 The 2011 accounting records of Verlander Transport reveal these transactions and events.

Payment of interest $ 10,000 Collection of accounts receivable $182,000
Cash sales 48,000 Payment of salaries and wages 53,000
Receipt of dividend revenue 18,000 Depreciation expense 16,000
Payment of income taxes 12,000 Proceeds from sale of vehicles 12,000
Net income 38,000 Purchase of equipment for cash 22,000
Payment of accounts payable Loss on sale of vehicles 3,000

for merchandise 115,000 Payment of dividends 14,000
Payment for land 74,000 Payment of operating expenses 28,000

Instructions
Prepare the cash flows from operating activities section using the direct method. (Not all of the
items will be used.)

*E13-14 The following information is taken from the 2011 general ledger of Pierzynski
Company.

Rent Rent expense $ 40,000
Prepaid rent, January 1 5,900
Prepaid rent, December 31 9,000

Salaries Salaries expense $ 54,000
Salaries payable, January 1 10,000
Salaries payable, December 31 8,000

Sales Revenue from sales $170,000
Accounts receivable, January 1 16,000
Accounts receivable, December 31 7,000

Instructions
In each case, compute the amount that should be reported in the operating activities section of
the statement of cash flows under the direct method.

Compute cash provided by
operating activities—direct
method.

(SO 6)

Visit the book’s companion website at www.wiley.com/college/weygandt, and choose the Student
Companion site, to access Exercise Set B and a set of Challenge Exercises.

EXERCISES: SET B AND CHALLENGE EXERCISES w

w
w

.wiley.com

/c
o

ll
e

g
e
/w

ey
gandt

Calculate cash flows—direct
method.

(SO 6)

Compute cash payments—
direct method.

(SO 6)

Compute cash flow from oper-
ating activities—direct method.

(SO 6)

658 Chapter 13 Statement of Cash Flows

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Problems: Set A 659

Instructions
Complete the table indicating whether each item (1) should be reported as an operating (O) ac-
tivity, investing (I) activity, financing (F) activity, or as a noncash (NC) transaction reported in a
separate schedule; and (2) represents a cash inflow or cash outflow or has no cash flow effect.
Assume use of the indirect approach.

P13-2A The following account balances relate to the stockholders’ equity accounts of Gore
Corp. at year-end.

Cash Inflow,
Where Reported Outflow, or

Transaction on Statement No Effect?

(a) Recorded depreciation expense on the
plant assets.

(b) Recorded and paid interest expense.
(c) Recorded cash proceeds from a sale of

plant assets.
(d) Acquired land by issuing common stock.
(e) Paid a cash dividend to preferred

stockholders.
(f) Distributed a stock dividend to common

stockholders.
(g) Recorded cash sales.
(h) Recorded sales on account.
(i) Purchased inventory for cash.
(j) Purchased inventory on account.

P13-1A You are provided with the following transactions that took place during a recent fiscal
year.

PROBLEMS: SET A

A small stock dividend was declared and issued in 2011. The market value of the shares was
$10,500. Cash dividends were $15,000 in both 2011 and 2010. The common stock has no par or
stated value.

Instructions
(a) What was the amount of net income reported by Gore Corp. in 2011?
(b) Determine the amounts of any cash inflows or outflows related to the common stock and

dividend accounts in 2011.
(c) Indicate where each of the cash inflows or outflows identified in (b) would be classified on

the statement of cash flows.

P13-3A The income statement of Elbert Company is presented here.

(a) Net income $65,500

2011 2010

Common stock, 10,500 and 10,000 shares,
respectively, for 2011 and 2010 $160,000 $140,000

Preferred stock, 5,000 shares 125,000 125,000
Retained earnings 300,000 260,000

ELBERT COMPANY
Income Statement

For the Year Ended November 30, 2011

Sales $7,700,000
Cost of goods sold

Beginning inventory $1,900,000
Purchases 4,400,000

Goods available for sale 6,300,000
Ending inventory 1,400,000

Distinguish among operating,
investing, and financing
activities.

(SO 2)

Determine cash flow effects of
changes in equity accounts.

(SO 3)
Prepare the operating activities
section—indirect method.
(SO 3)

JWCL165_c13_612-673.qxd 8/13/09 11:15 AM Page 659

Additional information:

1. Accounts receivable increased $250,000 during the year, and inventory decreased $500,000.
2. Prepaid expenses increased $150,000 during the year.
3. Accounts payable to suppliers of merchandise decreased $340,000 during the year.
4. Accrued expenses payable decreased $100,000 during the year.
5. Operating expenses include depreciation expense of $90,000.

Instructions
Prepare the operating activities section of the statement of cash flows for the year ended
November 30, 2011, for Elbert Company, using the indirect method.

*P13-4A Data for Elbert Company are presented in P13-3A.

Instructions
Prepare the operating activities section of the statement of cash flows using the direct
method.

P13-5A Grania Company’s income statement contained the condensed information below.

Cash from operations
$1,400,000

Cash from operations
$1,400,000

Cash from operations
$308,000

Cash from
operations
$308,000

Grania’s balance sheet contained the comparative data at December 31, shown below.

GRANIA COMPANY
Income Statement

For the Year Ended December 31, 2011

Revenues $970,000
Operating expenses, excluding depreciation $624,000
Depreciation expense 60,000
Loss on sale of equipment 16,000 700,000

Income before income taxes 270,000
Income tax expense 40,000

Net income $230,000

2011 2010

Accounts receivable $75,000 $60,000
Accounts payable 41,000 28,000
Income taxes payable 11,000 7,000

Cost of goods sold 4,900,000

Gross profit 2,800,000
Operating expenses 1,150,000

Net income $1,650,000

Accounts payable pertain to operating expenses.

Instructions
Prepare the operating activities section of the statement of cash flows using the indirect
method.

*P13-6A Data for Grania Company are presented in P13-5A.

Instructions
Prepare the operating activities section of the statement of cash flows using the direct method.

Prepare the operating activities
section—direct method.

(SO 6)
Prepare the operating activities
section—indirect method.
(SO 3)
Prepare the operating activities
section—direct method.
(SO 6)

660 Chapter 13 Statement of Cash Flows

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Problems: Set A 661

Additional data:

1. Dividends declared and paid were $25,000.
2. During the year equipment was sold for $8,500 cash. This equipment cost $18,000 originally

and had a book value of $8,500 at the time of sale.
3. All depreciation expense, $14,500, is in the operating expenses.
4. All sales and purchases are on account.

Instructions
(a) Prepare a statement of cash flows using the indirect method.
(b) Compute free cash flow.

P13-8A Data for Weller Company are presented in P13-7A. Further analysis reveals the
following.

1. Accounts payable pertain to merchandise suppliers.
2. All operating expenses except for depreciation were paid in cash.

Instructions
(a) Prepare a statement of cash flows for Weller Company using the direct method.
(b) Compute free cash flow.

WELLER COMPANY
Income Statement

For the Year Ended December 31, 2011

Sales $242,000
Cost of goods sold 175,000

Gross profit 67,000
Operating expenses 24,000

Income from operations 43,000
Interest expense 3,000

Income before income taxes 40,000
Income tax expense 8,000

Net income $ 32,000

WELLER COMPANY
Comparative Balance Sheets

December 31
Assets 2011 2010

Cash $ 35,000 $ 20,000
Accounts receivable 33,000 14,000
Merchandise inventory 27,000 20,000
Property, plant, and equipment 60,000 78,000
Accumulated depreciation (29,000) (24,000)

Total $126,000 $108,000

Liabilities and Stockholders’ Equity

Accounts payable $ 29,000 $ 15,000
Income taxes payable 7,000 8,000
Bonds payable 27,000 33,000
Common stock 18,000 14,000
Retained earnings 45,000 38,000

Total $126,000 $108,000

(a) Cash from operations
$33,500

(a) Cash from operations
$33,500

Prepare a statement of cash
flows—indirect method, and
compute free cash flow.

(SO 3, 4)

Prepare a statement of cash
flows—direct method, and
compute free cash flow.

(SO 4, 6)

P13-7A Presented below are the financial statements of Weller Company.

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P13-9A Condensed financial data of Arma Inc. follow.

ARMA INC.
Income Statement

For the Year Ended December 31, 2011

Sales $392,780
Less:

Cost of goods sold $135,460
Operating expenses, excluding

depreciation 12,410
Depreciation expense 46,500
Income taxes 27,280
Interest expense 4,730
Loss on sale of plant assets 7,500 233,880

Net income $158,900

ARMA INC.
Comparative Balance Sheets

December 31
Assets 2011 2010

Cash $ 90,800 $ 48,400
Accounts receivable 92,800 33,000
Inventories 112,500 102,850
Prepaid expenses 28,400 26,000
Investments 138,000 114,000
Plant assets 270,000 242,500
Accumulated depreciation (50,000) (52,000)

Total $682,500 $514,750

Liabilities and Stockholders’ Equity

Accounts payable $112,000 $ 67,300
Accrued expenses payable 16,500 17,000
Bonds payable 110,000 150,000
Common stock 220,000 175,000
Retained earnings 224,000 105,450

Total $682,500 $514,750
Additional information:

1. New plant assets costing $85,000 were purchased for cash during the year.
2. Old plant assets having an original cost of $57,500 were sold for $1,500 cash.
3. Bonds matured and were paid off at face value for cash.
4. A cash dividend of $40,350 was declared and paid during the year.

Instructions
Prepare a statement of cash flows using the indirect method.

*P13-10A Data for Arma Inc. are presented in P13-9A. Further analysis reveals that accounts
payable pertain to merchandise creditors.

Instructions
Prepare a statement of cash flows for Arma Inc. using the direct method.

P13-11A The comparative balance sheets for Ramirez Company as of December 31 are
presented on the next page.

Cash from operations
$185,250

Cash from operations
$185,250
Prepare a statement of cash
flows—indirect method.
(SO 3)

Prepare a statement of cash
flows—direct method.

(SO 6)
Prepare a statement of cash
flows—indirect method.
(SO 3)

662 Chapter 13 Statement of Cash Flows

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Problems: Set A 663

Additional information:

1. Operating expenses include depreciation expense of $42,000 and charges from prepaid ex-
penses of $5,720.

2. Land was sold for cash at book value.
3. Cash dividends of $15,000 were paid.
4. Net income for 2011 was $37,000.
5. Equipment was purchased for $95,000 cash. In addition, equipment costing $22,000 with a

book value of $10,000 was sold for $6,000 cash.
6. Bonds were converted at face value by issuing 40,000 shares of $1 par value common stock.

Instructions
Prepare a statement of cash flows for the year ended December 31, 2011, using the indirect method.

*P13-12A Condensed financial data of Oprah Company appear below.

OPRAH COMPANY
Comparative Balance Sheets

December 31
Assets 2011 2010

Cash $ 92,700 $ 47,250
Accounts receivable 90,800 57,000
Inventories 121,900 102,650
Investments 84,500 87,000
Plant assets 250,000 205,000
Accumulated depreciation (49,500) (40,000)

$590,400 $458,900

Liabilities and Stockholders’ Equity

Accounts payable $ 57,700 $ 48,280
Accrued expenses payable 12,100 18,830
Bonds payable 100,000 70,000
Common stock 250,000 200,000
Retained earnings 170,600 121,790

$590,400 $458,900

RAMIREZ COMPANY
Comparative Balance Sheets

December 31
Assets 2011 2010

Cash $ 71,000 $ 45,000
Accounts receivable 44,000 62,000
Inventory 151,450 142,000
Prepaid expenses 15,280 21,000
Land 105,000 130,000
Equipment 228,000 155,000
Accumulated depreciation—equipment (45,000) (35,000)
Building 200,000 200,000
Accumulated depreciation—building (60,000) (40,000)

Total $709,730 $680,000

Liabilities and Stockholders’ Equity

Accounts payable $ 47,730 $ 40,000
Bonds payable 260,000 300,000
Common stock, $1 par 200,000 160,000
Retained earnings 202,000 180,000

Total $709,730 $680,000

Cash from operations
$105,000

Prepare a worksheet—indirect
method.

(SO 5)

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Additional information:

1. New plant assets costing $92,000 were purchased for cash during the year.
2. Investments were sold at cost.
3. Plant assets costing $47,000 were sold for $15,550, resulting in gain of $8,750.
4. A cash dividend of $83,400 was declared and paid during the year.

Instructions
Prepare a worksheet for the statement of cash flows using the indirect method. Enter the recon-
ciling items directly in the worksheet columns, using letters to cross-reference each entry.

OPRAH COMPANY
Income Statement

For the Year Ended December 31, 2011

Sales $297,500
Gain on sale of plant assets 8,750

306,250
Less:

Cost of goods sold $99,460
Operating expenses (excluding

depreciation expense) 14,670
Depreciation expense 49,700
Income taxes 7,270
Interest expense 2,940 174,040

Net income $132,210

Cash Inflow,
Where Reported Outflow, or
Transaction on Statement No Effect?
(a) Recorded depreciation expense on the
plant assets.

(b) Incurred a loss on disposal of plant assets.
(c) Acquired a building by paying cash.
(d) Made principal repayments on a

mortgage.
(e) Issued common stock.
(f) Purchased shares of another company

to be held as a long-term equity
investment.

(g) Paid dividends to common stockholders.
(h) Sold inventory on credit. The company

uses a perpetual inventory system.
(i) Purchased inventory on credit.
(j) Paid wages to employees.

Reconciling items
total $610,210

Instructions
Complete the table indicating whether each item (1) should be reported as an operating (O) ac-
tivity, investing (I) activity, financing (F) activity, or as a noncash (NC) transaction reported in a
separate schedule; and (2) represents a cash inflow or cash outflow or has no cash flow effect.
Assume use of the indirect approach.

P13-1B You are provided with the following transactions that took place during a recent
fiscal year.

PROBLEMS: SET B

Distinguish among operating,
investing, and financing
activities.
(SO 2)

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Problems: Set B 665

P13-2B The following selected account balances relate to the plant asset accounts of Wegent
Inc. at year-end.

2011 2010

Accumulated depreciation—buildings $337,500 $300,000
Accumulated depreciation—equipment 144,000 96,000
Buildings 750,000 750,000
Depreciation expense 101,500 85,500
Equipment 300,000 240,000
Land 100,000 70,000
Loss on sale of equipment 8,000 0

ROSENTHAL COMPANY
Income Statement

For the Year Ended December 31, 2011

Sales $5,400,000
Cost of goods sold

Beginning inventory $1,780,000
Purchases 3,430,000

Goods available for sale 5,210,000
Ending inventory 1,900,000

Cost of goods sold 3,310,000

Gross profit 2,090,000
Operating expenses

Depreciation expense 105,000
Amortization expense 20,000
Other expenses 945,000 1,070,000

Net income $1,020,000

Additional information:

1. Wegent purchased $95,000 of equipment and $30,000 of land for cash in 2011.
2. Wegent also sold equipment in 2011.
3. Depreciation expense in 2011 was $37,500 on building and $64,000 on equipment.

Instructions
(a) Determine the amounts of any cash inflows or outflows related to the plant asset accounts in

2011.
(b) Indicate where each of the cash inflows or outflows identified in (a) would be classified on

the statement of cash flows.

P13-3B The income statement of Rosenthal Company is presented below.

Additional information:

1. Accounts receivable decreased $320,000 during the year, and inventory increased $120,000.
2. Prepaid expenses increased $175,000 during the year.
3. Accounts payable to merchandise suppliers increased $50,000 during the year.
4. Accrued expenses payable increased $155,000 during the year.

(a) Cash proceeds $11,000

Instructions
Prepare the operating activities section of the statement of cash flows for the year ended
December 31, 2011, for Rosenthal Company, using the indirect method.

*P13-4B Data for Rosenthal Company are presented in P13-3B.

Instructions
Prepare the operating activities section of the statement of cash flows using the direct
method.

Cash from operations
$1,375,000

Cash from operations
$1,375,000

Determine cash flow effects of
changes in plant asset accounts.

(SO 3)
Prepare the operating activities
section—indirect method.
(SO 3)
Prepare the operating activities
section—direct method.
(SO 6)

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P13-5B The income statement of Brislin Inc. reported the following condensed information.

BRISLIN INC.
Income Statement

For the Year Ended December 31, 2011

Revenues $545,000
Operating expenses 400,000

Income from operations 145,000
Income tax expense 36,000

Net income $109,000

2011 2010

Accounts receivable $50,000 $70,000
Accounts payable 30,000 51,000
Income taxes payable 10,000 4,000

ORTEGA COMPANY
Comparative Balance Sheets

December 31
Assets 2011 2010

Cash $ 24,000 $ 33,000
Accounts receivable 25,000 14,000
Merchandise inventory 41,000 25,000
Property, plant, and equipment $ 70,000 $ 78,000
Less: Accumulated depreciation 27,000 43,000 24,000 54,000

Total $133,000 $126,000

Liabilities and Stockholders’ Equity

Accounts payable $ 31,000 $ 43,000
Income taxes payable 24,000 20,000
Bonds payable 20,000 10,000
Common stock 25,000 25,000
Retained earnings 33,000 28,000

Total $133,000 $126,000

ORTEGA COMPANY
Income Statement

For the Year Ended December 31, 2011

Sales $286,000
Cost of goods sold 204,000

Gross profit 82,000

Brislin’s balance sheet contained these comparative data at December 31.

Brislin has no depreciable assets. Accounts payable pertain to operating expenses.

Instructions
Prepare the operating activities section of the statement of cash flows using the indirect method.

*P13-6B Data for Brislin Inc. are presented in P13-5B.

Instructions
Prepare the operating activities section of the statement of cash flows using the direct
method.

P13-7B Presented below are the financial statements of Ortega Company.

Cash from operations
$114,000

Cash from operations
$114,000
Prepare the operating activities
section—indirect method.
(SO 3)
Prepare the operating activities
section—direct method.
(SO 6)
Prepare a statement of cash
flows—indirect method, and
compute free cash flow.
(SO 3, 4)

666 Chapter 13 Statement of Cash Flows

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Problems: Set B 667

Operating expenses 37,000

Income from operations 45,000
Interest expense 7,000

Income before income taxes 38,000
Income tax expense 10,000

Net income $ 28,000

ZIEBERT COMPANY
Comparative Balance Sheets

December 31
Assets 2011 2010

Cash $102,700 $ 33,400
Accounts receivable 60,800 37,000
Inventories 126,900 102,650
Investments 79,500 107,000
Plant assets 315,000 205,000
Accumulated depreciation (44,500) (40,000)

Total $640,400 $445,050

Liabilities and Stockholders’ Equity

Accounts payable $ 57,700 $ 48,280
Accrued expenses payable 15,100 18,830
Bonds payable 145,000 70,000
Common stock 250,000 200,000
Retained earnings 172,600 107,940

Total $640,400 $445,050

ZIEBERT COMPANY
Income Statement

For the Year Ended December 31, 2011

Sales $297,500
Gain on sale of plant assets 5,000

302,500

Prepare a statement of cash
flows—direct method, and
compute free cash flow.
(SO 4, 6)
Additional data:

1. Dividends of $23,000 were declared and paid.
2. During the year equipment was sold for $10,000 cash. This equipment cost $15,000 originally

and had a book value of $10,000 at the time of sale.
3. All depreciation expense, $8,000, is in the operating expenses.
4. All sales and purchases are on account.
5. Additional equipment was purchased for $7,000 cash.

Instructions
(a) Prepare a statement of cash flows using the indirect method.
(b) Compute free cash flow.

*P13-8B Data for Ortega Company are presented in P13-7B. Further analysis reveals the
following.

1. Accounts payable pertains to merchandise creditors.
2. All operating expenses except for depreciation are paid in cash.

Instructions
(a) Prepare a statement of cash flows using the direct method.
(b) Compute free cash flow.

P13-9B Condensed financial data of Ziebert Company are shown below.

(a) Cash from operations
$1,000

(a) Cash from operations
$1,000
Prepare a statement of cash
flows—indirect method.
(SO 3)

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Additional information:

1. New plant assets costing $146,000 were purchased for cash during the year.
2. Investments were sold at cost.
3. Plant assets costing $36,000 were sold for $15,000, resulting in a gain of $5,000.
4. A cash dividend of $48,000 was declared and paid during the year.

Instructions
Prepare a statement of cash flows using the indirect method.

*P13-10B Data for Ziebert Company are presented in P13-9B. Further analysis reveals that
accounts payable pertain to merchandise creditors.

Instructions
Prepare a statement of cash flows for Ziebert Company using the direct method.

P13-11B Presented below are the comparative balance sheets for Marin Company at
December 31.

Less:
Cost of goods sold $99,460
Operating expenses, excluding

depreciation expense 19,670
Depreciation expense 30,500
Income taxes 37,270
Interest expense 2,940 189,840

Net income $112,660

MARIN COMPANY
Comparative Balance Sheets

December 31
Assets 2011 2010

Cash $ 41,000 $ 57,000
Accounts receivable 77,000 64,000
Inventory 172,000 140,000
Prepaid expenses 12,140 16,540
Land 110,000 150,000
Equipment 215,000 175,000
Accumulated depreciation—equipment (70,000) (42,000)
Building 250,000 250,000
Accumulated depreciation—building (70,000) (50,000)

Total $737,140 $760,540

Liabilities and Stockholders’ Equity

Accounts payable $ 58,000 $ 45,000
Bonds payable 235,000 265,000
Common stock, $1 par 280,000 250,000
Retained earnings 164,140 200,540

Total $737,140 $760,540

Cash from operations $95,800

Cash from operations $95,800
Additional information:

1. Operating expenses include depreciation expense $55,000 and charges from prepaid expenses
of $4,400.

2. Land was sold for cash at cost.
3. Cash dividends of $84,290 were paid.
4. Net income for 2011 was $47,890.
5. Equipment was purchased for $80,000 cash. In addition, equipment costing $40,000 with a

book value of $33,000 was sold for $37,000 cash.
6. Bonds were converted at face value by issuing 30,000 shares of $1 par value common stock.

Instructions
Prepare a statement of cash flows for 2011 using the indirect method.

Cash from operations
$71,290

Prepare a statement of cash
flows—direct method.
(SO 6)
Prepare a statement of cash
flows—indirect method.
(SO 3)

668 Chapter 13 Statement of Cash Flows

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Financial Reporting Problem: PepsiCo, Inc.
BYP13-1 Refer to the financial statements of PepsiCo’s, presented in Appendix A, and
answer the following questions.

(a) What was the amount of net cash provided by operating activities for the year ended
December 27, 2008? For the year ended December 29, 2007?

(b) What was the amount of increase or decrease in cash and cash equivalents for the year ended
December 27, 2008? For the year ended December 29, 2007?

(c) Which method of computing net cash provided by operating activities does PepsiCo use?
(d) From your analysis of the 2008 statement of cash flows, did the change in accounts and notes

receivable require or provide cash? Did the change in inventories require or provide cash?
Did the change in accounts payable and other current liabilities require or provide cash?

(e) What was the net outflow or inflow of cash from investing activities for the year ended
December 27, 2008?

(f) What was the amount of interest paid in the year ended December 27, 2008? What was the
amount of income taxes paid in the year ended December 27, 2008? (See Note 14.)

Comparative Analysis Problem: PepsiCo, Inc.
vs. The Coca-Cola Company
BYP13-2 PepsiCo’s financial statements are presented in Appendix A. Financial statements
of The Coca-Cola Company are presented in Appendix B.

Instructions
(a) Based on the information contained in these financial statements, compute free cash flow for

each company.
(b) What conclusions concerning the management of cash can be drawn from these data?

Exploring the Web
BYP13-3 Purpose: Learn about the SEC.

Address: www.sec.gov/index.html, or go to www.wiley.com/college/weygandt

From the SEC homepage, choose About the SEC.

FINANCIAL REPORTING AND ANALYSIS

B R O A D E N I N G Y O U R P E R S P E C T I V E

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Broadening Your Perspective 669

Visit the book’s companion website at www.wiley.com/college/weygandt and choose the Student
Companion site to access Problem Set C.

PROBLEMS: SET C ww
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(Note: This is a continuation of the Cookie Chronicle from Chapters 1 through 12.)

CCC13 Natalie has prepared the balance sheet and income statement of Cookie & Coffee
Creations Inc. and would like you to prepare the cash flow statement.

CONTINUING COOKIE CHRONICLE

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Go to the book’s companion website,
www.wiley.com/college/weygandt,
to see the completion of this problem.

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670 Chapter 13 Statement of Cash Flows

Instructions
Answer the following questions.

(a) How many enforcement actions does the SEC take each year against securities law violators?
What are typical infractions?

(b) Congress passed the Securities Acts of 1933 and 1934 to improve investor confidence in the
markets. What two “common sense” notions are these laws based on?

(c) Who was the President of the United States at the time of the creation of the SEC? Who was
the first SEC Chairperson?

BYP13-4 Purpose: Use the Internet to view SEC filings.

Address: biz.yahoo.com/i, or go to www.wiley.com/college/weygandt

Steps
1. Type in a company name.
2. Choose Profile.
3. Choose SEC Filings. (This will take you to Yahoo-Edgar Online.)

Instructions
Answer the following questions.

(a) What company did you select?
(b) Which filing is the most recent? What is the date?
(c) What other recent SEC filings are available for your viewing?

Decision Making Across the Organization
BYP13-5 Ron Nord and Lisa Smith are examining the following statement of cash flows for
Carpino Company for the year ended January 31, 2011.

CARPINO COMPANY
Statement of Cash Flows

For the Year Ended January 31, 2011

Sources of cash
From sales of merchandise $380,000
From sale of capital stock 420,000
From sale of investment (purchased below) 80,000
From depreciation 55,000
From issuance of note for truck 20,000
From interest on investments 6,000

Total sources of cash 961,000

Uses of cash
For purchase of fixtures and equipment 330,000
For merchandise purchased for resale 258,000
For operating expenses (including depreciation) 160,000
For purchase of investment 75,000
For purchase of truck by issuance of note 20,000
For purchase of treasury stock 10,000
For interest on note payable 3,000

Total uses of cash 856,000

Net increase in cash $ 105,000

CRITICAL THINKING

Ron claims that Carpino’s statement of cash flows is an excellent portrayal of a superb first year
with cash increasing $105,000. Lisa replies that it was not a superb first year. Rather, she says,
the year was an operating failure, that the statement is presented incorrectly, and that $105,000
is not the actual increase in cash. The cash balance at the beginning of the year was $140,000.

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Broadening Your Perspective 671

Instructions
With the class divided into groups, answer the following.

(a) Using the data provided, prepare a statement of cash flows in proper form using the indirect
method. The only noncash items in the income statement are depreciation and the gain from
the sale of the investment.

(b) With whom do you agree, Ron or Lisa? Explain your position.

Communication Activity
BYP13-6 Kyle Benson, the owner-president of Computer Services Company, is unfamiliar
with the statement of cash flows that you, as his accountant, prepared. He asks for further
explanation.

Instructions
Write him a brief memo explaining the form and content of the statement of cash flows as shown
in Illustration 13-13 (page 628).

Ethics Case
BYP13-7 Tappit Corp. is a medium-sized wholesaler of automotive parts. It has 10 stockhold-
ers who have been paid a total of $1 million in cash dividends for 8 consecutive years. The
board’s policy requires that, for this dividend to be declared, net cash provided by operating
activities as reported in Tappit’s current year’s statement of cash flows must exceed $1 million.
President and CEO Willie Morton’s job is secure so long as he produces annual operating cash
flows to support the usual dividend.

At the end of the current year, controller Robert Jennings presents president Willie
Morton with some disappointing news: The net cash provided by operating activities is calculated
by the indirect method to be only $970,000. The president says to Robert, “We must get that
amount above $1 million. Isn’t there some way to increase operating cash flow by another
$30,000?” Robert answers, “These figures were prepared by my assistant. I’ll go back to my
office and see what I can do.” The president replies, “I know you won’t let me down, Robert.”

Upon close scrutiny of the statement of cash flows, Robert concludes that he can get the
operating cash flows above $1 million by reclassifying a $60,000, 2-year note payable listed in
the financing activities section as “Proceeds from bank loan—$60,000.” He will report the note
instead as “Increase in payables—$60,000” and treat it as an adjustment of net income in the
operating activities section. He returns to the president, saying, “You can tell the board to de-
clare their usual dividend. Our net cash flow provided by operating activities is $1,030,000.”
“Good man, Robert! I knew I could count on you,” exults the president.

Instructions
(a) Who are the stakeholders in this situation?
(b) Was there anything unethical about the president’s actions? Was there anything unethical

about the controller’s actions?
(c) Are the board members or anyone else likely to discover the misclassification?

“All About You” Activity
BYP13-8 In this chapter you learned that companies prepare a statement of cash flows in
order to keep track of their sources and uses of cash and to help them plan for their future cash
needs. Planning for your own short- and long-term cash needs is every bit as important as it is
for a company.

Instructions
Read the article (“Financial Uh-Oh? No Problem”) provided at www.fool.com/personal-finance/
saving/index.aspx, and answer the following questions.

(a) Describe the three factors that determine how much money you should set aside for short-
term needs.

(b) How many months of living expenses does the article suggest to set aside?
(c) Estimate how much you should set aside based upon your current situation. Are you closer

to Cliff’s scenario or to Prudence’s?

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672 Chapter 13 Statement of Cash Flows

FASB Codification Activity
BYP13-9 Access the FASB Codification at http://asc.fasb.org to prepare responses to the
following. Use the Master Glossary to determine the proper definitions.
(a) What are cash equivalents?
(b) What are financing activities?
(c) What are investing activities?
(d) What are operating activities?
(e) What is the primary objective for the statement of cash flows? Is working capital the basis for

meeting this objective?
(f) Do companies need to disclose information about investing and financing activities that do

not affect cash receipts or cash payments? If so, how should such information be disclosed?

Answers to Insight and Accounting Across
the Organization Questions
p. 617 Net What?
Q: In general, why do differences exist between net income and net cash provided by operating

activities?
A: The differences are explained by differences in the timing of the reporting of revenues and

expenses under accrual accounting versus cash. Under accrual accounting, companies report
revenues when earned, even if cash hasn’t been received, and they report expenses when in-
curred, even if cash hasn’t been paid.

p. 619 Cash Flow Isn’t Always What It Seems
Q: For what reasons might managers at WorldCom and at Dynegy take the actions noted above?
A: Analysts increasingly use cash-flow-based measures of income, such as cash flow provided by

operations, in addition to net income. More investors now focus on cash flow from operations,
and some compensation contracts now have bonuses tied to cash-flow numbers. Thus, some
managers have taken actions that artificially increase cash flow from operations.

p. 626 GM Must Sell More Cars
Q: Why does GM’s cash provided by operating activities drop so precipitously when the com-

pany’s sales figures decline?
A: GM’s cash inflow is directly related to how many cars it sells. But many of its cash outflows are

not tied to sales—they are “fixed.” For example, many of its employee payroll costs are very
rigid due to labor contracts. Therefore, even though sales (and therefore cash inflows) fall, these
cash outflows don’t decline.

Authors’ Comments on All About You: Where Does the
Money Go?, p. 633
There are really two issues to consider here. The first centers on the problems associated with ac-
cumulating debt to support discretionary expenditures. If you think that you will simply pay off
your debts when you graduate, consider the fact that it is not unusual for people to spend 10 years
to pay off the debts they accumulated during college.

A second issue relates to the impact that working so many hours can have on your academic
performance. Research shows that college students today spend more hours working at jobs and
fewer hours studying than at any time in the past. This same research shows that academic perform-
ance declines when students work too many hours at their jobs. If you could cut back on your dis-
cretionary expenditures, you could quit working so many hours, which would mean that you would
do better in school, which would mean that you would have a better shot at a good job after college.

The bottom line: While we think that borrowing to invest in yourself through your education
makes good sense, we think that borrowing to support a Starbucks habit is a bad idea. For more
ideas on how to get your cash flow under control, see http://financialplan.about.com/cs/college/
a/MoneyCollege.htm.

Answers to Self-Study Questions
1. c 2. a 3. b 4. a 5. c 6. d 7. b 8. c 9. d 10. b 11. b 12. a 13. b
14. a 15. d *16. b *17. b *18. c *19. d

Remember to go back to the Navigator box on the chapter-opening page and check off your completed work.✓

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674

Chapter

Financial Statement
Analysis
After studying this chapter, you should be
able to:
1 Discuss the need for comparative analysis.
2 Identify the tools of financial

statement

analysis.
3 Explain and apply horizontal analysis.
4 Describe and apply vertical analysis.
5 Identify and compute ratios used in

analyzing a firm’s liquidity, profitability,
and solvency.

6 Understand the concept of earning
power, and how irregular items are
presented.

7 Understand the concept of quality of
earnings.

S T U D Y O B J E C T I V E S

Feature Story

The Navigator✓

14

IT PAYS TO BE PATIENT

In 2008 Forbes magazine listed Warren Buffett as the richest person in the
world. His estimated wealth was $62 billion, give or take a few million. How
much is $62 billion? If you invested $62 billion in an investment earning just
4%, you could spend $6.8 million per day—every day—forever. How did
Mr. Buffett amass this wealth? Through careful investing.

You think you might want to follow Buffett’s example and transform your
humble nest-egg into a mountain of cash. His techniques have been widely
circulated and emulated, but never practiced with the same degree of
success. Buffett epitomizes a “value investor.” To this day he applies the
same basic techniques he learned in the 1950s from the great value investor

Scan Study Objectives ■

Read Feature Story ■

Read Preview ■

Read text and answer
p. 681 ■ p. 694 ■ p. 699 ■ p. 701 ■

Work Comprehensive p. 703 ■

Review Summary of Study Objectives ■

Answer Self-Study Questions ■

Complete Assignments ■

The Navigator✓

Do it!

Do it!

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 674

675

Benjamin Graham. That means he spends his time
looking for companies that have good long-term
potential but are currently underpriced. He invests in
companies that have low exposure to debt and that
reinvest their earnings for future growth. He does
not get caught up in fads or the latest trend. Instead,
he looks for companies in industries with sound
economics and ones that have high returns on
stockholders’ equity. He looks for steady earnings
trends and high margins.

Buffett sat out on the dot-com mania in the 1990s,
when investors put lots of money into fledgling high-
tech firms, because he did not find dot-com compa-
nies that met his criteria. He didn’t get to enjoy the
stock price boom on the way up, but on the other hand, he didn’t have to
ride the price back down to earth. Instead, when the dot-com bubble burst,
and nearly everyone else was suffering from investment shock, he swooped in
and scooped up deals on companies that he had been following for years.

So, how does Mr. Buffett spend his money? Basically, he doesn’t! He still
lives in the same house that he purchased in Omaha, Nebraska, in 1958
for $31,500. He still drives his own car (a Cadillac DTS). And in case you
were thinking that his kids are riding the road to easy street, think again.
Buffett has committed to giving virtually all of his money to charity before
he dies.

So, given that neither you nor anyone else will be inheriting Mr. Buffett’s
riches, you should start honing your financial analysis skills as soon as possible.
A good way for you to begin your career as a successful investor is to master
the fundamentals of financial analysis discussed in this chapter.

The Navigator✓

Inside Chapter 14…

• How to Manage the Current Ratio (p. 685)

• Keeping Up to Date as an Investor (p. 693)

• What Does “Non-Recurring” Really Mean? (p. 698)

• All About You: Should I Play the Market Yet? (p. 702)

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BASICS OF FINANCIAL STATEMENT ANALYSIS

Preview of Chapter 14

We can learn an important lesson from Warren Buffett. The lesson: Study companies carefully if you wish to
invest. Do not get caught up in fads, but instead find companies that are financially healthy. Using some of
the basic decision tools presented in this book, you can perform a rudimentary analysis on any U.S. com-
pany and draw basic conclusions about its financial health. Although it would not be wise for you to bet your
life savings on a company’s stock relying solely on your current level of knowledge, we strongly encourage
you to practice your new skills wherever possible. Only with practice will you improve your ability to interpret
financial

numbers.

Before unleashing you on the world of high finance, we will present a few more important concepts and
techniques, as well as provide you with one more comprehensive review of corporate financial statements.
We use all of the decision tools presented in this text to analyze a single company—J.C. Penney Company,
one of the country’s oldest and largest retail store chains.

The content and organization of Chapter 14 are as follows.

676

Analyzing financial statements involves evaluating three characteristics: a com-
pany’s liquidity, profitability, and solvency. A short-term creditor, such as a bank, is
primarily interested in liquidity—the ability of the borrower to pay obligations
when they come due. The liquidity of the borrower is extremely important in eval-
uating the safety of a loan. A long-term creditor, such as a bondholder, looks to
profitability and solvency measures that indicate the company’s ability to survive
over a long period of time. Long-term creditors consider such measures as the
amount of debt in the company’s capital structure and its ability to meet interest
payments. Similarly, stockholders look at the profitability and solvency of the com-
pany. They want to assess the likelihood of dividends and the growth potential of
the stock.

Need for Comparative Analysis
Every item reported in a financial statement has significance. When
J.C. Penney Company, Inc. reports cash of $2,471 million on its balance
sheet, we know the company had that amount of cash on the balance sheet
date. But, we do not know whether the amount represents an increase

The Navigator✓

Financial Statement Analysis

Basics of Financial
Statement Analysis

• Need for
comparative
analysis

• Tools of analysis

Ratio Analysis

• Liquidity
• Profitability
• Solvency
• Summary

Horizontal and
Vertical Analysis

• Balance sheet
• Income statement
• Retained earnings

statement

Earning Power and
Irregular Items

• Discontinued
operations

•

Extraordinary items

• Changes in

accounting principle
•

Comprehensive

income

Quality of Earnings

• Alternative
accounting methods

• Pro forma income
• Improper

recognition

Discuss the need for comparative
analysis.

S T U D Y O B J E C T I V E 1

JWCL165_c14_674-725.qxd 8/20/09 11:11 AM Page 676

over prior years, or whether it is adequate in relation to the company’s need for
cash. To obtain such information, we need to compare the amount of cash with
other financial statement data.

Comparisons can be made on a number of different bases.Three are illustrated
in this chapter:

1. Intracompany basis. This basis compares an item or financial relationship
within a company in the current year with the same item or relationship in one
or more prior years. For example, J.C. Penney can compare its cash balance at
the end of the current year with last year’s balance to find the amount of the in-
crease or decrease. Likewise, J.C. Penney can compare the percentage of cash
to current assets at the end of the current year with the percentage in one or
more prior years. Intracompany comparisons are useful in detecting changes in
financial relationships and significant trends.

2. Industry averages. This basis compares an item or financial relationship of
a company with industry averages (or norms) published by financial ratings
organizations such as Dun & Bradstreet, Moody’s, and Standard & Poor’s.
For example, J.C. Penney’s net income can be compared with the average net
income of all companies in the retail chain-store industry. Comparisons with in-
dustry averages provide information as to a company’s relative performance
within the industry.

3. Intercompany basis. This basis compares an item or financial relationship of
one company with the same item or relationship in one or more competing
companies. Analysts make these comparisons on the basis of the published fi-
nancial statements of the individual companies. For example, we can compare
J.C. Penney’s total sales for the year with the total sales of a major competitor
such as Kmart. Intercompany comparisons are useful in determining a com-
pany’s competitive position.

Tools of Analysis
We use various tools to evaluate the significance of financial statement
data. Three commonly used tools are these:

• Horizontal analysis evaluates a series of financial statement data over
a period of time.

• Vertical analysis evaluates financial statement data by expressing each item in
a financial statement as a percent of a base amount.

• Ratio analysis expresses the relationship among selected items of financial
statement data.

Horizontal analysis is used primarily in intracompany comparisons. Two fea-
tures in published financial statements facilitate this type of comparison: First, each
of the basic financial statements presents comparative financial data for a mini-
mum of two years. Second, a summary of selected financial data is presented for a
series of five to ten years or more. Vertical analysis is used in both intra- and inter-
company comparisons. Ratio analysis is used in all three types of comparisons. In
the following sections, we explain and illustrate each of the three types of analysis.

Horizontal Analysis 677

Identify the tools of financial
statement analysis.

S T U D Y O B J E C T I V E 2

XYZ
Co.

Industry averages

A
Co.

B
Co.

C
Co.

A + B + C
3

⎫
⎪
⎪
⎪
⎪
⎪
⎪
⎬
⎪
⎪
⎪
⎪
⎪
⎪
⎭

XYZ
Co.

2011 ↔ 2012

Intracompany

XYZ
Co.
A
Co.

Intercompany

HORIZONTAL ANALYSIS

Horizontal analysis, also called trend analysis, is a technique for evaluat-
ing a series of financial statement data over a period of time. Its purpose is
to determine the increase or decrease that has taken place. This change

Explain and apply horizontal
analysis.

S T U D Y O B J E C T I V E 3

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 677

may be expressed as either an amount or a percentage. For example, the recent net
sales figures of J.C. Penney Company are as follows.

678 Chapter 14 Financial Statement Analysis

J.C. PENNEY COMPANY
Net Sales (in millions)

2007 2006 2005

$19,860 $19,903 $18,781

If we assume that 2005 is the base year, we can measure all percentage
increases or decreases from this base period amount as follows.

Illustration 14-1
J.C. Penney Company’s
net sales

Current Results in
�

Current Year Amount
Relation to Base Period Base Year Amount

For example, we can determine that net sales for J.C. Penney increased from 2005
to 2006 approximately 6% [($19,903 � $18,781) � $18,781]. Similarly, we can de-
termine that net sales increased from 2005 to 2007 approximately 5.7% [($19,860 �
$18,781) � $18,781].

Alternatively, we can express current year sales as a percentage of the base
period.We do this by dividing the current year amount by the base year amount, as
shown below.

Change Since
�

Current Year Amount � Base Year Amount
Base Period Base Year Amount

Illustration 14-4 presents this analysis for J.C. Penney for a three-year period using
2005 as the base period.

J.C. PENNEY COMPANY
Net Sales (in millions)

in relation to base period 2005

2007 2006 2005

$19,860 $19,903 $18,781
105.7% 106.0% 100.0%

Illustration 14-2
Formula for horizontal
analysis of changes since
base period

Illustration 14-3
Formula for horizontal
analysis of current year in
relation to base year

Balance Sheet
To further illustrate horizontal analysis, we will use the financial statements of
Quality Department Store Inc., a fictional retailer. Illustration 14-5 (page 679)
presents a horizontal analysis of its two-year condensed balance sheets, showing
dollar and percentage changes.

Illustration 14-4
Horizontal analysis of
J.C. Penney Company’s
net sales in relation to
base period

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 678

The comparative balance sheets in Illustration 14-5 show that a number of sig-
nificant changes have occurred in Quality Department Store’s financial structure
from 2006 to 2007:

• In the assets section, plant assets (net) increased $167,500, or 26.5% ($167,500 �
$632,500).

• In the liabilities section, current liabilities increased $41,500, or 13.7% ($41,500 �
$303,000).

• In the stockholders’ equity section, retained earnings increased $202,600, or
38.6% ($202,600 � $525,000).

These changes suggest that the company expanded its asset base during 2007 and
financed this expansion primarily by retaining income rather than assuming addi-
tional long-term debt.

Income Statement
Illustration 14-6 (page 680) presents a horizontal analysis of the two-year condensed
income statements of Quality Department Store Inc. for the years 2007 and 2006.
Horizontal analysis of the income statements shows the following changes:

• Net sales increased $260,000, or 14.2% ($260,000 � $1,837,000).
• Cost of goods sold increased $141,000, or 12.4% ($141,000 � $1,140,000).
• Total operating expenses increased $37,000, or 11.6% ($37,000 � $320,000).

Overall, gross profit and net income were up substantially. Gross profit increased
17.1%, and net income, 26.5%. Quality’s profit trend appears favorable.

Horizontal Analysis 679

QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets

December 31

Increase or (Decrease)
during 2007

2007 2006

Amount Percent

Assets

Current assets $1,020,000 $ 945,000 $ 75,000 7.9%
Plant assets (net) 800,000 632,500 167,500 26.5%
Intangible assets 15,000 17,500 (2,500) (14.3%)

Total assets $1,835,000 $1,595,000 $240,000 15.0%

Liabilities

Current liabilities $ 344,500 $ 303,000 $ 41,500 13.7%
Long-term liabilities 487,500 497,000 (9,500) (1.9%)

Total liabilities 832,000 800,000 32,000 4.0%

Stockholders’ Equity

Common stock, $1 par 275,400 270,000 5,400 2.0%
Retained earnings 727,600 525,000 202,600 38.6%

Total stockholders’ equity 1,003,000 795,000 208,000 26.2%

Total liabilities and
stockholders’ equity $1,835,000 $1,595,000 $240,000 15.0%

Illustration 14-5
Horizontal analysis of
balance sheets

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 679

Retained Earnings Statement
Illustration 14-7 presents a horizontal analysis of Quality Department Store’s com-
parative retained earnings statements.Analyzed horizontally, net income increased
$55,300, or 26.5%, whereas dividends on the common stock increased only $1,200,
or 2%. We saw in the horizontal analysis of the balance sheet that ending retained
earnings increased 38.6%. As indicated earlier, the company retained a significant
portion of net income to finance additional plant facilities.

680 Chapter 14 Financial Statement Analysis

H E L P F U L H I N T
Note that though the
amount column is
additive (the total is
$55,300), the percentage
column is not additive
(26.5% is not the total).
A separate percentage
has been calculated for
each item.

QUALITY DEPARTMENT STORE INC.
Condensed Income Statements

For the Years Ended December 31

Increase or (Decrease)
during 2007
2007 2006 Amount Percent

Sales $2,195,000 $1,960,000 $235,000 12.0%
Sales returns and allowances 98,000 123,000 (25,000) (20.3%)

Net sales 2,097,000 1,837,000 260,000 14.2%
Cost of goods sold 1,281,000 1,140,000 141,000 12.4%

Gross profit 816,000 697,000 119,000 17.1%

Selling expenses 253,000 211,500 41,500 19.6%
Administrative expenses 104,000 108,500 (4,500) (4.1%)

Total operating expenses 357,000 320,000 37,000 11.6%

Income from operations 459,000 377,000 82,000 21.8%
Other revenues and gains

Interest and dividends 9,000 11,000 (2,000) (18.2%)
Other expenses and losses

Interest expense 36,000 40,500 (4,500) (11.1%)

Income before income taxes 432,000 347,500 84,500 24.3%
Income tax expense 168,200 139,000 29,200 21.0%

Net income $ 263,800 $ 208,500 $ 55,300 26.5%

QUALITY DEPARTMENT STORE INC.
Retained Earnings Statements

For the Years Ended December 31
Increase or (Decrease)
during 2007
2007 2006 Amount Percent

Retained earnings, Jan. 1 $525,000 $376,500 $148,500 39.4%
Add: Net income 263,800 208,500 55,300 26.5%

788,800 585,000 203,80

0

Deduct: Dividends 61,200 60,000 1,200 2.0%

Retained earnings, Dec. 31 $727,600 $525,000 $202,600 38.6%

Horizontal analysis of changes from period to period is relatively straight-
forward and is quite useful. But complications can occur in making the computa-
tions. If an item has no value in a base year or preceding year but does have a value
in the next year, we cannot compute a percentage change. Similarly, if a negative

Illustration 14-6
Horizontal analysis of
income statements

Illustration 14-7
Horizontal analysis of
retained earnings statements

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 680

before you go on…

amount appears in the base or preceding period and a positive amount exists the
following year (or vice versa), no percentage change can be computed.

Vertical Analysis 681

Related exercise material: BE14-2, BE14-3, BE14-5, BE14-6, BE14-7, E14-1, E14-3, E14-4, and 14-1.Do it!

Action Plan

• Find the percentage change
by dividing the amount of the
increase by the 2010 amount
(base year).

The Navigator✓

Do it!
Summary financial information for Rosepatch Company is as follows.

December 31, 2011 December 31, 20

10

Current assets $234,000 $180,000
Plant assets (net) 756,000 420,000

Total assets $990,000 $600,000

Compute the amount and percentage changes in 2011 using horizontal analysis, assuming 2010 is
the base year.

Solution

Increase in 2011

Amount Percent

Current assets $ 54,000 30% [($234,000 � $180,000) � $180,000]
Plant assets (net) 336,000 80% [($756,000 � $420,000) � $420,000]

Total assets $390,000 65% [($990,000 � $600,000) � $600,000]

Horizontal Analysis

Vertical analysis, also called common-size analysis, is a technique that
expresses each financial statement item as a percent of a base amount. On
a balance sheet we might say that current assets are 22% of total assets—
total assets being the base amount. Or on an income statement, we might
say that selling expenses are 16% of net sales—net sales being the base amount.

Balance Sheet
Illustration 14-8 (page 682) presents the vertical analysis of Quality Department
Store Inc.’s comparative balance sheets. The base for the asset items is total assets.
The base for the liability and stockholders’ equity items is total liabilities and
stockholders’ equity.

Vertical analysis shows the relative size of each category in the balance sheet.
It also can show how the percentage in the individual asset, liability, and stockholders’
equity items changes from year to year. For example, we can see that current assets
decreased from 59.2% of total assets in 2006 to 55.6% in 2007 (even though the ab-
solute dollar amount increased $75,000 in that time). Plant assets (net) have in-
creased from 39.7% to 43.6% of total assets. Retained earnings have increased
from 32.9% to 39.7% of total liabilities and stockholders’ equity. These results
reinforce the earlier observations that Quality is choosing to finance its growth
through retention of earnings rather than through issuing additional debt.

Income Statement
Illustration 14-9 (page 682) shows vertical analysis of Quality’s income statements.
Cost of goods sold as a percentage of net sales declined 1% (62.1% vs. 61.1%), and total
operating expenses declined 0.4% (17.4% vs. 17.0%). As a result, it is not surprising

VERTICAL ANALYSIS

Describe and apply vertical
analysis.

S T U D Y O B J E C T I V E 4

JWCL165_c14_674-725.qxd 8/20/09 11:11 AM Page 681

682 Chapter 14 Financial Statement Analysis

QUALITY DEPARTMENT STORE INC.
Condensed Income Statements
For the Years Ended December 31

2007 2006

Amount Percent Amount Percent

Sales $2,195,000 104.7% $1,960,000 106.7%
Sales returns and allowances 98,000 4.7% 123,000 6.7%

Net sales 2,097,000 100.0% 1,837,000 100.0%
Cost of goods sold 1,281,000 61.1% 1,140,000 62.1%

Gross profit 816,000 38.9% 697,000 37.9%

Selling expenses 253,000 12.0% 211,500 11.5%
Administrative expenses 104,000 5.0% 108,500 5.9%

Total operating expenses 357,000 17.0% 320,000 17.4%

Income from operations 459,000 21.9% 377,000 20.5%
Other revenues and gains

Interest and dividends 9,000 0.4% 11,000 0.6%

Other expenses and losses
Interest expense 36,000 1.7% 40,500 2.2%

Income before income taxes 432,000 20.6% 347,500 18.9%
Income tax expense 168,200 8.0% 139,000 7.5%

Net income $ 263,800 12.6% $ 208,500 11.4%

QUALITY DEPARTMENT STORE INC.
Condensed Balance Sheets

December 31
2007 2006
Amount Percent Amount Percent
Assets

Current assets $1,020,000 55.6% $ 945,000 59.2%
Plant assets (net) 800,000 43.6% 632,500 39.7%
Intangible assets 15,000 0.8% 17,500 1.1%

Total assets $1,835,000 100.0% $1,595,000 100.0%

Liabilities

Current liabilities $ 344,500 18.8% $ 303,000

19.0%

Long-term liabilities 487,500 26.5% 497,000 31.2%

Total liabilities 832,000 45.3% 800,000 50.2%

Stockholders’ Equity

Common stock, $1 par 275,400 15.0% 270,000 16.9%
Retained earnings 727,600 39.7% 525,000 32.9%

Total stockholders’ equity 1,003,000 54.7% 795,000 49.8%

Total liabilities and
stockholders’ equity $1,835,000 100.0% $1,595,000 100.0%

Illustration 14-8
Vertical analysis of balance
sheets

Illustration 14-9
Vertical analysis of income
statements

to see net income as a percent of net sales increase from 11.4% to 12.6%. Quality
appears to be a profitable enterprise that is becoming even more successful.

An associated benefit of vertical analysis is that it enables you to compare com-
panies of different sizes. For example, Quality’s main competitor is a J.C. Penney
store in a nearby town. Using vertical analysis, we can compare the condensed

H E L P F U L H I N T
The formula for calculat-
ing these balance sheet
percentages is:

= %
Each item on B/S

Total assets

H E L P F U L H I N T
The formula for calculating
these income statement
percentages is:
Each item on I/S

Net sales
= %

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 682

income statements of Quality Department Store Inc. (a small retail company)
with J.C. Penney Company, Inc. (a giant international retailer), as shown in
Illustration 14-10.

Ratio Analysis 683

CONDENSED INCOME STATEMENTS
(in thousands)

Quality Department J.C. Penney
Store Inc. Company1

Dollars Percent Dollars Percent

Net sales $2,097 100.0% $19,860,000 100.0%
Cost of goods sold 1,281 61.1% 12,189,000 61.4%

Gross profit 816 38.9% 7,671,000 38.6%
Selling and administrative expenses 357 17.0% 5,357,000 27.0%

Income from operations 459 21.9% 2,314,000 11.6%
Other expenses and revenues

(including income taxes) 195 9.3% 1,203,000 6.0%

Net income $ 264 12.6% $ 1,111,000 5.6%

J.C. Penney’s net sales are 9,471 times greater than the net sales of relatively
tiny Quality Department Store. But vertical analysis eliminates this difference in
size. The percentages show that Quality’s and J.C. Penney’s gross profit rates were
comparable at 38.9% and 38.6%. However, the percentages related to income from
operations were significantly different at 21.9% and 11.6%. This disparity can be
attributed to Quality’s selling and administrative expense percentage (17%) which
is much lower than J.C. Penney’s (27.0%).Although J.C. Penney earned net income
more than 4,208 times larger than Quality’s, J.C. Penney’s net income as a percent
of each sales dollar (5.6%) is only 44% of Quality’s (12.6%).

Ratio analysis expresses the relationship among selected items of financial
statement data. A ratio expresses the mathematical relationship between
one quantity and another. The relationship is expressed in terms of either
a percentage, a rate, or a simple proportion.To illustrate, in 2007 Nike, Inc.,
had current assets of $8,839.3 million and current liabilities of $3,321.5
million. We can find the relationship between these two measures by dividing cur-
rent assets by current liabilities. The alternative means of expression are:

Percentage: Current assets are 266% of current liabilities.
Rate: Current assets are 2.66 times current liabilities.

Proportion: The relationship of current assets to current liabilities
is 2.66:1.

To analyze the primary financial statements, we can use ratios to evaluate
liquidity, profitability, and solvency. Illustration 14-11 (page 684) describes these
classifications.

RATIO ANALYSIS

Identify and compute ratios used
in analyzing a firm’s liquidity,
profitability, and solvency.

S T U D Y O B J E C T I V E 5

12007 Annual Report J.C. Penney Company, Inc. (Dallas, Texas).

Illustration 14-10
Intercompany income
statement comparison

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 683

Current Assets
Current Ratio �

Current Liabilities

Quality Department Store

2007 2006

$1,020,000
� 2.96�1

$945,000
$344,500 $303,000

� 3.12�1

Industry average J.C. Penney Company

1.06�1 2.02�1

Ratios can provide clues to underlying conditions that may not be ap-
parent from individual financial statement components. However, a single
ratio by itself is not very meaningful. Thus, in the discussion of ratios we
will use the following types of comparisons.

1. Intracompany comparisons for two years for Quality Department Store.
2. Industry average comparisons based on median ratios for department

stores.
3. Intercompany comparisons based on J.C. Penney Company as Quality

Department Store’s principal competitor.

Liquidity Ratios

Liquidity ratios measure the short-term ability of the company to pay its
maturing obligations and to meet unexpected needs for cash. Short-term
creditors such as bankers and suppliers are particularly interested in
assessing liquidity. The ratios we can use to determine the enterprise’s
short-term debt-paying ability are the current ratio, the acid-test ratio, re-
ceivables turnover, and inventory turnover.

1. CURRENT RATIO
The current ratio is a widely used measure for evaluating a company’s
liquidity and short-term debt-paying ability.The ratio is computed by dividing
current assets by current liabilities. Illustration 14-12 shows the 2007 and
2006 current ratios for Quality Department Store and comparative data.

684 Chapter 14 Financial Statement Analysis

Solvency Ratios

Measure the ability of
the company to survive
over a long period of time

Profitability Ratios

Measure the income or
operating success of a company
for a given period of time– =

Net
incomeRevenues Expenses

XYZ Co.

Founded in 1892

Liquidity Ratios

Measure short-term ability
of the company to pay its
maturing obligations and to
meet unexpected needs for cash

INTERNATIONAL NOTE
As more countries adopt in-

ternational accounting standards,
the ability of analysts to compare
companies from different countries
should improve. However, inter-
national standards are open to
widely varying interpretations. In
addition, some countries adopt
international standards “with
modifications.” As a consequence,
most cross-country comparisons
are still not as transparent as
within-country comparisons.

E T H I C S N O T E

Companies can affect the
current ratio by speeding up or
withholding payments on accounts
payable just before the balance
sheet date. Management can alter
the cash balance by increasing or
decreasing long-term assets or
long-term debt, or by issuing or
purchasing equity shares.

Illustration 14-11
Financial ratio classifications

Illustration 14-12
Current ratio

JWCL165_c14_674-725.qxd 8/20/09 11:11 AM Page 684

QUALITY DEPARTMENT STORE INC.
Balance Sheet (partial)

2007 2006

Current assets
Cash $ 100,000 $155,000
Short-term investments 20,000 70,000
Receivables (net*) 230,000 180,000
Inventory 620,000 500,000
Prepaid expenses 50,000 40,000

Total current assets $1,020,000 $945,000

*Allowance for doubtful accounts is $10,000 at the end of each year.

What does the ratio actually mean? The 2007 ratio of 2.96:1 means that for
every dollar of current liabilities, Quality has $2.96 of current assets. Quality’s cur-
rent ratio has decreased in the current year. But, compared to the industry average
of 1.06:1, Quality appears to be reasonably liquid. J.C. Penney has a current ratio of
2.02 which indicates it has adequate current assets relative to its current liabilities.

The current ratio is sometimes referred to as the working capital ratio; working
capital is current assets minus current liabilities. The current ratio is a more de-
pendable indicator of liquidity than working capital.Two companies with the same
amount of working capital may have significantly different current ratios.

The current ratio is only one measure of liquidity. It does not take into account
the composition of the current assets. For example, a satisfactory current ratio does
not disclose the fact that a portion of the current assets may be tied up in slow-
moving inventory. A dollar of cash would be more readily available to pay the bills
than a dollar of slow-moving inventory.

Ratio Analysis 685

H E L P F U L H I N T
Can any company operate
successfully without
working capital? Yes, if it
has very predictable cash
flows and solid earnings.
A number of companies
(e.g., Whirlpool, American
Standard, and Campbell’s
Soup) are pursuing this
goal. The rationale: Less
money tied up in working
capital means more money
to invest in the business.

ACCOUNTING ACROSS THE ORGANIZATION
How to Manage the Current Ratio

The apparent simplicity of the current ratio can have real-world limitations. An
addition of equal amounts to both the numerator and the denominator causes

the ratio to change.
Assume, for example, that a company has $2,000,000 of current assets and $1,000,000 of

current liabilities. Its current ratio is 2:1. If it purchases $1,000,000 of inventory on account, it
will have $3,000,000 of current assets and $2,000,000 of current liabilities. Its current ratio
will decrease to 1.5:1. If, instead, the company pays off $500,000 of its current liabilities, it will
have $1,500,000 of current assets and $500,000 of current liabilities, and its current ratio will
increase to 3:1. Thus, any trend analysis should be done with care, because the ratio is suscep-
tible to quick changes and is easily influenced by management.

How might management influence the company’s current ratio?

2. ACID-TEST RATIO
The acid-test (quick) ratio is a measure of a company’s immediate short-term
liquidity.We compute this ratio by dividing the sum of cash, short-term investments,
and net receivables by current liabilities.Thus, it is an important complement to the
current ratio. For example, assume that the current assets of Quality Department
Store for 2007 and 2006 consist of the items shown in Illustration 14-13.

Illustration 14-13
Current assets of Quality
Department Store

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 685

Cash � Short-Term Investments � Receivables (Net)
Acid-Test Ratio �

Current Liabilities
Quality Department Store
2007 2006

$100,000 � $20,000 � $230,000
� 1.02�1

$155,000 � $70,000 � $180,000
� 1.34�1

$344,500 $303,000

Industry average J.C. Penney Company

0.29�1 0.87�1

Net Credit Sales
Receivables Turnover �

Average Net Receivables

Quality Department Store
2007 2006

$2,097,000 $1,837,000
$180,000 � $230,000

� 10.2 times
$200,000 � $180,000

� 9.7 times

2 2

Industry average J.C. Penney Company
28.2 times 57 times

Cash, short-term investments, and receivables (net) are highly liquid compared
to inventory and prepaid expenses. The inventory may not be readily saleable, and
the prepaid expenses may not be transferable to others. Thus, the acid-test ratio
measures immediate liquidity. The 2007 and 2006 acid-test ratios for Quality
Department Store and comparative data are as follows.

686 Chapter 14 Financial Statement Analysis

Illustration 14-14
Acid-test ratio

The ratio has declined in 2007. Is an acid-test ratio of 1.02:1 adequate? This
depends on the industry and the economy. When compared with the industry
average of 0.29:1 and Penney’s of 0.87:1, Quality’s acid-test ratio seems adequate.

3. RECEIVABLES TURNOVER
We can measure liquidity by how quickly a company can convert certain assets to cash.
How liquid, for example, are the receivables? The ratio used to assess the liquidity of
the receivables is receivables turnover. It measures the number of times, on average,
the company collects receivables during the period.We compute receivables turnover
by dividing net credit sales (net sales less cash sales) by the average net receivables.
Unless seasonal factors are significant, average net receivables can be computed
from the beginning and ending balances of the net receivables.2

Assume that all sales are credit sales.The balance of net receivables at the begin-
ning of 2006 is $200,000. Illustration 14-15 shows the receivables turnover for Quality
Department Store and comparative data. Quality’s receivables turnover improved in
2007. The turnover of 10.2 times is substantially lower than J.C. Penney’s 57 times,
and is also lower than the department store industry’s average of 28.2 times.

2If seasonal factors are significant, the average receivables balance might be determined by using
monthly amounts.

[ [

[ [

Illustration 14-15
Receivables turnover

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 686

Cost of Goods Sold
Inventory Turnover � Average Inventory

Quality Department Store
2007 2006

$1,281,000 $1,140,000
$500,000 � $620,000

� 2.3 times
$450,000 � $500,000

� 2.4 times

2 2

Industry average J.C. Penney Company
7.0 times 3.5 times

Average Collection Period. A popular variant of the receivables turnover ratio
is to convert it to an average collection period in terms of days. To do so, we divide
the receivables turnover ratio into 365 days. For example, the receivables turnover
of 10.2 times divided into 365 days gives an average collection period of approxi-
mately 36 days.This means that receivables are collected on average every 36 days,
or about every 5 weeks.Analysts frequently use the average collection period to as-
sess the effectiveness of a company’s credit and collection policies.The general rule
is that the collection period should not greatly exceed the credit term period (the
time allowed for payment).

4. INVENTORY TURNOVER
Inventory turnover measures the number of times, on average, the inventory is sold
during the period. Its purpose is to measure the liquidity of the inventory. We
compute the inventory turnover by dividing cost of goods sold by the average
inventory. Unless seasonal factors are significant, we can use the beginning and
ending inventory balances to compute average inventory.

Assuming that the inventory balance for Quality Department Store at the
beginning of 2006 was $450,000, its inventory turnover and comparative data are as
shown in Illustration 14-16. Quality’s inventory turnover declined slightly in 2007.
The turnover of 2.3 times is relatively low compared with the industry average of 7.0
and J.C. Penney’s 3.5. Generally, the faster the inventory turnover, the less cash a
company has tied up in inventory and the less the chance of inventory obsolescence.

Ratio Analysis 687

Days in Inventory. A variant of inventory turnover is the days in inventory. We
calculate it by dividing the inventory turnover into 365. For example, Quality’s 2007
inventory turnover of 2.3 times divided into 365 is approximately 159 days. An
average selling time of 159 days is also relatively high compared with the industry
average of 52.1 days (365 � 7.0) and J.C. Penney’s 104.3 days (365 � 3.5).

Inventory turnover ratios vary considerably among industries. For example,
grocery store chains have a turnover of 10 times and an average selling period of
37 days. In contrast, jewelry stores have an average turnover of 1.3 times and an
average selling period of 281 days.

Profitability Ratios
Profitability ratios measure the income or operating success of a company for a
given period of time. Income, or the lack of it, affects the company’s ability to obtain
debt and equity financing. It also affects the company’s liquidity position and the
company’s ability to grow. As a consequence, both creditors and investors are
interested in evaluating earning power—profitability.Analysts frequently use prof-
itability as the ultimate test of management’s operating effectiveness.

Illustration 14-16
Inventory turnover

[ [ [ [

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Net Sales

Asset Turnover �

Average Assets

Quality Department Store
2007 2006

$2,097,000 $1,837,000
$1,595,000 � $1,835,000

� 1.22 times
$1,446,000 � $1,595,000

� 1.21 times

2 2

Industry average J.C. Penney Company
2.14 times 1.47 times

Net Income

Profit Margin �

Net Sales
Quality Department Store
2007 2006

$263,800 $208,500
$2,097,000

� 12.6%
$1,837,000

� 11.4%

Industry average J.C. Penney Company
3.7% 5.6%

5. PROFIT MARGIN
Profit margin is a measure of the percentage of each dollar of sales that results in
net income.We can compute it by dividing net income by net sales. Illustration 14-17
shows Quality Department Store’s profit margin and comparative data.

688 Chapter 14 Financial Statement Analysis

A L T E R N A T I V E
T E R M I N O L O G Y

Profit margin is also
called the rate of return
on sales.

Quality experienced an increase in its profit margin from 2006 to 2007. Its
profit margin is unusually high in comparison with the industry average of 3.7%
and J.C. Penney’s 5.6%.

High-volume (high inventory turnover) enterprises such as grocery stores
(Safeway or Kroger) and discount stores (Kmart or Wal-Mart) generally experi-
ence low profit margins. In contrast, low-volume enterprises such as jewelry stores
(Tiffany & Co.) or airplane manufacturers (Boeing Co.) have high profit margins.

6. ASSET TURNOVER
Asset turnover measures how efficiently a company uses its assets to generate
sales. It is determined by dividing net sales by average assets.The resulting number
shows the dollars of sales produced by each dollar invested in assets. Unless seasonal
factors are significant, we can use the beginning and ending balance of total assets
to determine average total assets. Assuming that total assets at the beginning of
2006 were $1,446,000, the 2007 and 2006 asset turnover for Quality Department
Store and comparative data are shown in Illustration 14-18.

Illustration 14-17
Profit margin

Illustration 14-18
Asset turnover

Asset turnover shows that in 2007 Quality generated sales of $1.22 for each dollar it had
invested in assets.The ratio changed little from 2006 to 2007. Quality’s asset turnover is
below the industry average of 2.14 times and J.C. Penney’s ratio of 1.47 times.

Asset turnover ratios vary considerably among industries. For example, a large
utility company like Consolidated Edison (New York) has a ratio of 0.49 times, and
the large grocery chain Kroger Stores has a ratio of 4.34 times.

[ [ [ [

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 688

Return on Common Net Income
Stockholders’ Equity

�
Average Common Stockholders’ Equity

Quality Department Store
2007 2006

$263,800 $208,500
$795,000 � $1,003,000

� 29.3%
$667,000 � $795,000

� 28.5%

2 2

Industry average J.C. Penney Company
19.2% 23.1%

Net Income
Return on Assets �

Average Assets
Quality Department Store
2007 2006

$263,800 $208,500
$1,595,000 � $1,835,000

� 15.4%
$1,446,000 � $1,595,000

� 13.7%

2 2

Industry average J.C. Penney Company
7.9% 8.2%

7. RETURN ON ASSETS
An overall measure of profitability is return on assets.We compute this ratio by di-
viding net income by average assets.The 2007 and 2006 return on assets for Quality
Department Store and comparative data are shown below.

Ratio Analysis 689

Quality’s return on assets improved from 2006 to 2007. Its return of 15.4% is very
high compared with the department store industry average of 7.9% and J.C.
Penney’s 8.2%.

8. RETURN ON COMMON STOCKHOLDERS’ EQUITY
Another widely used profitability ratio is return on common stockholders’ equity.
It measures profitability from the common stockholders’ viewpoint. This ratio
shows how many dollars of net income the company earned for each dollar in-
vested by the owners. We compute it by dividing net income by average common
stockholders’ equity.Assuming that common stockholders’ equity at the beginning
of 2006 was $667,000, Illustration 14-20 shows the 2007 and 2006 ratios for Quality
Department Store and comparative data.

Illustration 14-19
Return on assets

Illustration 14-

20

Return on common

stockholders’ equity

Quality’s rate of return on common stockholders’ equity is high at 29.3%,
considering an industry average of 19.2% and a rate of 23.1% for J.C. Penney.

With Preferred Stock. When a company has preferred stock, we must deduct
preferred dividend requirements from net income to compute income available to
common stockholders. Similarly, we deduct the par value of preferred stock (or call
price, if applicable) from total stockholders’ equity to determine the amount of
common stockholders’ equity used in this ratio. The ratio then appears as follows.

[ [ [ [
[ [ [ [

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 689

Earnings Net Income
per Share � Weighted-Average Common Shares Outstanding

Quality Department Store
2007 2006

$263,800 $208,500
� $0.77

270,000 � 275,400
� $0.97

270,000
2

690 Chapter 14 Financial Statement Analysis

Return on Common
�

Net Income � Preferred Dividends
Stockholders’ Equity Average Common Stockholders’ Equity

Illustration 14-21
Return on common
stockholders’ equity with
preferred stock

Note that Quality’s rate of return on stockholders’ equity (29.3%) is substantially
higher than its rate of return on assets (15.4%). The reason is that Quality has made
effective use of leverage. Leveraging or trading on the equity at a gain means that the
company has borrowed money at a lower rate of interest than it is able to earn by
using the borrowed money. Leverage enables Quality Department Store to use
money supplied by nonowners to increase the return to the owners. A comparison of
the rate of return on total assets with the rate of interest paid for borrowed money in-
dicates the profitability of trading on the equity. Quality Department Store earns more
on its borrowed funds than it has to pay in the form of interest.Thus the return to stock-
holders exceeds the return on the assets, due to benefits from the positive leveraging.

9. EARNINGS PER SHARE (EPS)
Earnings per share (EPS) is a measure of the net income earned on each share of
common stock. It is computed by dividing net income by the number of weighted-
average common shares outstanding during the year. A measure of net income
earned on a per share basis provides a useful perspective for determining prof-
itability. Assuming that there is no change in the number of outstanding shares
during 2006 and that the 2007 increase occurred midyear, Illustration 14-22 shows
the net income per share for Quality Department Store for 2007 and 2006.

Illustration 14-22
Earnings per share

Note that no industry or J.C. Penney data are presented. Such comparisons are
not meaningful because of the wide variations in the number of shares of out-
standing stock among companies. The only meaningful EPS comparison is an in-
tracompany trend comparison: Quality’s earnings per share increased 20 cents per
share in 2007. This represents a 26% increase over the 2006 earnings per share of
77 cents.

The terms “earnings per share” and “net income per share” refer to the amount
of net income applicable to each share of common stock. Therefore, in computing
EPS, if there are preferred dividends declared for the period, we must deduct them
from net income to determine income available to the common stockholders.

10. PRICE-EARNINGS RATIO
The price-earnings (P-E) ratio is an oft-quoted measure of the ratio of the market
price of each share of common stock to the earnings per share. The price-earnings
(P-E) ratio reflects investors’ assessments of a company’s future earnings.We com-
pute it by dividing the market price per share of the stock by earnings per share.
Assuming that the market price of Quality Department Store Inc. stock is $8 in
2006 and $12 in 2007, the price-earnings ratio computation is as follows.

[ [

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 690

Cash Dividends
Payout Ratio �

Net Income
Quality Department Store
2007 2006

$61,200 $60,000
$263,800

� 23.2%
$208,500

� 28.8%

Industry average J.C. Penney Company
16.1% 15.7%

Market Price per Share of Stock
Price-Earnings Ratio �

Earnings per Share

Quality Department Store
2007 2006

$12.00 $8.00
$0.97

� 12.4 times
$0.77

� 10.4 times

Industry average J.C. Penney Company
17.1 times 9.7 times

Illustration 14-23
Price-earnings ratio

In 2007 each share of Quality’s stock sold for 12.4 times the amount that the
company earned on each share. Quality’s price-earnings ratio is lower than the
industry average of 17.1 times, but 28% higher than the ratio of 9.7 times for
J.C. Penney. The average price-earnings ratio for the stocks that constitute the
Standard and Poor’s 500 Index (500 largest U.S. firms) in early 2007 was approxi-
mately 19.1 times.

11. PAYOUT RATIO
The payout ratio measures the percentage of earnings distributed in the form
of cash dividends. We compute it by dividing cash dividends by net income.
Companies that have high growth rates generally have low payout ratios because
they reinvest most of their net income into the business. The 2007 and 2006 payout
ratios for Quality Department Store are computed as shown in Illustration 14-24.

Illustration 14-24
Payout ratio

Ratio Analysis 691

Quality’s payout ratio is higher than J.C. Penney’s payout ratio of 15.7%. As
indicated earlier (page 681), Quality funded its purchase of plant assets through
retention of earnings but still is able to pay dividends.

Solvency Ratios
Solvency ratios measure the ability of a company to survive over a long period of
time. Long-term creditors and stockholders are particularly interested in a com-
pany’s ability to pay interest as it comes due and to repay the face value of debt at
maturity. Debt to total assets and times interest earned are two ratios that provide
information about debt-paying ability.

12. DEBT TO TOTAL ASSETS RATIO
The debt to total assets ratio measures the percentage of the total assets that credi-
tors provide. We compute it by dividing total debt (both current and long-term

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 691

Times Interest Income before Income Taxes and Interest Expense
Earned

�
Interest Expense

Quality Department Store
2007 2006

$468,000
� 13 times

$388,000
� 9.6 times

$36,000 $40,500

Industry average J.C. Penney Company
10.7 times 12.3 times

Total Debt
Debt to Total Assets Ratio �

Total Assets

Quality Department Store
2007 2006

$832,000 $800,000
$1,835,000

� 45.3%
$1,595,000

� 50.2%

Industry average J.C. Penney Company
40.1% 62.9%

liabilities) by total assets. This ratio indicates the company’s degree of leverage. It
also provides some indication of the company’s ability to withstand losses without
impairing the interests of creditors.The higher the percentage of debt to total assets, the
greater the risk that the company may be unable to meet its maturing obligations.The
2007 and 2006 ratios for Quality Department Store and comparative data are as follows.

692 Chapter 14 Financial Statement Analysis

A ratio of 45.3% means that creditors have provided 45.3% of Quality
Department Store’s total assets. Quality’s 45.3% is above the industry average of
40.1%. It is considerably below the high 62.9% ratio of J.C. Penney. The lower the
ratio, the more equity “buffer” there is available to the creditors. Thus, from the
creditors’ point of view, a low ratio of debt to total assets is usually desirable.

The adequacy of this ratio is often judged in the light of the company’s earn-
ings. Generally, companies with relatively stable earnings (such as public utilities)
have higher debt to total assets ratios than cyclical companies with widely fluctuat-
ing earnings (such as many high-tech companies).

13. TIMES INTEREST EARNED
Times interest earned provides an indication of the company’s ability to meet
interest payments as they come due. We compute it by dividing income before
interest expense and income taxes by interest expense. Illustration 14-26 shows the
2007 and 2006 ratios for Quality Department Store and comparative data. Note
that times interest earned uses income before income taxes and interest expense.
This represents the amount available to cover interest. For Quality Department
Store the 2007 amount of $468,000 is computed by taking the income before in-
come taxes of $432,000 and adding back the $36,000 of interest expense.

Illustration 14-25
Debt to total assets ratio

A L T E R N A T I V E
T E R M I N O L O G Y

Times interest earned
is also called interest
coverage.

Illustration 14-26
Times interest earned

Quality’s interest expense is well covered at 13 times, compared with the indus-
try average of 10.7 times and J.C. Penney’s 12.3 times.

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 692

Ratio Analysis 693

If you want to keep current with the financial and operating developments of a com-
pany in which you own shares, what are some ways you can do so?

I N V E S T O R I N S I G H T
Keeping Up to Date as an Investor

Today, investors have access to information provided by corporate managers that used
to be available only to professional analysts. Corporate managers have always made them-
selves available to security analysts for questions at the end of every quarter. Now, because of
a combination of new corporate disclosure requirements by the Securities and Exchange
Commission and technologies that make communication to large numbers of people possible
at a very low price, the average investor can listen in on these discussions. For example, one in-
dividual investor, Matthew Johnson, a Nortel Networks local area network engineer in Belfast,
Northern Ireland, “stayed up past midnight to listen to Apple Computer’s Internet conference
call. Hearing the company’s news ‘from the dog’s mouth,’ he says ‘gave me better information’
than hunting through chat-rooms.”

Source: Jeff D. Opdyke, “Individuals Pick Up on Conference Calls,” Wall Street Journal, November 20, 2000.

Summary of Ratios
Illustration 14-27 summarizes the ratios discussed in this chapter. The summary in-
cludes the formula and purpose or use of each ratio.

Ratio Formula Purpose or Use

Liquidity Ratios

1. Current ratio Current assets
Current liabilities Measures short-term debt-paying ability.

Cash � Short-term
2. Acid-test (quick) ratio investments � Receivables (net) Measures immediate short-term liquidity.

Current liabilities

3. Receivables turnover Net credit sales
Average net receivables Measures liquidity of receivables.

4. Inventory turnover Cost of goods sold
Average inventory Measures liquidity of inventory.

Profitability Ratios

5. Profit margin Net income Measures net income generated by each dollar
Net sales of sales.

6. Asset turnover Net sales Measures how efficiently assets are used to
Average assets generate sales.

7. Return on assets Net income
Average assets Measures overall profitability of assets.

8. Return on common

Net income � Preferred
dividends

stockholders’ equity Average common
Measures profitability of owners’ investment.

stockholders’ equity

Illustration 14-27
Summary of liquidity,
profitability, and
solvency ratios

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 693

before you go on…

694 Chapter 14 Financial Statement Analysis

Ratio Formula Purpose or Use

9. Earnings per share (EPS)

Net income � Preferred
dividends

Weighted-average common
Measures net income earned on each share of

shares outstanding
common stock.

10. Price-earnings (P-E) ratio
Market price

per share of stock Measures the ratio of the market price per share to
Earnings per share earnings per share.

11. Payout ratio Cash dividends Measures percentage of earnings distributed in the
Net income form of cash dividends.

Solvency Ratios

12. Debt to total assets ratio Total debt Measures the percentage of total assets provided
Total assets by creditors.

13. Times interest earned
Income before income taxes

and interest expense Measures ability to meet interest payments as they
Interest expense come due.

Illustration 14-27
(continued)

Do it!
The condensed financial statements of John Cully Company, for the years

ended June 30, 2011 and 2010, are presented below.
Ratio Analysis

JOHN CULLY COMPANY
Balance Sheets

June

30

(in thousands)
Assets

2011 2010

Current assets
Cash and cash equivalents $ 553.3 $ 611.6
Accounts receivable (net) 776.6 664.9
Inventories 768.3 653.5
Prepaid expenses and other current assets 204.4 269.2

Total current assets 2,302.6 2,199.2
Property, plant, and equipment (net) 694.2 647.0
Investments 12.3 12.6
Intangibles and other assets 876.7 849.3

Total assets $3,885.8 $3,708.1

Liabilities and Stockholders’ Equity

Current liabilities $1,497.7 $1,322.0
Long-term liabilities 679.5 637.1
Stockholders’ equity—common 1,708.6 1,749.0

Total liabilities and stockholders’ equity $3,885.8 $3,708.1

JWCL165_c14_674-725.qxd 8/20/09 11:11 AM Page 694

Ratio Analysis 695

Compute the following ratios for 2011 and 2010.

(a) Current ratio.
(b) Inventory turnover. (Inventory on 6/30/09 was $599.0.)
(c) Profit margin.
(d) Return on assets. (Assets on 6/30/09 were $3,349.9.)
(e) Return on common stockholders’ equity. (Stockholders’ equity on 6/30/09 was $1,795.9.)
(f) Debt to total assets ratio.
(g) Times interest earned.

JOHN CULLY COMPANY
Income Statements

For the Years Ended June 30

(in thousands)
2011 2010

Revenues $6,336.3 $5,790.4
Costs and expenses

Cost of goods sold 1,617.4 1,476.3
Selling and administrative expenses 4,007.6 3,679.0
Interest expense 13.9 27.1

Total costs and expenses 5,638.9 5,182.4

Income before income taxes 697.4 608.0
Income tax expense 291.3 232.6

Net income $ 406.1 $ 375.4

The Navigator✓
Solution

2011 2010
(a) Current ratio:

$2,302.6 � $1,497.7 � 1.5�1
$2,199.2 � $1,322.0 � 1.7�1

(b) Inventory turnover:
$1,617.4 � [($768.3 � $653.5) � 2] � 2.3 times
$1,476.3 � [($653.5 � $599.0) � 2] � 2.4 times

(c) Profit margin:
$406.1 � $6,336.3 6.4%
$375.4 � $5,790.4 6.5%

(d) Return on assets:
$406.1 � [($3,885.8 � $3,708.1) � 2] � 10.7%
$375.4 � [($3,708.1 � $3,349.9) � 2] � 10.6%

(e) Return on common stockholders’ equity:
$406.1 � [($1,708.6 � $1,749.0) � 2] � 23.5%
$375.4 � [($1,749.0 � $1,795.9) � 2] � 21.2%

(f) Debt to total assets ratio:
($1,497.7 � $679.5) � $3,885.8 � 56.0%
($1,322.0 � $637.1) � $3,708.1 � 52.8%

(g) Times interest earned:
($406.1 � $291.3 � $13.9) � $13.9 � 51.2 times
($375.4 � $232.6 � $27.1) � $27.1 � 23.4 times

Related exercise material: BE14-9, BE14-10, BE14-11, BE14-12, BE14-13, E14-5, E14-6, E14-7, E14-8,
E14-9, E14-10, E14-11, and 14-2.Do it!

Action Plan

• Remember that the current
ratio includes all current assets.
The acid-test ratio uses only
cash, short-term investments,
and net receivables.

• Use average balances for
turnover ratios like inventory,
receivables, and assets.

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 695

696 Chapter 14 Financial Statement Analysis

Users of financial statements are interested in the concept of earning
power. Earning power means the normal level of income to be obtained in
the future. Earning power differs from actual net income by the amount of
irregular revenues, expenses, gains, and losses. Users are interested in
earning power because it helps them derive an estimate of future earnings

without the “noise” of irregular items.
For users of financial statements to determine earning power or regular in-

come, the “irregular” items are separately identified on the income statement.
Companies report two types of “irregular” items.

1. Discontinued operations.
2. Extraordinary items.

These “irregular” items are reported net of income taxes. That is, the income state-
ment first reports income tax on the income before “irregular” items. Then the
amount of tax for each of the listed “irregular” items is computed.The general con-
cept is “let the tax follow income or loss.”

Discontinued Operations
Discontinued operations refers to the disposal of a significant component of a busi-
ness. Examples involve stopping an entire activity or eliminating a major class of
customers. For example, Kmart reported as discontinued operations its decision to
terminate its interest in four business activities, including PACE Membership
Warehouse and PayLess Drug Stores Northwest.

Following the disposal of a significant component, the company should report
on its income statement both income from continuing operations and income (or
loss) from discontinued operations. The income (loss) from discontinued operations
consists of two parts: the income (loss) from operations and the gain (loss) on disposal
of the segment.

To illustrate, assume that during 2011 Acro Energy Inc. has income before in-
come taxes of $800,000. During 2011 Acro discontinued and sold its unprofitable
chemical division. The loss in 2011 from chemical operations (net of $60,000 taxes)
was $140,000. The loss on disposal of the chemical division (net of $30,000 taxes)
was $70,000. Assuming a 30% tax rate on income, Illustration 14-28 shows Acro’s
income statement presentation.

EARNING POWER AND IRREGULAR ITEMS

Understand the concept of
earning power, and how irregular
items are presented.

S T U D Y O B J E C T I V E 6

ACRO ENERGY INC.
Income Statement (partial)

For the Year Ended December 31, 2011

Income before income taxes $800,000
Income tax expense 240,000

Income from continuing operations 560,000
Discontinued operations

Loss from operations of chemical division,
net of $60,000 income tax saving $140,000

Loss from disposal of chemical division,
net of $30,000 income tax saving 70,000 210,000

Net income $350,000

H E L P F U L H I N T
Observe the dual
disclosures: (1) The
results of operations of
the discontinued division
must be eliminated from
the results of continuing
operations. (2) The
company must also
report the disposal of
the operation.

Illustration 14-28
Statement presentation of
discontinued operations

Note that the statement uses the caption “Income from continuing operations,”
and adds a new section “Discontinued operations.” The new section reports both
the operating loss and the loss on disposal net of applicable income taxes. This

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 696

presentation clearly indicates the separate effects of continuing operations and dis-
continued operations on net income.

Extraordinary Items
Extraordinary items are events and transactions that meet two conditions:They are (1)
unusual in nature, and (2) infrequent in occurrence.To be unusual, the item should be
abnormal and only incidentally related to the company’s customary activities.To be in-
frequent, the item should not be reasonably expected to recur in the foreseeable future.

A company must evaluate both criteria in terms of its operating environment.Thus,
Weyerhaeuser Co. reported the $36 million in damages to its timberland caused by the
volcanic eruption of Mount St. Helens as an extraordinary item.The eruption was both
unusual and infrequent.In contrast, Florida Citrus Company does not report frost dam-
age to its citrus crop as an extraordinary item, because frost damage is not infrequent.
Illustration 14-29 shows the classification of extraordinary and ordinary items.

Earning Power and Irregular Items 697

Extraordinary items

1. Effects of major natural
casualties, if rare in
the area.

2. Expropriation (takeover)
of property by a foreign
government.

3. Effects of a newly enacted
law or regulation, such as
a property condemnation
action.

Ordinary items

1. Effects of major natural
casualties, not
uncommon in the area.

2. Write-down of
inventories
or write-off of
receivables.

3. Losses attributable
to labor strikes.

4. Gains or losses from
sales of property,
plant, or equipment.

unco
llectib

le
XYZ

INVOICE

Illustration 14-29
Examples of extraordinary
and ordinary items

Companies report extraordinary items net of taxes in a separate section of the
income statement, immediately below discontinued operations. To illustrate, assume
that in 2011 a foreign government expropriated property held as an investment by Acro
Energy Inc. If the loss is $70,000 before applicable income taxes of $21,000, the income
statement will report a deduction of $49,000, as shown in Illustration 14-30 (page 698).
When there is an extraordinary item to report, the company adds the caption “Income
before extraordinary item” immediately before the section for the extraordinary item.
This presentation clearly indicates the effect of the extraordinary item on net income.

What if a transaction or event meets one (but not both) of the criteria for an
extraordinary item? In that case the company reports it under either “Other revenues
and gains” or “Other expenses and losses” at its gross amount (not net of tax).This is
true, for example,of gains (losses) resulting from the sale of property,plant,and equip-
ment, as explained in Chapter 9. It is quite common for companies to use the label
“Non-recurring charges” for losses that do not meet the extraordinary item criteria.

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698 Chapter 14 Financial Statement Analysis

H E L P F U L H I N T
If there are no
discontinued
operations, the third
line of the income
statement would be
labeled “Income before
extraordinary item.”

ACRO ENERGY INC.
Income Statement (partial)
For the Year Ended December 31, 2011
Income before income taxes $800,000
Income tax expense 240,000
Income from continuing operations 560,000
Discontinued operations
Loss from operations of chemical division,
net of $60,000 income tax saving $140,000
Loss from disposal of chemical division,
net of $30,000 income tax saving 70,000 210,000

Income before extraordinary item 350,000
Extraordinary item

Expropriation of investment, net of
$21,000 income tax saving 49,000

Net income $301,000

Illustration 14-30
Statement presentation of
extraordinary items

If a company takes a large restructuring charge, what is the effect on the company’s
current income statement versus future ones?

I N V E S T O R I N S I G H T
What Does “Non-Recurring” Really Mean?

Many companies incur restructuring charges as they attempt to reduce costs. They
often label these items in the income statement as “non-recurring” charges to suggest that
they are isolated events which are unlikely to occur in future periods. The question for analysts
is, are these costs really one-time, “non-recurring” events, or do they reflect problems that the
company will be facing for many periods in the future? If they are one-time events, they can
be largely ignored when trying to predict future earnings.

But some companies report “one-time” restructuring charges over and over again. For
example, toothpaste and other consumer-goods giant Procter & Gamble Co. reported a re-
structuring charge in 12 consecutive quarters. Motorola had “special” charges in 14-consecutive
quarters. On the other hand, other companies have a restructuring charge only once in a five-
or ten-year period. There appears to be no substitute for careful analysis of the numbers that
comprise net income.

Changes in Accounting Principle
For ease of comparison, users of financial statements expect companies to
prepare such statements on a basis consistent with the preceding period. A
change in accounting principle occurs when the principle used in the current
year is different from the one used in the preceding year. Accounting rules
permit a change when management can show that the new principle is
preferable to the old principle.An example is a change in inventory costing
methods (such as FIFO to average-cost).

Companies report most changes in accounting principle retroactively.
That is, they report both the current period and previous periods using the

new principle. As a result the same principle applies in all periods. This treatment
improves the ability to compare results across years.

E T H I C S N O T E

Changes in accounting
principle should result in financial
statements that are more
informative for statement users.
They should not be used to
artificially improve the reported
performance or financial position
of the corporation.

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before you go on…

Quality of Earnings 699

Comprehensive Income
The income statement reports most revenues, expenses, gains, and losses recog-
nized during the period. However, over time, specific exceptions to this general
practice have developed. Certain items now bypass income and are reported di-
rectly in stockholders’ equity.

For example, in Chapter 12 you learned that companies do not include in income
any unrealized gains and losses on available-for-sale securities. Instead, they report
such gains and losses in the balance sheet as adjustments to stockholders’ equity.
Why are these gains and losses on available-for-sale securities excluded from net
income? Because disclosing them separately (1) reduces the volatility of net income
due to fluctuations in fair value, yet (2) informs the financial statement user of the
gain or loss that would be incurred if the securities were sold at fair value.

Many analysts have expressed concern over the significant increase in the
number of items that bypass the income statement. They feel that such reporting
has reduced the usefulness of the income statement. To address this concern, in ad-
dition to reporting net income, a company must also report comprehensive income.
Comprehensive income includes all changes in stockholders’ equity during a period
except those resulting from investments by stockholders and distributions to stock-
holders. A number of alternative formats for reporting comprehensive income are
allowed. These formats are discussed in advanced accounting courses.

In its proposed 2011 income statement, AIR Corporation reports income
before income taxes $400,000, extraordinary loss due to earthquake $100,000, income taxes
$120,000 (not including irregular items), loss on operation of discontinued flower division
$50,000, and loss on disposal of discontinued flower division $90,000. The income tax rate is 30%.
Prepare a correct income statement, beginning with “Income before income taxes.”

Solution

Irregular Items
Do it!

Action Plan

• Recall that a loss is
extraordinary if it is both
unusual and infrequent.

• Disclose the income tax effect
of each component of income,
beginning with income before
any irregular items.

• Show discontinued operations
before extraordinary items.

AIR CORPORATION
Income Statement (partial)

For the Year Ended December 31, 2011

Income before income taxes $400,000
Income tax expense 120,000

Income from continuing operations 280,000
Discontinued operations

Loss from operation of flower
division, net of $15,000 tax saving $35,000

Loss on disposal of flower
division, net of $27,000 tax saving 63,000 98,000

Income before extraordinary item 182,000
Extraordinary earthquake loss, net of

$30,000 tax saving 70,000

Net income $112,000

Related exercise material: BE14-14, BE14-15, E14-12, E14-13, and 14-3.Do it!

The Navigator✓

In evaluating the financial performance of a company, the quality of a
company’s earnings is of extreme importance to analysts. A company that
has a high quality of earnings provides full and transparent information
that will not confuse or mislead users of the financial statements.

QUALITY OF EARNINGS

Understand the concept of
quality of earnings.

S T U D Y O B J E C T I V E 7

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700 Chapter 14 Financial Statement Analysis

The issue of quality of earnings has taken on increasing importance because
recent accounting scandals suggest that some companies are spending too much
time managing their income and not enough time managing their business. Here
are some of the factors affecting quality of earnings.

Alternative Accounting Methods
Variations among companies in the application of generally accepted accounting
principles may hamper comparability and reduce quality of earnings. For example,
one company may use the FIFO method of inventory costing, while another com-
pany in the same industry may use LIFO. If inventory is a significant asset to both
companies, it is unlikely that their current ratios are comparable. For example, if
General Motors Corporation had used FIFO instead of LIFO for inventory valua-
tion, its inventories in a recent year would have been 26% higher, which signifi-
cantly affects the current ratio (and other ratios as well).

In addition to differences in inventory costing methods, differences also exist in
reporting such items as depreciation, depletion, and amortization. Although these
differences in accounting methods might be detectable from reading the notes to
the financial statements, adjusting the financial data to compensate for the differ-
ent methods is often difficult, if not impossible.

Pro Forma Income
Companies whose stock is publicly traded are required to present their income
statement following generally accepted accounting principles (GAAP). In recent
years, many companies have also reported a second measure of income, called pro
forma income. Pro forma income usually excludes items that the company thinks
are unusual or nonrecurring. For example, at one time, Cisco Systems (a high-tech
company) reported a quarterly net loss under GAAP of $2.7 billion. Cisco re-
ported pro forma income for the same quarter as a profit of $230 million.This large
difference in profits between GAAP income numbers and pro forma income is not
unusual these days. For example, during one 9-month period the 100 largest firms on
the Nasdaq stock exchange reported a total pro forma income of $19.1 billion, but a
total loss as measured by GAAP of $82.3 billion—a difference of about $100 billion!

To compute pro forma income, companies generally can exclude any items
they deem inappropriate for measuring their performance. Many analysts and in-
vestors are critical of the practice of using pro forma income because these numbers
often make companies look better than they really are. As the financial press
noted, pro forma numbers might be called EBS, which stands for “earnings before
bad stuff.” Companies, on the other hand, argue that pro forma numbers more
clearly indicate sustainable income because they exclude unusual and nonrecurring
expenses.“Cisco’s technique gives readers of financial statements a clear picture of
Cisco’s normal business activities,” the company said in a statement issued in re-
sponse to questions about its pro forma income accounting.

The SEC has provided some guidance on how companies should present pro
forma information. Stay tuned: Everyone seems to agree that pro forma numbers can
be useful if they provide insights into determining a company’s sustainable income.
However, many companies have abused the flexibility that pro forma numbers allow
and have used the measure as a way to put their companies in a good light.

Improper Recognition
Because some managers have felt pressure from Wall Street to continually increase
earnings, they have manipulated the earnings numbers to meet these expectations.
The most common abuse is the improper recognition of revenue. One practice that
companies are using is channel stuffing: Offering deep discounts on their products
to customers, companies encourage their customers to buy early (stuff the channel)

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before you go on…

rather than later.This lets the company report good earnings in the current period,
but it often leads to a disaster in subsequent periods because customers have no
need for additional goods.To illustrate, Bristol-Myers Squibb at one time indicated
that it used sales incentives to encourage wholesalers to buy more drugs than
needed to meet patients’ demands. As a result, the company had to issue revised
financial statements showing corrected revenues and income.

Another practice is the improper capitalization of operating expenses. The
classic case is WorldCom. It capitalized over $7 billion dollars of operating ex-
penses so that it would report positive net income. In other situations, companies
fail to report all their liabilities. Enron had promised to make payments on certain
contracts if financial difficulty developed, but these guarantees were not reported
as liabilities. In addition, disclosure was so lacking in transparency that it was im-
possible to understand what was happening at the company.

Quality of Earnings 701

Match each of the following terms with the phrase that it best matches.

Comprehensive income Vertical analysis
Quality of earnings Pro forma income
Solvency ratio Extraordinary item

1. ______ Measures the ability of the company to survive over a long period of time.

2. ______ Usually excludes items that a company thinks are unusual or non-recurring.

3. ______ Includes all changes in stockholders’ equity during a period except those resulting

from investments by stockholders and distributions to stockholders.

4. ______ Indicates the level of full and transparent information provided to users of the
financial statements.

5. ______ Describes events and transactions that are unusual in nature and infrequent in
occurrence.

6. ______ Expresses each item within a financial statement as a percent of a base amount.

Solution

Quality of Earnings,
Financial Statement Analysis

1. Solvency ratio: Measures the ability of the company to survive over a long period of time.

2. Pro forma income: Usually excludes items that a company thinks are unusual or non-recurring.

3. Comprehensive income: Includes all changes in stockholders’ equity during a period except
those resulting from investments by stockholders and distributions to stockholders.

4. Quality of earnings: Indicates the level of full and transparent information provided to users
of the financial statements.

5. Extraordinary item: Describes events and transactions that are unusual in nature and in-
frequent in occurrence.

6. Vertical analysis: Expresses each item within a financial statement as a percent of a base
amount.

Related exercise material: 14-4.Do it!

The Navigator✓
Action Plan

• Develop a sound understanding
of basic methods used for
financial reporting.

• Understand the use of
fundamental analysis
techniques.

Do it!

Should I Play
the Market Yet?

on page 702 for informa-
tion on how topics in this

chapter apply to you.

all about Y U*
Be sure to read

JWCL165_c14_674-725.qxd 8/20/09 11:11 AM Page 701

Some Facts*
* 83.4 million Americans own stock investments,

either through mutual funds or individual stocks;
89% of stock investors own stock mutual funds.

* 44% of the people who own stock bought their first
stock before 1990.

* The typical equity investor is in his or her late 40s,
is married, is employed, and has a household
income in the low $60,000s.

* 58% of people who own stock said that they rely
on professional financial advisors when making
decisions regarding the purchase and sale of stock.

* 46% of people who own stock used the Internet to
check stock prices, and 38% use it to read online
financial publications.

*all about Y U*

Source: “Equity Ownership in America,” Investment Company Institute and the Securities Industry
Association, 2002, p. 1.

0
10
20
30

40

60

50

U.S. Households
(millions) 15.9 30.2 34.6 40.6 49.2 52.7

Equity Ownership in the U.S., 1983–2002, Selected Years
(number and percent of U.S. households)

19.0%

1983 1989 1992 1995 1999 2002

32.5%

36.6%

41.0%

48.2% 49.5%

IIn this chapter you learned how to use many toolsfor performing a financial analysis of a company.
Sometimes companies fail even though they have a
good product and good sales growth. All too often
the cause of failure is something that should have
caused only momentary discomfort. But if a company
lacks sufficient liquidity, a momentary hiccup can be
fatal. This is true for individual investors as well.

For example, the decision to invest in common
stock can be risky. As a company’s net income
changes, its stock price can be volatile. You must take
this into consideration when deciding whether to buy
stock. You don’t want to be in a situation where you
have to sell a stock whose price has fallen in order to
raise cash to pay your bills.

What Do You Think?*
Rachael West has been working at her new job for six months. She has a
good salary, with lots of opportunities for growth. She has already
accumulated $8,000 in savings, which right now is sitting in a bank savings
account earning very little interest. She has decided to take $7,000 out of
this savings account and buy common stock of her employer, a young
company that has been in business for two years. Rachael’s liquid assets,
including her savings account, total $10,000. Her monthly expenses are
approximately $3,000. Should Rachael make this investment?

YES: She has a good income, and this is a great opportunity for her to get
in on the ground floor of her employer’s fast-growing company.

NO: She shouldn’t invest all of her money in one company, particularly the
company at which she works.

*
The authors’ comments on this situation appear on p. 725.

Source: “Equity Ownership in America,” Investment Company Institute and the Securities Industry
Association, 2002.

Should I Play the Market Yet?

702

About the Numbers*
The percentage of Americans who buy stock, either through mutual funds or individ-
ual shares, has increased significantly in recent years. A big part of this increase is
due to the increasing prevalence of employer-sponsored retirement plans, such as
401(k) plans.

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 702

The events and transactions of Dever Corporation for the year ending December 31, 2011,
resulted in the following data.

Cost of goods sold $2,600,000
Net sales 4,400,000
Other expenses and losses 9,600
Other revenues and gains 5,600
Selling and administrative expenses 1,100,000
Income from operations of plastics division 70,000
Gain from disposal of plastics division 500,000
Loss from tornado disaster (extraordinary loss) 600,000

Analysis reveals that:

1. All items are before the applicable income tax rate of 30%.
2. The plastics division was sold on July 1.
3. All operating data for the plastics division have been segregated.

Instructions
Prepare an income statement for the year.

Solution to Comprehensive Do it!

Do it!

Action Plan
• Report material items not

typical of continuing operations
in separate sections, net of
taxes.

• Associate income taxes with the
item that affects the taxes.

• Apply the corporate tax rate to
income before income taxes to
determine tax expense.

• Recall that all data presented
in determining income before
income taxes are the same as
for unincorporated companies.

Comprehensive

DEVER CORPORATION
Income Statement

For the Year Ended December 31, 2011

Net sales $4,400,000
Cost of goods sold 2,600,000

Gross profit 1,800,000
Selling and administrative expenses 1,100,000

Income from operations 700,000
Other revenues and gains $ 5,600
Other expenses and losses 9,600 4,000

Income before income taxes 696,000
Income tax expense ($696,000 � 30%) 208,800

Income from continuing operations 487,200
Discontinued operations

Income from operations of plastics division, net of
$21,000 income taxes ($70,000 � 30%) 49,000

Gain from disposal of plastics division, net of $150,000
income taxes ($500,000 � 30%) 350,000 399,000

Income before extraordinary item 886,200
Extraordinary item

Tornado loss, net of $180,000 income tax saving
($600,000 � 30%) 420,000

Net income $ 466,200

The Navigator✓

Comprehensive Do it! 703

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1 Discuss the need for comparative analysis. There are
three bases of comparison: (1) Intracompany, which com-
pares an item or financial relationship with other data
within a company. (2) Industry, which compares company
data with industry averages. (3) Intercompany, which com-
pares an item or financial relationship of a company with
data of one or more competing companies.

2 Identify the tools of financial statement analysis.
Financial statements can be analyzed horizontally, verti-
cally, and with ratios.

3 Explain and apply horizontal analysis. Horizontal analy-
sis is a technique for evaluating a series of data over a period
of time to determine the increase or decrease that has taken
place, expressed as either an amount or a percentage.

4 Describe and apply vertical analysis. Vertical analysis is
a technique that expresses each item within a financial
statement in terms of a percentage of a relevant total or a
base amount.

5 Identify and compute ratios used in analyzing a firm’s
liquidity, profitability, and solvency. The formula and
purpose of each ratio was presented in Illustration 14-27
(page 693).

6 Understand the concept of earning power, and how
irregular items are presented. Earning power refers to
a company’s ability to sustain its profits from operations.
“Irregular items”—discontinued operations and extraordi-
nary items—are presented net of tax below income from
continuing operations to highlight their unusual nature.

7 Understand the concept of quality of earnings. A high
quality of earnings provides full and transparent informa-
tion that will not confuse or mislead users of the financial
statements. Issues related to quality of earnings are (1) al-
ternative accounting methods, (2) pro forma income, and
(3) improper recognition.

SUMMARY OF STUDY OBJECTIVES

The Navigator✓

Acid-test (quick) ratio A measure of a company’s immedi-
ate short-term liquidity; computed by dividing the sum of
cash, short-term investments, and net receivables by cur-
rent liabilities. (p. 685).

Asset turnover A measure of how efficiently a company
uses its assets to generate sales; computed by dividing net
sales by average assets. (p. 688).

Change in accounting principle The use of a principle in
the current year that is different from the one used in the
preceding year. (p. 698).

Comprehensive income Includes all changes in stockhold-
ers’ equity during a period except those resulting from
investments by stockholders and distributions to stock-
holders. (p. 699).

Current ratio A measure used to evaluate a company’s
liquidity and short-term debt-paying ability; computed by
dividing current assets by current liabilities. (p. 684).

Debt to total assets ratio Measures the percentage of total
assets provided by creditors; computed by dividing total
debt by total assets. (p. 691).

Discontinued operations The disposal of a significant
segment of a business. (p. 696).

Earnings per share (EPS) The net income earned on each
share of common stock; computed by dividing net income
minus preferred dividends (if any) by the number of
weighted-average common shares outstanding. (p. 690).

Extraordinary items Events and transactions that are un-
usual in nature and infrequent in occurrence. (p. 697).

Horizontal analysis A technique for evaluating a series of
financial statement data over a period of time, to determine

the increase (decrease) that has taken place, expressed as
either an amount or a percentage. (p. 677).

Inventory turnover A measure of the liquidity of inven-
tory; computed by dividing cost of goods sold by average
inventory. (p. 687).

Leveraging See Trading on the equity. (p. 690).

Liquidity ratios Measures of the short-term ability of the
company to pay its maturing obligations and to meet un-
expected needs for cash. (p. 684).

Payout ratio Measures the percentage of earnings distrib-
uted in the form of cash dividends; computed by dividing
cash dividends by net income. (p. 691).

Price-earnings (P-E) ratio Measures the ratio of the market
price of each share of common stock to the earnings per
share; computed by dividing the market price of the stock
by earnings per share. (p. 690).

Profit margin Measures the percentage of each dollar of
sales that results in net income; computed by dividing net
income by net sales. (p. 688).

Profitability ratios Measures of the income or operating
success of a company for a given period of time. (p. 687).

Pro forma income A measure of income that usually ex-
cludes items that a company thinks are unusual or nonre-
curring. (p. 700).

Quality of earnings Indicates the level of full and transpar-
ent information provided to users of the financial state-
ments. (p. 699).

Ratio An expression of the mathematical relationship between
one quantity and another.The relationship may be expressed
either as a percentage, a rate, or a simple proportion. (p. 683).

GLOSSARY

704 Chapter 14 Financial Statement Analysis

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Self-Study Questions 705

Ratio analysis A technique for evaluating financial state-
ments that expresses the relationship between selected
financial statement data. (p. 683).

Receivables turnover A measure of the liquidity of receiv-
ables; computed by dividing net credit sales by average net
receivables. (p. 686).

Return on assets An overall measure of profitability; com-
puted by dividing net income by average assets. (p. 689).

Return on common stockholders’ equity Measures the
dollars of net income earned for each dollar invested by the
owners; computed by dividing net income minus preferred
dividends (if any) by average common stockholders’
equity. (p. 689).

Solvency ratios Measures of the ability of the company to
survive over a long period of time. (p. 691).

Times interest earned Measures a company’s ability to
meet interest payments as they come due; computed by
dividing income before interest expense and income taxes
by interest expense. (p. 692).

Trading on the equity Borrowing money at a lower rate of
interest than can be earned by using the borrowed money.
(p. 690).

Vertical analysis A technique for evaluating financial state-
ment data that expresses each item within a financial state-
ment as a percent of a base amount. (p. 681).

SELF-STUDY

QUESTIONS

Answers are at the end of the chapter.

1. Comparisons of data within a company are an example of
the following comparative basis:
a. Industry averages.
b. Intracompany.
c. Intercompany.
d. Both (b) and (c).

2. In horizontal analysis, each item is expressed as a percent-
age of the:
a. net income amount.
b. stockholders’ equity amount.
c. total assets amount.
d. base year amount.

3. In vertical analysis, the base amount for depreciation ex-
pense is generally:
a. net sales.
b. depreciation expense in a previous year.
c. gross profit.
d. fixed assets.

4. The following schedule is a display of what type of analysis?

Amount Percent

Current assets $200,000 25%
Property, plant,

and equipment 600,000 75%

Total assets $800,000

a. Horizontal analysis.
b. Differential analysis.
c. Vertical analysis.
d. Ratio analysis.

5. Sammy Corporation reported net sales of $300,000,
$330,000, and $360,000 in the years, 2009, 2010, and 2011,
respectively. If 2009 is the base year, what is the trend per-
centage for 2011?
a. 77%.
b. 108%.
c. 120%.
d. 130%.

6. Which of the following measures is an evaluation of a
firm’s ability to pay current liabilities?
a. Acid-test ratio.
b. Current ratio.
c. Both (a) and (b).
d. None of the above.

7. A measure useful in evaluating the efficiency in managing
inventories is:
a. inventory turnover.
b. average days to sell inventory.
c. Both (a) and (b).
d. None of the above.

Use the following financial statement information as of
the end of each year to answer Self-Study Questions 8–12.

2011 2010

Inventory $ 54,000 $ 48,000
Current assets 81,000 106,000
Total assets 482,000 426,000
Current liabilities 27,000 36,000
Total liabilities 102,000 88,000
Common stockholders’ equity 280,000 238,000
Preferred stock 100,000 100,000
Net sales 784,000 697,000
Cost of goods sold 306,000 277,000
Net income 134,000 90,000
Tax expense 22,000 18,000
Interest expense 12,000 12,000
Dividends paid to preferred

stockholders 20,000 20,000
Dividends paid to common

stockholders 15,000 10,000

8. Compute the days in inventory for 2011.
a. 64.4 days. c. 6 days.
b. 60.8 days. d. 24 days.

9. Compute the current ratio for 2011.
a. 1.26:1. c. .80:1.
b. 3.0:1. d. 3.75:1.

(SO 1)

(SO 3)

(SO 4)

(SO 4)
(SO 3)

(SO 5)

(SO 5)
(SO 5)
(SO 5)

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706 Chapter 14 Financial Statement Analysis

10. Compute the profit margin for 2011.
a. 17.1%. c. 37.9%.
b. 18.1%. d. 5.9%.

11. Compute the return on common stockholders’ equity for
2011.
a. 47.9%. c. 40.7%.
b. 51.7%. d. 44.0%.

12. Compute the times interest earned for 2011.
a. 11.2 times. c. 14.0 times.
b. 65.3 times. d. 13.0 times.

13. In reporting discontinued operations, the income state-
ment should show in a special section:
a. gains and losses on the disposal of the discontinued

segment.
b. gains and losses from operations of the discontinued

segment.
c. Both (a) and (b).
d. Neither (a) nor (b).

14. Scout Corporation has income before taxes of $400,000
and an extraordinary loss of $100,000. If the income tax
rate is 25% on all items, the income statement should
show income before extraordinary items and extraordi-
nary items, respectively, of:
a. $325,000 and $100,000.
b. $325,000 and $75,000.
c. $300,000 and $100,000
d. $300,000 and $75,000.

15. Which situation below might indicate a company has a
low quality of earnings?
a. The same accounting principles are used each year.
b. Revenue is recognized when earned.
c. Maintenance costs are expensed as incurred.
d. The company is continually reporting pro forma income

numbers.

Go to the book’s companion website,
www.wiley.com/college/weygandt,
for Additional Self-Study Questions.

(SO 5)

(SO 6)

(SO 7)

The Navigator✓
(SO 5)
(SO 5)
(SO 6)
QUESTIONS

1. (a) Juan Marichal believes that the analysis of financial
statements is directed at two characteristics of a com-
pany: liquidity and profitability. Is Juan correct? Explain.

(b) Are short-term creditors, long-term creditors, and
stockholders interested primarily in the same charac-
teristics of a company? Explain.

2. (a) Distinguish among the following bases of comparison:
(1) intracompany, (2) industry averages, and (3) inter-
company.

(b) Give the principal value of using each of the three
bases of comparison.

3. Two popular methods of financial statement analysis
are horizontal analysis and vertical analysis. Explain
the difference between these two methods.

4. (a) If Leonard Company had net income of $360,000 in
2011 and it experienced a 24.5% increase in net in-
come for 2012, what is its net income for 2012?

(b) If six cents of every dollar of Leonard revenue is net
income in 2011, what is the dollar amount of 2011
revenue?

5. What is a ratio? What are the different ways of expressing
the relationship of two amounts? What information does a
ratio provide?

6. Name the major ratios useful in assessing (a) liquidity and
(b) solvency.

7. Raphael Ochoa is puzzled. His company had a profit margin
of 10% in 2011. He feels that this is an indication that the
company is doing well. Cindy Lore, his accountant, says
that more information is needed to determine the firm’s
financial well-being. Who is correct? Why?

8. What do the following classes of ratios measure? (a)
Liquidity ratios. (b) Profitability ratios. (c) Solvency ratios.

9. What is the difference between the current ratio and the
acid-test ratio?

10. Donte Company, a retail store, has a receivables turnover
of 4.5 times. The industry average is 12.5 times. Does
Donte have a collection problem with its receivables?

11. Which ratios should be used to help answer the following
questions?
(a) How efficient is a company in using its assets to pro-

duce sales?
(b) How near to sale is the inventory on hand?
(c) How many dollars of net income were earned for each

dollar invested by the owners?
(d) How able is a company to meet interest charges as

they fall due?

12. The price-earnings ratio of General Motors (automobile
builder) was 8, and the price-earnings ratio of Microsoft
(computer software) was 38.Which company did the stock
market favor? Explain.

13. What is the formula for computing the payout ratio?
Would you expect this ratio to be high or low for a growth
company?

14. Holding all other factors constant, indicate whether each
of the following changes generally signals good or bad
news about a company.
(a) Increase in profit margin.
(b) Decrease in inventory turnover.
(c) Increase in the current ratio.
(d) Decrease in earnings per share.

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 706

Brief Exercises 707

(e) Increase in price-earnings ratio.
(f) Increase in debt to total assets ratio.
(g) Decrease in times interest earned.

15. The return on assets for Tresh Corporation is 7.6%.
During the same year Tresh’s return on common stock-
holders’ equity is 12.8%. What is the explanation for the
difference in the two rates?

16. Which two ratios do you think should be of greatest inter-
est to:
(a) A pension fund considering the purchase of 20-year

bonds?
(b) A bank contemplating a short-term loan?
(c) A common stockholder?

17. Why must preferred stock dividends be subtracted from
net income in computing earnings per share?

18. (a) What is meant by trading

on the equity?

(b) How would you determine the profitability of trading

on the equity?

19. Hillman Inc. has net income of $160,000, weighted-average
shares of common stock outstanding of 50,000, and pre-
ferred dividends for the period of $40,000.What is Hillman’s
earnings per share of common stock? Kate Hillman, the
president of Hillman Inc., believes the computed EPS of
the company is high. Comment.

20. Why is it important to report discontinued operations
separately from income from continuing operations?

21. You are considering investing in Shawnee Transportation.
The company reports 2011 earnings per share of $6.50 on
income before extraordinary items and $4.75 on net in-
come. Which EPS figure would you consider more rele-
vant to your investment decision? Why?

22. STL Inc. reported 2010 earnings per share of $3.20 and
had no extraordinary items. In 2011, EPS on income
before extraordinary items was $2.99, and EPS on net in-
come was $3.49. Is this a favorable trend?

23. Indicate which of the following items would be reported
as an extraordinary item in Mordica Corporation’s in-
come statement.
(a) Loss from damages caused by volcano eruption.
(b) Loss from sale of temporary investments.
(c) Loss attributable to a labor strike.
(d) Loss caused when manufacture of a product was pro-

hibited by the Food and Drug Administration.
(e) Loss from flood damage. (The nearby Black River

floods every 2 to 3 years.)
(f) Write-down of obsolete inventory.
(g) Expropriation of a factory by a foreign government.

24. Identify and explain factors that affect quality of earnings.

25. Identify the specific sections in PepsiCo’s 2008
annual report where horizontal and vertical analyses of fi-
nancial data are presented.

BRIEF

EXERCISES

Follow the rounding procedures used in the chapter.

BE14-1 You recently received a letter from your Uncle Frank. A portion of the letter is pre-
sented below.

You know that I have a significant amount of money I saved over the years. I am thinking about
starting an investment program. I want to do the investing myself, based on my own research and
analysis of financial statements. I know that you are studying accounting, so I have a couple of
questions for you. I have heard that different users of financial statements are interested in dif-
ferent characteristics of companies. Is this true, and, if so, why? Also, some of my friends, who are
already investing, have told me that comparisons involving a company’s financial data can be
made on a number of different bases. Can you explain these bases to me?

Instructions
Write a letter to your Uncle Frank which answers his questions.

BE14-2 Drew Carey Corporation reported the following amounts in 2010, 2011, and 2012.

2010 2011 2012

Current assets $200,000 $230,000 $240,000
Current liabilities $160,000 $168,000 $184,000
Total assets $500,000 $600,000 $620,000

Instructions
(a) Identify and describe the three tools of financial statement analysis. (b) Perform each of the
three types of analysis on Drew Carey’s current assets.

Discuss need for comparative
analysis.

(SO 1)

Identify and use tools of
financial statement analysis.

(SO 2, 3, 4, 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 707

BE14-3 Using the following data from the comparative balance sheet of Rodenbeck
Company, illustrate horizontal analysis.

December 31, 2012 December 31, 2011

Accounts receivable $ 520,000 $ 400,000
Inventory $ 840,000 $ 600,000
Total assets $3,000,000 $2,500,000

BE14-4 Using the same data presented above in BE14-3 for Rodenbeck Company, illustrate
vertical analysis.

BE14-5 Net income was $500,000 in 2010, $450,000 in 2011, and $522,000 in 2012. What is the
percentage of change from (a) 2010 to 2011 and (b) 2011 to 2012? Is the change an increase or a
decrease?

BE14-6 If Soule Company had net income of $585,000 in 2012 and it experienced a 30% in-
crease in net income over 2011, what was its 2011 net income?

BE14-7 Horizontal analysis (trend analysis) percentages for Epstein Company’s sales, cost of
goods sold, and expenses are shown below.

Horizontal Analysis

2012 2011 2010

Sales 96.2 106.8 100.0
Cost of goods sold 102.0 97.0 100.0
Expenses 109.6 98.4 100.0

Did Epstein’s net income increase, decrease, or remain unchanged over the 3-year period?

BE14-8 Vertical analysis (common size) percentages for Charles Company’s sales, cost of
goods sold, and expenses are shown below.

Vertical Analysis 2012 2011 2010

Sales 100.0 100.0 100.0
Cost of goods sold 59.2 62.4 64.5
Expenses 25.0 25.6 27.5

Did Charles’s net income as a percent of sales increase, decrease, or remain unchanged over the
3-year period? Provide numerical support for your answer.

BE14-9 Selected condensed data taken from a recent balance sheet of Perkins Inc. are as follows.

PERKINS INC.
Balance Sheet (partial)

Cash $ 8,041,000
Short-term investments 4,947,000
Accounts receivable 12,545,000
Inventories 14,814,000
Other current assets 5,571,000

Total current assets $45,918,000

Total current liabilities $40,644,000

What are the (a) working capital, (b) current ratio, and (c) acid-test ratio?

BE14-10 McLaren Corporation has net income of $11.44 million and net revenue of $80 mil-
lion in 2010. Its assets are $14 million at the beginning of the year and $18 million at the end of
the year. What are McLaren’s (a) asset turnover and (b) profit margin?

BE14-11 The following data are taken from the financial statements of Morino Company.

2012 2011

Accounts receivable (net), end of year $ 550,000 $ 520,000
Net sales on account 3,960,000 3,100,000
Terms for all sales are 1/10, n/60.

(a) Compute for each year (1) the receivables turnover and (2) the average collection period.
At the end of 2010, accounts receivable (net) was $480,000.

708 Chapter 14 Financial Statement Analysis

Prepare vertical analysis.

(SO 4)

Calculate percentage of change.

(SO 3)

Calculate net income.

(SO 3)

Calculate change in net income.

(SO 3)
Calculate change in net income.
(SO 4)

Calculate liquidity ratios.

(SO 5)

Prepare horizontal analysis.

(SO 3)

Calculate profitability ratios.

(SO 5)

Evaluate collection of accounts
receivable.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 708

(b) What conclusions about the management of accounts receivable can be drawn
from

these data?

BE14-12 The following data are from the income statements of Huntsinger Company.

2012 2011
Sales $6,420,000 $6,240,000
Beginning inventory 980,000 860,000
Purchases 4,340,000 4,661,000
Ending inventory 1,020,000 980,000

(a) Compute for each year (1) the inventory turnover and (2) the average days to sell the inventory.
(b) What conclusions concerning the management of the inventory can be drawn from

these data?

BE14-13 Gladow Company has stockholders’ equity of $400,000 and net income of $66,000. It
has a payout ratio of 20% and a rate of return on assets of 15%. How much did Gladow pay in
cash dividends, and what were its average assets?

BE14-14 An inexperienced accountant for Ming Corporation showed the following in the
income statement: income before income taxes and extraordinary item $400,000, and extraordi-
nary loss from flood (before taxes) $70,000. The extraordinary loss and taxable income are both
subject to a 30% tax rate. Prepare a correct income statement.

BE14-15 On June 30, Reeves Corporation discontinued its operations in Mexico. During the
year, the operating loss from the Mexico facility was $300,000 before taxes. On September 1,
Reeves disposed of the Mexico facility at a pretax loss of $120,000. The applicable tax rate is
30%. Show the discontinued operations section of the income statement.

Do it! Review 709

Evaluate management of
inventory.

(SO 5)
Calculate profitability ratios.
(SO 5)

Prepare income statement
including extraordinary items.

(SO 6)

Prepare discontinued
operations section of income
statement.

(SO 6)

14-1 Summary financial information for Holland Company is as follows.

December 31, 2012 December 31, 2011

Current assets $ 199,000 $ 220,000
Plant assets 821,000 780,000

Total assets $1,020,000 $1,000,000

Compute the amount and percentage changes in 2012 using horizontal analysis, assuming 2011 is
the base year.

14-2 The condensed financial statements of Eau Fraîche Company for the years 2010
and 2011 are presented below.

EAU FRAÎCHE COMPANY
Balance Sheets
December 31

2011 2010
Current assets

Cash and cash equivalents $ 330 $ 360
Accounts receivable (net) 470 400
Inventories 460 390
Prepaid expenses 120 160

Total current assets 1,380 1,310
Property, plant, and equipment 420 380
Investments 10 10
Intangibles and other assets 530 510

Total assets $2,340 $2,210

Current liabilities $ 900 $ 790
Long-term liabilities 410 380
Stockholders’ equity—common 1,030 1,040

Total liabilities and stockholders’ equity $2,340 $2,210

Do it!
Do it!

ReviewDo it!
Prepare horizontal analysis.

(SO 3)

Compute ratios.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 709

EAU FRAÎCHE COMPANY
Income Statements

For the Years Ended December 31
2011 2010

Revenues $3,800 $3,460

Costs and expenses
Cost of goods sold 970 890
Selling & administrative expenses 2,400 2,330
Interest expense 10 20

Total costs and expenses 3,380 3,240

Income before income taxes 420 220
Income tax expense 168 132

Net income $ 252 $ 88

Compute the following ratios for 2010 and 2011.
(a) Current ratio.
(b) Inventory turnover. (Inventory on 12/31/09 was $340.)
(c) Profit margin.
(d) Return on assets. (Assets on 12/31/09 were $1,900.)
(e) Return on common stockholders’ equity.(Stockholders’ equity—common on 12/31/09 was $900.)
(f) Debt to total assets ratio.
(g) Times interest earned.

14-3 In its proposed 2011 income statement, Supply Corporation reports income
before income taxes $500,000, extraordinary loss due to earthquake $150,000, income taxes
$200,000 (not including irregular items), loss on operation of discontinued music division
$60,000, and gain on disposal of discontinued music division $40,000.The income tax rate is 40%.
Prepare a correct income statement, beginning with income before income taxes.

14-4 Match each of the following terms with the phrase that it best matches.

(a) Quality of earnings (d) Pro forma income
(b) Current ratio (e) Discontinued operations
(c) Horizontal analysis (f) Comprehensive income

1. ______ A measure used to evaluate a company’s liquidity.
2. ______ Usually excludes items that a company thinks are unusual or nonrecurring.
3. ______ Indicates the level of full and transparent information provided to users of the finan-

cial statements.
4. ______ The disposal of a significant segment of a business.
5. ______ Determines increases or decreases in a series of financial statement data.
6. ______ Includes all changes in stockholders’ equity during a period except those resulting

from investments by stockholders and distributions to stockholders.
Do it!
Do it!

710 Chapter 14 Financial Statement Analysis

Prepare income statement,
including irregular items.

(SO 6)

Match terms relating to quality
of earnings and financial
statement analysis.

(SO 3, 4, 5, 6, 7)

Follow the rounding procedures used in the chapter.

E14-1 Financial information for Blevins Inc. is presented below.

December 31, 2012 December 31, 2011

Current assets $125,000 $100,000
Plant assets (net) 396,000 330,000
Current liabilities 91,000 70,000
Long-term liabilities 133,000 95,000
Common stock, $1 par 161,000 115,000
Retained earnings 136,000 150,000

Instructions
Prepare a schedule showing a horizontal analysis for 2012 using 2011 as the base year.

EXERCISES
Prepare horizontal analysis.
(SO 3)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 710

E14-2 Operating data for Gallup Corporation are presented below.

2012 2011

Sales $750,000 $600,000
Cost of goods sold 465,000 390,000
Selling expenses 120,000 72,000
Administrative expenses 60,000 54,000
Income tax expense 33,000 24,000
Net income 72,000 60,000

Instructions
Prepare a schedule showing a vertical analysis for 2012 and 2011.

E14-3 The comparative condensed balance sheets of Conard Corporation are presented below.

CONARD CORPORATION
Comparative Condensed Balance Sheets

December 31
2012 2011

Assets
Current assets $ 74,000 $ 80,000
Property, plant, and equipment (net) 99,000 90,000
Intangibles 27,000 40,000

Total assets $200,000 $210,000

Liabilities and stockholders’ equity
Current liabilities $ 42,000 $ 48,000
Long-term liabilities 143,000 150,000
Stockholders’ equity 15,000 12,000

Total liabilities and stockholders’ equity $200,000 $210,000

Instructions
(a) Prepare a horizontal analysis of the balance sheet data for Conard Corporation using 2011

as a base.
(b) Prepare a vertical analysis of the balance sheet data for Conard Corporation in columnar

form for 2012.

E14-4 The comparative condensed income statements of Hendi Corporation are shown below.

HENDI CORPORATION
Comparative Condensed Income Statements

For the Years Ended December 31
2012 2011

Net sales $600,000 $500,000
Cost of goods sold 483,000 420,000

Gross profit 117,000 80,000
Operating expenses 57,200 44,000

Net income $ 59,800 $ 36,000

Instructions
(a) Prepare a horizontal analysis of the income statement data for Hendi Corporation using

2011 as a base.
(b) Prepare a vertical analysis of the income statement data for Hendi Corporation in columnar

form for both years.

E14-5 Nordstrom, Inc. operates department stores in numerous states. Selected financial
statement data for the year ending January 31, 2009, are shown on the next page.

Exercises 711

Prepare vertical analysis.
(SO 4)

Prepare horizontal and vertical
analyses.

(SO 3, 4)

Prepare horizontal and vertical
analyses.
(SO 3, 4)

Compute liquidity ratios and
compare results.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 711

For the year, net credit sales were $8,272, and cost of goods sold was $5,417 (in millions).

Instructions
(a) Compute the four liquidity ratios at the end of the year.
(b) Using the data in the chapter, compare Nordstrom’s liquidity with (1) that of J.C. Penney

Company, and (2) the industry averages for department stores.

E14-6 Leach Incorporated had the following transactions occur involving current assets and
current liabilities during February 2011.

Feb. 3 Accounts receivable of $15,000 are collected.
7 Equipment is purchased for $28,000 cash.

11 Paid $3,000 for a 3-year insurance policy.
14 Accounts payable of $12,000 are paid.
18 Cash dividends of $5,000 are declared.

Additional information:

1. As of February 1, 2011, current assets were $130,000, and current liabilities were $50,000.
2. As of February 1, 2011, current assets included $15,000 of inventory and $2,000 of prepaid

expenses.

Instructions
(a) Compute the current ratio as of the beginning of the month and after each transaction.
(b) Compute the acid-test ratio as of the beginning of the month and after each transaction.

E14-7 Bennis Company has the following comparative balance sheet data.

BENNIS COMPANY
Balance Sheets
December 31

2012 2011

Cash $ 15,000 $ 30,000
Receivables (net) 70,000 60,000
Inventories 60,000 50,000
Plant assets (net) 200,000 180,000

$345,000 $320,000

Accounts payable $ 50,000 $ 60,000
Mortgage payable (15%) 100,000 100,000
Common stock, $10 par 140,000 120,000
Retained earnings 55,000 40,000

$345,000 $320,000

Additional information for 2012:

1. Net income was $25,000.
2. Sales on account were $410,000. Sales returns and allowances were $20,000.
3. Cost of goods sold was $198,000.
4. The allowance for doubtful accounts was $2,500 on December 31, 2012, and $2,000 on

December 31, 2011.

712 Chapter 14 Financial Statement Analysis

NORDSTROM, INC.
Balance Sheet (partial)

(in millions) End-of-Year Beginning-of-Year

Cash and cash equivalents $ 72 $ 358
Accounts receivable (net) 1,942 1,788
Merchandise inventory 900 956
Prepaid expenses 93 78
Other current assets 210 181
Total current assets $3,217 $3,361

Total current liabilities $1,601 $1,635

Perform current and acid-test
ratio analysis.

(SO 5)

Compute selected ratios.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 712

Instructions
Compute the following ratios at December 31, 2012.

(a) Current.
(b) Acid-test.
(c) Receivables turnover.
(d) Inventory turnover.

E14-8 Selected comparative financial statement data for Willingham Products Company are
presented below. All balance sheet data are as of December 31.

2012 2011

Net sales $760,000 $720,000
Cost of goods sold 480,000 440,000
Interest expense 7,000 5,000
Net income 50,000 42,000
Accounts receivable 120,000 100,000
Inventory 85,000 75,000
Total assets 580,000 500,000
Total common stockholders’ equity 430,000 325,000

Instructions
Compute the following ratios for 2012.

(a) Profit margin.
(b) Asset turnover.
(c) Return on assets.
(d) Return on common stockholders’ equity.

E14-9 The income statement for Christensen, Inc., appears below.

CHRISTENSEN, INC.
Income Statement

For the Year Ended December 31, 2011

Sales $400,000
Cost of goods sold 230,000

Gross profit 170,000
Expenses (including $16,000 interest and $24,000 income taxes) 105,000

Net income $ 65,000

Additional information:

1. The weighted-average common shares outstanding in 2011 were 30,000 shares.
2. The market price of Christensen, Inc. stock was $13 in 2011.
3. Cash dividends of $26,000 were paid, $5,000 of which were to preferred stockholders.

Instructions
Compute the following ratios for 2011.

(a) Earnings per share.
(b) Price-earnings.
(c) Payout.
(d) Times interest earned.

E14-10 Rees Corporation experienced a fire on December 31, 2012, in which its financial
records were partially destroyed. It has been able to salvage some of the records and has ascer-
tained the following balances.

December 31, 2012 December 31, 2011

Cash $ 30,000 $ 10,000
Receivables (net) 72,500 126,000
Inventory 200,000 180,000
Accounts payable 50,000 90,000
Notes payable 30,000 60,000
Common stock, $100 par 400,000 400,000
Retained earnings 113,500 101,000

Compute selected ratios.
(SO 5)
Compute selected ratios.
(SO 5)

Compute amounts from ratios.

(SO 5)

Exercises 713

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 713

Additional information:

1. The inventory turnover is 3.5 times.
2. The return on common stockholders’ equity is 24%. The company had no additional paid-in

capital.
3. The receivables turnover is 8.8 times.
4. The return on assets is 20%.
5. Total assets at December 31, 2011, were $605,000.

Instructions
Compute the following for Rees Corporation.

(a) Cost of goods sold for 2012.
(b) Net sales (credit) for 2012.
(c) Net income for 2012.
(d) Total assets at December 31, 2012.

E14-11 Scully Corporation’s comparative balance sheets are presented below.

SCULLY CORPORATION
Balance Sheets
December 31

2011 2010
Cash $ 4,300 $ 3,700
Accounts receivable 21,200 23,400
Inventory 10,000 7,000
Land 20,000 26,000
Building 70,000 70,000
Accumulated depreciation (15,000) (10,000)

Total $110,500 $120,100

Accounts payable $ 12,370 $ 31,100
Common stock 75,000 69,000
Retained earnings 23,130 20,000

Total $110,500 $120,100

Scully’s 2011 income statement included net sales of $100,000, cost of goods sold of $60,000, and
net income of $15,000.

Instructions
Compute the following ratios for 2011.

(a) Current ratio.
(b) Acid-test ratio.
(c) Receivables turnover.
(d) Inventory turnover.
(e) Profit margin.
(f) Asset turnover.
(g) Return on assets.
(h) Return on common stockholders’ equity.
(i) Debt to total assets ratio.

E14-12 For its fiscal year ending October 31, 2011, Molini Corporation reports the following
partial data.

Income before income taxes $540,000
Income tax expense (30% � $390,000) 117,000

Income before extraordinary items 423,000
Extraordinary loss from flood 150,000

Net income $273,000

The flood loss is considered an extraordinary item. The income tax rate is 30% on all items.

714 Chapter 14 Financial Statement Analysis

Compute ratios.
(SO 5)

Prepare a correct income
statement.

(SO 6)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 714

Instructions
(a) Prepare a correct income statement, beginning with income before income taxes.
(b) Explain in memo form why Molini’s reported income statement data are incorrect.

E14-13 Yadier Corporation has income from continuing operations of $290,000 for the year
ended December 31, 2011. It also has the following items (before considering income taxes).

1. An extraordinary loss of $80,000.
2. A gain of $30,000 on the discontinuance of a division.
3. A correction of an error in last year’s financial statements that resulted in a $20,000 under-

statement of 2010 net income.

Assume all items are subject to income taxes at a 30% tax rate.

Instructions
(a) Prepare an income statement, beginning with income from continuing operations.
(b) Indicate the statement presentation of any item not included in (a) above.

Problems 715

EXERCISES: SET B AND CHALLENGE EXERCISES

Visit the book’s companion website at www.wiley.com/college/weygandt, and choose the Student
Companion site, to access Exercise Set B and a set of Challenge Exercises.

w
w

w

.wiley.com

/c
o

ll
e

g
e
/w

ey
gandt

Prepare income statement.

(SO 6)
Follow the rounding procedures used in the chapter.

P14-1 Comparative financial statement data for Douglas Company and Maulder Company,
two competitors, appear below. All balance sheet data are as of December 31, 2012, and
December 31, 2011.

Douglas Company Maulder Company

2012 2011 2012 2011

Net sales $1,549,035 $339,038
Cost of goods sold 1,080,490 241,000
Operating expenses 302,275 79,000
Interest expense 8,980 2,252
Income tax expense 54,500 6,650
Current assets 325,975 $312,410 83,336 $ 79,467
Plant assets (net) 521,310 500,000 139,728 125,812
Current liabilities 65,325 75,815 35,348 30,281
Long-term liabilities 108,500 90,000 29,620 25,000
Common stock, $10 par 500,000 500,000 120,000 120,000
Retained earnings 173,460 146,595 38,096 29,998

Instructions
(a) Prepare a vertical analysis of the 2012 income statement data for Douglas Company and

Maulder Company in columnar form.
(b) Comment on the relative profitability of the companies by computing the return

on assets and the return on common stockholders’ equity ratios for both companies.

PROBLEMS

Prepare vertical analysis and
comment on profitability.

(SO 4, 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 715

P14-2 The comparative statements of Villa Tool Company are presented below.

VILLA TOOL COMPANY
Income Statements

For the Years Ended December 31
2012 2011

Net sales $1,818,500 $1,750,500
Cost of goods sold 1,011,500 996,000

Gross profit 807,000 754,500
Selling and administrative expense 516,000 479,000

Income from operations 291,000 275,500
Other expenses and losses

Interest expense 18,000 14,000

Income before income taxes 273,000 261,500
Income tax expense 81,000 77,000

Net income $ 192,000 $ 184,500

VILLA TOOL COMPANY
Balance Sheets
December 31

Assets 2012 2011

Current assets
Cash $ 60,100 $ 64,200
Short-term investments 69,000 50,000
Accounts receivable (net) 117,800 102,800
Inventory 123,000 115,500

Total current assets 369,900 332,500

Plant assets (net) 600,300 520,300

Total assets $970,200 $852,800

Liabilities and Stockholders’ Equity

Current liabilities
Accounts payable $160,000 $145,400
Income taxes payable 43,500 42,000

Total current liabilities 203,500 187,400

Bonds payable 200,000 200,000

Total liabilities 403,500 387,400

Stockholders’ equity
Common stock ($5 par) 280,000 300,000
Retained earnings 286,700 165,400

Total stockholders’ equity 566,700 465,400

Total liabilities and stockholders’ equity $970,200 $852,800

Instructions
Compute the following ratios for 2012. (Weighted-average common shares in 2012 were 57,000,
and all sales were on account.)

(a) Earnings per share. (f) Receivables turnover.
(b) Return on common stockholders’ equity. (g) Inventory turnover.
(c) Return on assets. (h) Times interest earned.
(d) Current. (i) Asset turnover.
(e) Acid-test. (j) Debt to total assets.

716 Chapter 14 Financial Statement Analysis

Compute ratios from balance
sheet and income statement.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 716

P14-3 Condensed balance sheet and income statement data for Kersenbrock Corporation
appear below.

KERSENBROCK CORPORATION
Balance Sheets
December 31

2012 2011 2010

Cash $ 25,000 $ 20,000 $ 18,000
Receivables (net) 50,000 45,000 48,000
Other current assets 90,000 95,000 64,000
Investments 75,000 70,000 45,000
Plant and equipment (net) 400,000 370,000 358,000

$640,000 $600,000 $533,000

Current liabilities $ 75,000 $ 80,000 $ 70,000
Long-term debt 80,000 85,000 50,000
Common stock, $10 par 340,000 310,000 300,000
Retained earnings 145,000 125,000 113,000

$640,000 $600,000 $533,000

KERSENBROCK CORPORATION
Income Statements

For the Years Ended December 31
2012 2011

Sales $740,000 $700,000
Less: Sales returns and allowances 40,000 50,000

Net sales 700,000 650,000
Cost of goods sold 420,000 400,000

Gross profit 280,000 250,000
Operating expenses (including income taxes) 235,000 220,000

Net income $ 45,000 $ 30,000

Additional information:

1. The market price of Kersenbrock’s common stock was $4.00, $5.00, and $8.00 for 2010, 2011,
and 2012, respectively.

2. All dividends were paid in cash.

Instructions
(a) Compute the following ratios for 2011 and 2012.

(1) Profit margin.
(2) Asset turnover.
(3) Earnings per share. (Weighted-average common shares in 2012 were 32,000 and in 2011

were 31,000.)
(4) Price-earnings.
(5) Payout.
(6) Debt to total assets.

(b) Based on the ratios calculated, discuss briefly the improvement or lack
thereof in financial position and operating results from 2011 to 2012 of Kersenbrock
Corporation.

Problems 717

Perform ratio analysis, and
evaluate financial position and
operating results.

(SO 5)

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 717

P14-4 Financial information for Hanshew Company is presented below.

HANSHEW COMPANY
Balance Sheets
December 31

Assets 2012 2011

Cash $ 70,000 $ 65,000
Short-term investments 52,000 40,000
Receivables (net) 98,000 80,000
Inventories 125,000 135,000
Prepaid expenses 29,000 23,000
Land 130,000 130,000
Building and equipment (net) 180,000 175,000

$684,000 $648,000

Liabilities and Stockholders’ Equity

Notes payable $100,000 $100,000
Accounts payable 48,000 42,000
Accrued liabilities 50,000 40,000
Bonds payable, due 2015 150,000 150,000
Common stock, $10 par 200,000 200,000
Retained earnings 136,000 116,000

$684,000 $648,000

HANSHEW COMPANY
Income Statements

For the Years Ended December 31
2012 2011

Sales $850,000 $790,000
Cost of goods sold 620,000 575,000

Gross profit 230,000 215,000
Operating expenses 187,000 173,000

Net income $ 43,000 $ 42,000

Additional information:

1. Inventory at the beginning of 2011 was $118,000.
2. Receivables (net) at the beginning of 2011 were $88,000.
3. Total assets at the beginning of 2011 were $630,000.
4. No common stock transactions occurred during 2011 or 2012.
5. All sales were on account.

Instructions
(a) Indicate, by using ratios, the change in liquidity and profitability of Hanshew Company from

2011 to 2012. (Note: Not all profitability ratios can be computed.)
(b) Given below are three independent situations and a ratio that may be affected. For each

situation, compute the affected ratio (1) as of December 31, 2012, and (2) as of December 31,
2013, after giving effect to the situation. Net income for 2013 was $50,000. Total assets on
December 31, 2013, were $700,000.

Situation Ratio

(1) 18,000 shares of common stock were sold Return on common stockholders’
at par on July 1, 2013. equity

(2) All of the notes payable were paid in 2013. Debt to total assets
The only change in liabilities was that the
notes payable were paid.

(3) Market price of common stock was $9 Price-earnings ratio
on December 31, 2012, and $12.80 on
December 31, 2013.

718 Chapter 14 Financial Statement Analysis

Compute ratios, and comment
on overall liquidity and
profitability.

(SO 5)

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P14-5 Selected financial data of Target and Wal-Mart for a recent year are presented here (in
millions).

Target Wal-Mart
Corporation Stores, Inc.

Income Statement Data for Year

Net sales $61,471 $374,526
Cost of goods sold 41,895 286,515
Selling and administrative expenses 16,200 70,847
Interest expense 647 1,798
Other income (expense) 1,896 4,273
Income tax expense 1,776 6,908

Net income $ 2,849 $ 12,731

Balance Sheet Data (End of Year)

Current assets $18,906 $ 47,585
Noncurrent assets 25,654 115,929

Total assets $44,560 $163,514

Current liabilities $11,782 $ 58,454
Long-term debt 17,471 40,452
Total stockholders’ equity 15,307 64,608
Total liabilities and stockholders’ equity $44,560 $163,514

Beginning-of-Year Balances

Total assets $37,349 $151,587
Total stockholders’ equity 15,633 61,573
Current liabilities 11,117 52,148
Total liabilities 21,716 90,014

Other Data

Average net receivables $ 7,124 $ 3,247
Average inventory 6,517 34,433
Net cash provided by operating activities 4,125 20,354

Instructions
(a) For each company, compute the following ratios.

(1) Current. (7) Asset turnover.
(2) Receivables turnover. (8) Return on assets.
(3) Average collection period. (9) Return on common stockholders’ equity.
(4) Inventory turnover. (10) Debt to total assets.
(5) Days in inventory. (11) Times interest earned.
(6) Profit margin.

(b) Compare the liquidity, profitability, and solvency of the two companies.

P14-6 The comparative statements of Dillon Company are presented below and on the next page.

DILLON COMPANY
Income Statements

For the Years Ended December 31
2012 2011

Net sales (all on account) $600,000 $520,000

Expenses
Cost of goods sold 415,000 354,000
Selling and administrative 120,800 114,800
Interest expense 7,800 6,000
Income tax expense 18,000 14,000

Total expenses 561,600 488,800

Net income $ 38,400 $ 31,200

Problems 719

Compute selected ratios, and
compare liquidity, profitability,
and solvency for two
companies.

(SO 5)

Compute numerous ratios.

(SO 5)

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DILLON COMPANY
Balance Sheets
December 31

Assets 2012 2011

Current assets
Cash $ 21,000 $ 18,000
Short-term investments 18,000 15,000
Accounts receivable (net) 86,000 74,000
Inventory 90,000 70,000

Total current assets 215,000 177,000

Plant assets (net) 423,000 383,000

Total assets $638,000 $560,000

Liabilities and Stockholders’ Equity

Current liabilities
Accounts payable $122,000 $110,000
Income taxes payable 23,000 20,000

Total current liabilities 145,000 130,000

Long-term liabilities
Bonds payable 120,000 80,000

Total liabilities 265,000 210,000

Stockholders’ equity
Common stock ($5 par) 150,000 150,000
Retained earnings 223,000 200,000

Total stockholders’ equity 373,000 350,000

Total liabilities and stockholders’ equity $638,000 $560,000

Additional data:

The common stock recently sold at $19.50 per share.
The year-end balance in the allowance for doubtful accounts was $3,000 for 2012 and $2,400 for 2011.

Instructions
Compute the following ratios for 2012.

(a) Current. (h) Return on common stockholders’ equity.
(b) Acid-test. (i) Earnings per share.
(c) Receivables turnover. (j) Price-earnings.
(d) Inventory turnover. (k) Payout.
(e) Profit margin. (l) Debt to total assets.
(f) Asset turnover. (m) Times interest earned.
(g) Return on assets.

P14-7 Presented below and on the next page is an incomplete income statement and an in-
complete comparative balance sheet of Cotte Corporation.

COTTE CORPORATION
Income Statement

For the Year Ended December 31, 2012

Sales $11,000,000
Cost of goods sold ?

Gross profit ?
Operating expenses 1,665,000

Income from operations ?
Other expenses and losses

Interest expense ?

Income before income taxes ?
Income tax expense 560,000

Net income $ ?

720 Chapter 14 Financial Statement Analysis

Compute missing information
given a set of ratios.

(SO 5)

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COTTE CORPORATION
Balance Sheets
December 31

Assets 2012 2011

Current assets
Cash $ 450,000 $ 375,000
Accounts receivable (net) ? 950,000
Inventory ? 1,720,000

Total current assets ? 3,045,000

Plant assets (net) 4,620,000 3,955,000

Total assets $ ? $7,000,000

Liabilities and Stockholders’ Equity

Current liabilities $ ? $ 825,000
Long-term notes payable ? 2,800,000

Total liabilities ? 3,625,000

Common stock, $1 par 3,000,000 3,000,000
Retained earnings 400,000 375,000

Total stockholders’ equity 3,400,000 3,375,000

Total liabilities and stockholders’ equity $ ? $7,000,000

Additional information:

1. The receivables turnover for 2012 is 10 times.
2. All sales are on account.
3. The profit margin for 2012 is 14.5%.
4. Return on assets is 22% for 2012.
5. The current ratio on December 31, 2012, is 3.0.
6. The inventory turnover for 2012 is 4.8 times.

Instructions
Compute the missing information given the ratios above. Show computations. (Note: Start with
one ratio and derive as much information as possible from it before trying another ratio. List all
missing amounts under the ratio used to find the information.)

P14-8 Cheaney Corporation owns a number of cruise ships and a chain of hotels. The hotels,
which have not been profitable, were discontinued on September 1, 2011. The 2011 operating re-
sults for the company were as follows.

Operating revenues $12,850,000
Operating expenses 8,700,000

Operating income $ 4,150,000

Analysis discloses that these data include the operating results of the hotel chain, which were:
operating revenues $2,000,000 and operating expenses $2,400,000.The hotels were sold at a gain
of $200,000 before taxes. This gain is not included in the operating results. During the year,
Cheaney suffered an extraordinary loss of $800,000 before taxes, which is not included in the
operating results. In 2011, the company had other revenues and gains of $100,000, which are not
included in the operating results. The corporation is in the 30% income tax bracket.

Instructions
Prepare a condensed income statement.

P14-9 The ledger of LaRussa Corporation at December 31, 2011, contains the following sum-
mary data.

Net sales $1,700,000 Cost of goods sold $1,100,000
Selling expenses 120,000 Administrative expenses 150,000
Other revenues and gains 20,000 Other expenses and losses 28,000

Problems 721

Prepare income statement with
discontinued operations and
extraordinary loss.

(SO 6)

Prepare income statement with
nontypical items.

(SO 6)

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Financial Reporting Problem: PepsiCo, Inc.
BYP14-1 Your parents are considering investing in PepsiCo, common stock. They ask you, as
an accounting expert, to make an analysis of the company for them. Fortunately, excerpts from
a current annual report of PepsiCo are presented in Appendix A of this textbook. Note that all
dollar amounts are in millions.

Instructions
(Follow the approach in the chapter for rounding numbers.)

(a) Make a 5-year trend analysis, using 2004 as the base year, of (1) net sales and (2) net income.
Comment on the significance of the trend results.

(b) Compute for 2008 and 2007 the (1) profit margin, (2) asset turnover, (3) return on assets, and
(4) return on common stockholders’ equity. How would you evaluate PepsiCo’s profitabil-
ity? Total assets at December 31, 2006, were $29,930, and total stockholders’ equity at
December 31, 2006, was $15,447.

(c) Compute for 2008 and 2007 the (1) debt to total assets and (2) times interest earned ratio.
How would you evaluate PepsiCo’s long-term solvency?

(d) What information outside the annual report may also be useful to your parents in making a
decision about PepsiCo, Inc.?

FINANCIAL REPORTING AND ANALYSIS

B R O A D E N I N G Y O U R P E R S P E C T I V E

Your analysis reveals the following additional information that is not included in the above data.

1. The entire puzzles division was discontinued on August 31. The income from operations for
this division before income taxes was $20,000. The puzzles division was sold at a loss of
$90,000 before income taxes.

2. On May 15, company property was expropriated for an interstate highway. The settlement
resulted in an extraordinary gain of $120,000 before income taxes.

3. The income tax rate on all items is 30%.

Instructions
Prepare an income statement for the year ended December 31, 2011. Use the format illustrated
in the Comprehensive (p. 703).Do it!

722 Chapter 14 Financial Statement Analysis

Visit the book’s companion website at www.wiley.com/college/weygandt, and choose the Student
Companion site, to access Problem Set B.

PROBLEMS: SET B ww
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(Note: This is a continuation of the Cookie Chronicle from Chapters 1-13.)

CCC14 Natalie and Curtis have comparative balance sheets and income statements for
Cookie & Coffee Creations Inc.They have been told that they can use these financial statements
to prepare horizontal and vertical analyses, and to calculate financial ratios, to analyze how their
business is doing and to make some decisions they have been considering.

CONTINUING COOKIE CHRONICLE

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Go to the book’s companion website,
www.wiley.com/college/weygandt,
to see the completion of this problem.

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 722

Comparative Analysis Problem: PepsiCo, Inc.
vs. The Coca-Cola Company
BYP14-2 PepsiCo’s financial statements are presented in Appendix A. Financial statements
of The Coca-Cola Company are presented in Appendix B.

Instructions
(a) Based on the information contained in these financial statements, determine each of the fol-

lowing for each company.
(1) The percentage increase (decrease) in (i) net sales and (ii) net income from 2007 to 2008.
(2) The percentage increase in (i) total assets and (ii) total common stockholders’ (share-

holders’) equity from 2007 to 2008.
(3) The basic earnings per share and price-earnings ratio for 2008. (For both PepsiCo and

Coca-Cola, use the basic earnings per share.) Coca-Cola’s common stock had a market
price of $45.27 at the end of fiscal-year 2008.

(b) What conclusions concerning the two companies can be drawn from these data?

Broadening Your Perspective 723

Decision Making Across the Organization
BYP14-3 As the CPA for Carismo Manufacturing Inc., you have been asked to develop some
key ratios from the comparative financial statements. This information is to be used to convince
creditors that the company is solvent and will continue as a going concern. The data requested
and the computations developed from the financial statements follow.

2011 2010
Current ratio 3.1 times 2.1 times
Acid-test ratio .8 times 1.4 times
Asset turnover 2.8 times 2.2 times
Net income Up 32% Down 8%
Earnings per share $3.30 $2.50

Instructions
With the class divided into groups, answer the following.

Carismo Manufacturing Inc. asks you to prepare a list of brief comments stating how each of
these items supports the solvency and going-concern potential of the business. The company
wishes to use these comments to support its presentation of data to its creditors. You are to
prepare the comments as requested, giving the implications and the limitations of each item
separately. Then prepare a collective inference that may be drawn from the individual items
about Carismo’s solvency and going-concern potential.

BYP14-4 General Dynamics develops, produces, and supports innovative, reliable, and highly
sophisticated military and commercial products. In July of a recent year, the corporation an-
nounced that its Quincy Shipbuilding Division (Quincy) will be closed following the comple-
tion of the Maritime Prepositioning Ship construction program.

Prior to discontinuance, the operating results of Quincy were net sales $246.8 million, income
from operations before income taxes $28.3 million, and income taxes $12.5 million. The corpora-
tion’s loss on disposition of Quincy was $5.0 million, net of $4.3 million income tax benefits.

From its other operating activities, General Dynamics’ financial results were net sales
$8,163.8 million, cost of goods sold $6,958.8 million, and selling and administrative expenses
$537.0 million. In addition, the corporation had interest expense of $17.2 million and interest
revenue of $3.6 million. Income taxes were $282.9 million.

General Dynamics had an average of 42.3 million shares of common stock outstanding
during the year.

CRITICAL THINKING

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 723

Instructions
With the class divided into groups, answer the following.

(a) Prepare the income statement for the year, assuming that the year ended on December 31,
2010. Show earnings per share data on the income statement. All dollars should be stated in
millions, except for per share amounts. (For example, $8 million would be shown as $8.0)

(b) In the preceding year, Quincy’s earnings were $51.6 million before income taxes of $22.8
million. For comparative purposes, General Dynamics reported earnings per share of $0.61
from discontinued operations for Quincy in the preceding year.
(1) What was the average number of common shares outstanding during the preceding year?
(2) If earnings per share from continuing operations was $7.47, what was income from contin-

uing operations during the preceding year? (Round to two decimals.)

Communication Activity
BYP14-5 Beth Harlan is the CEO of Lafferty’s Electronics. Harlan is an expert engineer
but a novice in accounting. She asks you to explain (1) the bases for comparison in analyzing
Lafferty’s financial statements, and (2) the factors affecting quality of earnings.

Instructions
Write a letter to Beth Harlan that explains the bases for comparison and factors affecting qual-
ity of earnings.

Ethics Case
BYP14-6 Jack McClintock, president of McClintock Industries, wishes to issue a press release
to bolster his company’s image and maybe even its stock price, which has been gradually falling.
As controller, you have been asked to provide a list of twenty financial ratios along with some
other operating statistics relative to McClintock Industries’ first quarter financials and operations.

Two days after you provide the ratios and data requested, Jeremy Phelps, the public rela-
tions director of McClintock, asks you to prove the accuracy of the financial and operating data
contained in the press release written by the president and edited by Jeremy. In the press re-
lease, the president highlights the sales increase of 25% over last year’s first quarter and the
positive change in the current ratio from 1.5:1 last year to 3:1 this year. He also emphasizes that
production was up 50% over the prior year’s first quarter.

You note that the press release contains only positive or improved ratios and none of the neg-
ative or deteriorated ratios. For instance, no mention is made that the debt to total assets ratio has
increased from 35% to 55%, that inventories are up 89%, and that while the current ratio improved,
the acid-test ratio fell from 1:1 to .5:1. Nor is there any mention that the reported profit for the quar-
ter would have been a loss had not the estimated lives of McClintock’s plant and machinery been
increased by 30%. Jeremy emphasized, “The prez wants this release by early this afternoon.”

Instructions
(a) Who are the stakeholders in this situation?
(b) Is there anything unethical in president McClintock’s actions?
(c) Should you as controller remain silent? Does Jeremy have any responsibility?

“All About You” Activity
BYP14-7 In this chapter you learned how to use many tools for performing a financial analy-
sis of a company. When making personal investments, however, it is most likely that you won’t
be buying stocks and bonds in individual companies. Instead, when most people want to invest
in stock, they buy mutual funds. By investing in a mutual fund, you reduce your risk because
the fund diversifies by buying the stock of a variety of different companies, bonds, and other
investments, depending on the stated goals of the fund.

Before you invest in a fund, you will need to decide what type of fund you want. For ex-
ample, do you want a fund that has the potential of high growth (but also high risk), or are you
looking for lower risk and a steady stream of income? Do you want a fund that invests only in
U.S. companies, or do you want one that invests globally? Many resources are available to help
you with these types of decisions.

724 Chapter 14 Financial Statement Analysis

JWCL165_c14_674-725.qxd 8/16/09 7:46 AM Page 724

Instructions
Go to http://web.archive.org/web/20050210200843/http://www.cnb1.com/invallocmdl.htm and com-
plete the investment allocation questionnaire. Add up your total points to determine the type
of investment fund that would be appropriate for you.

FASB Codification Activity
BYP14-9 Access the FASB Codification at http://asc.fasb.org to prepare responses to the
following. Use the Master Glossary for determining the proper definitions.

(a) Discontinued operations.
(b) Extraordinary items.
(c) Comprehensive income.

Answers to Insight and Accounting Across
the Organization Questions
p. 685 How to Manage the Current Ratio
Q: How might management influence the company’s current ratio?
A: Management can affect the current ratio by speeding up or withholding payments on accounts

payable just before the balance sheet date. Management can alter the cash balance by increasing
or decreasing long-term assets or long-term debt, or by issuing or purchasing equity shares.

p. 693 Keeping Up to Date as an Investor
Q: If you want to keep current with the financial and operating developments of a company in

which you own shares, what are some ways you can do so?
A: You can obtain current information on your investments through a company’s website, financial

magazines and newspapers, CNBC television programs, investment letters, and a stockbroker.
p. 698 What Does “Non-Recurring” Really Mean?
Q: If a company takes a large restructuring charge, what is the effect on the company’s current

income statement versus future ones?
A: The current period’s net income can be greatly diminished by a large restructuring charge, while

the net income in future periods can be enhanced because they are relieved of costs (i.e., depre-
ciation and labor expenses) that would have been charged to them.

Authors’ Comments on All About You: Should I Play the
Market Yet?, p. 702
For a number of reasons, it is probably a bad idea for Rachael to buy her employer’s stock. First,
if Rachael is going to invest in the stock market, she should diversify her investments across a
number of different companies. Second, you should never have more than a small portion of your
total investment portfolio invested in your employer. Suppose that your employer starts to do
poorly, the stock price falls, and you get laid off. You lose on two counts: You don’t have income,
and your net worth has been affected adversely by the drop in the stock price. (This exact situa-
tion happened to thousands of Enron employees, who not only lost their jobs, but their retire-
ment savings as well, as Enron’s stock plummeted.) Third, after purchasing her employer’s stock,
Rachael’s liquidity would be negatively affected: She would have only $3,000 of remaining liquid
assets.

If Rachel invests $7,000, she actually has only enough liquid assets to cover one month’s worth
of expenses. It is true that she could sell her stock, but if it has fallen in value, she will be reluctant
to sell. In short, if she were to buy the stock, her financial flexibility would be very limited.

The bottom line is that we think that Rachael should invest in something that offers a higher
return than her bank savings account, but we question whether she has enough liquidity to invest
in individual stocks. We would recommend that she put some money in a stock mutual fund,
some in a short-term CD, and the rest in a money-market fund.

Answers to Self-Study Questions
1. b 2. d 3. a 4. c 5. c 6. c 7. c 8. b 9. b 10. a 11. d 12. c 13. c
14. d 15. d

Broadening Your Perspective 725

Remember to go back to the Navigator box on the chapter-opening page and check off your completed work.✓

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