Blueprint Problem: Statement of Cash Flows

Statement of Cash Flows and Business Activities

The statement of cash flows provides information about the cash inflows and cash outflows for a company. It is considered to be a complement to the other three financial statements. A company’s cash flows are generated from operating, investing, and financing activities. (Click on the activity name in the image for definitions.)

In the table below, review the transaction and select the appropriate type of activity and cash flow.

Transaction	Activity and flow
Paying commissions to sales force	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 1 of Item 1
Selling goods to customers	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 2 of Item 1
Buying equipment for use in manufacturing	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 3 of Item 1
Selling common stock to an investor	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 4 of Item 1
Borrowing cash from a bank	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 5 of Item 1
Selling equipment used in the company’s manufacturing	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 6 of Item 1
Purchasing goods to sell to customers	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 7 of Item 1
Buying land for a future plant site	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 8 of Item 1
Paying back the principal of a loan	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 9 of Item 1
Paying utility bills	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 10 of Item 1
Paying dividends to owners	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 11 of Item 1
Buying a display case for items to be sold	SelectFinancing, inflowInvesting, inflowOperating, inflowFinancing, outflowInvesting, outflowOperating, outflowCorrect 12 of Item 1

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Operating Activities and the Indirect Method

The first section of the statement of cash flows is the operating activities section. There are two methods to prepare this section: the direct method and the indirect method. Both methods calculate the same result. Under the indirect method, net income is adjusted to determine cash flows from operating activities.

Why is net income not equal to the increase in cash? Recall that under GAAP, net income is calculated on Selectan accruala cashCorrect 1 of Item 2 basis.

There are four types of adjustments to net income:

1.	Non-cash effects on net income:	Non-cash expenses are Selectadded tosubtracted fromCorrect 2 of Item 2 net income and
		non-cash revenues are Selectadded tosubtracted fromCorrect 3 of Item 2 net income.
2.	Gains and losses from investing or financing activities:	Gains are Selectadded tosubtracted fromCorrect 4 of Item 2 net income and
		losses are Selectadded tosubtracted fromCorrect 5 of Item 2 net income.
3.	Changes in current assets:	Increases in current assets are Selectadded tosubtracted fromCorrect 6 of Item 2 net income and
		decreases in current assets are Selectadded tosubtracted fromCorrect 7 of Item 2 net income.
4.	Changes in current liabilities	Increases in current liabilities are Selectadded tosubtracted fromCorrect 8 of Item 2 net income and
		decreases in current liabilities are Selectadded tosubtracted fromCorrect 9 of Item 2 net income.

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HideAPPLY THE CONCEPTS: Prepare the operating activities sectionThe income statement and comparative balance sheets for Leonardo Inc. can be viewed by clicking on the links below. No depreciable assets were purchased or sold during the period; therefore, the increase in Accumulated Depreciation is due to depreciation expense for the period. Complete the operating activities section of the statement of cash flows. Use a minus sign (-) to indicate an outflow of cash. No sign is needed to indicate an inflow of cash.+ Income StatementLeonardo Inc.Income StatementFor the Year Ended December 31, 2013Sales$244,800Cost of merchandise sold127,296Gross profit$117,504Operating expenses:Depreciation expense$2,560Other operating expenses80,672Total operating expenses83,232Income from operations$34,272Other revenue and expenses:Interest revenue$480Gain on sale of land2,2402,720Income before taxes$36,992Income taxes9,792Net income$27,200+ Comparative Balance SheetLeonardo Inc.Balance SheetsDecember 31, 201320132012AssetsCash$28,800$20,800Accounts receivable (net)7,20010,400Inventories76,32072,800Current assets$112,320$104,000Note Receivable135,52059,200Land47,04088,800Equipment192,400192,400Less: Accumulated depreciation46,96044,400Total assets$440,320$400,000LiabilitiesAccounts payable$4,480$8,800Wages payable20,64017,600Current liabilities$25,120$26,400Note payable61,60061,600Total liabilities$86,720$88,000Stockholders’ EquityCommon stock$68,800$62,400Additional paid-in capital153,200140,400Retained earnings131,600109,200Total equity$353,600$312,000Total liabilities and equity$440,320$400,000Leonardo Inc.Statement of Cash FlowsFor the Year Ended December 31, 2013Cash flows from operating activities:Accounts ReceivableGross profitSalesNet incomeCorrect 5 of Item 3$Correct 6 of Item 3Adjustments to net income:Common StockDepreciation expenseInterest RevenueOther Operating ExpensesCorrect 8 of Item 3Correct 9 of Item 3Additional paid-in capitalCommon StockGain on sale of landLandCorrect 10 of Item 3Correct 11 of Item 3Increase in Interest RevenueIncrease in Accounts ReceivableDecrease in InventoryDecrease in Accounts ReceivableCorrect 12 of Item 3Correct 13 of Item 3Increase in Retained EarningsIncrease in Accounts ReceivableDecrease in InventoryIncrease in InventoryCorrect 14 of Item 3Correct 15 of Item 3Increase in Income TaxesIncrease in Accounts PayableDecrease in Wages PayableIncrease in Wages PayableCorrect 16 of Item 3Correct 17 of Item 3Increase in Common StockIncrease in Accounts PayableDecrease in Wages PayableDecrease in Accounts PayableCorrect 18 of Item 3Correct 19 of Item 3Net cash provided by operating activitiesNet cash used by operating activitiesCorrect 20 of Item 3$Correct 21 of Item 3

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HideAPPLY THE CONCEPTS: Prepare the investing activities sectionInvesting ActivitiesInvesting activities include inflows and outflows of cash related to noncurrent assets. Additional data related to noncurrent assets and liabilities may need to be collected to correctly calculate the cash flows from investing activities. Inflows of cash from investing activities may include a gain or loss in the sale of a noncurrent asset.Additional information for investing activities: 1. One of Leonardo’s suppliers experienced a devastating loss due to a tornado. Leonardo loaned the company $76,320 cash to help restore its operations. The loan is interest-free. 2. Leonardo sold one of its parcels of land for $44,000.Use a minus sign (A????1) to indicate an outflow of cash. No sign is needed to indicate an inflow of cash.Cash flows from investing activities:Cash received from principal of loanCash received from sale of landCash received from accounts receivableCash received from common stockCorrect 5 of Item 4$Correct 6 of Item 4Cash loaned to supplierCash paid for cost of merchandise soldCash paid for operating expensesCash paid for common stockCorrect 7 of Item 4Correct 8 of Item 4Net cash provided by investing activitiesNet cash used by investing activitiesCorrect 9 of Item 4Correct 10 of Item 4

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HideFinancing ActivitiesFinancing activities include inflows and outflows of cash from transactions that either generate capital or repay capital provided to the company. As with investing activities, you must review the changes to equity accounts and noncurrent liabilities as well as collect any additional data related to equity accounts and noncurrent liabilities to correctly calculate the cash flows from financing activities.APPLY THE CONCEPTS: Prepare the financing activities sectionAdditional financing activities data:1. On February 1, 2013, Leonardo Inc. issued 6,400 shares of its $1 par value stock. The company received the par value for the shares and $12,800 in excess of par value. 2. Leonardo paid dividends of $4,800 to its stockholders on June 30, 2013.Use a minus sign (A????1) to indicate an outflow of cash. No sign is needed to indicate an inflow of cash.Cash flows from financing activities:Cash received from salesCash received from interest revenueCash received from issuance of stockCash paid for issuance of stockCorrect 5 of Item 5$Correct 6 of Item 5Cash paid for merchandise soldCash paid for dividendsCash paid for operating expensesCash paid for income taxesCorrect 7 of Item 5Correct 8 of Item 5Net cash provided by financing activitiesNet cash used by financing activitiesCorrect 9 of Item 5Correct 10 of Item 5

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HideComplete the Statement of Cash FlowsAfter determining the cash flows from the operating, investing, and financing activities, the net change in cash can be calculated by totaling the cash flows from each of the activities. The net change in Cash is added to the Cash balance at the beginning of the period. The sum should be equal to the balance in Cash at the end of the year.APPLY THE CONCEPTS: Complete the statement of cash flowsUse a minus sign (A????1) to indicate an outflow of cash. No sign is needed to indicate an inflow of cash.Net decrease in cashNet increase in cashCorrect 4 of Item 6$Correct 5 of Item 6Cash, beginning of the yearCash, end of the yearCorrect 6 of Item 6Correct 7 of Item 6Cash, beginning of the yearCash, end of the yearCorrect 8 of Item 6$Correct 9 of Item 6

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Additional Disclosures

Often a company will engage in significant investing or financing transactions that involve no cash flow. For example, a company may sign a long-term note payable in exchange for an asset, such as a building or equipment. Or, perhaps common stock is issued to retire bonds. These activities are not reported on the statement of cash flows because there is no cash flow in the current period.

These transactions should be Selectdisclosed in a separate schedule.ignored because there is no current cash flow.removed from the balance sheet to prevent confusion.Correct 1 of Item 7 Reporting significant noncash investing and financing activities follows the Selectfull-disclosurematchinghistorical costCorrect 2 of Item 7 principle.

The Rights Offerings Puzzle

In the United States, firms use general cash offers much more often than rights offerings. IN Table 16.10, of the 578 total issues represented, about 94 (or 16 percent) were rights offers. This reliance on general cash offers in the United States is something of a mystery because rights offerings are usually much cheaper in terms of flotation costs.

		Cash Offers
		Compensation	Other	Total Cost as
		as a	Expenses as	a Percentage
Size of Issue ($ in millions)		Percentage of Proceeds	a Percentage of Proceeds	of Proceeds
	Number
Under 0.50	0	—	—	—
.50– 0.99	6	6.96%	6.78%	13.74%
1.00– 1.99	18	10.40	4.89	15.29
2.00– 4.99	61	6.59	2.87	9.47
5.00– 9.99	66	5.50	1.53	7.03
10.00– 19.99	91	4.84	.71	5.55
20.00– 49.99	156	4.30	.37	4.67
50.00– 99.99	70	3.97	.21	4.18
100.00–500.00	16	3.81	.14	3.95
Total/average	484	5.02%	1.15%	6.17%
Rights with Standby Underwriting		Pure Rights
	Compensationas aPercentageof Proceeds	OtherPercentageof Proceeds
	Total Cost as		Total Cost as
	a Percentage		a Percentage
Number	of Proceeds	Number	of Proceeds
0	—	—	—	3	8.99%
2	3.43%	4.80%	8.24%	2	4.59
5	6.36	4.15	10.51%	5	4.90
9	5.20	2.85	8.06	7	2.85
4	3.92	2.18	6.10	6	1.39
10	4.14	1.21	5.35	3	.72
12	3.84	.90	4.74	1	.52
9	3.96	.74	4.70	2	.21
5	3.50	.50	4.00	9	.13
56	4.32%	1.73%	6.05%	38	2.45%

To give an idea of the relative flotation costs, Table 16.10 shows these costs from one study expressed as a percentage of the amount raised for different issue sizes and selling procedures. Overall, general cash offers had average flotation costs equal to 6.17 percent of the amount raised. For rights offerings with standby underwriting, total costs were 6.05 percent. For pure rights offerings (those involving no underwriter), these costs were only 2.45 percent of the amount raised, representing a significant savings. Overall, Table 16.10 suggests that pure rights offerings have a pronounced cost advantage. Furthermore, rights offerings protect the proportionate interest of existing shareholders. No one knows why rights offerings are not used more often, and it is an intriguing anomaly. Various arguments in favor of general cash offers with underwriting have been put forth:

1. Underwriters increase the stock price. This is supposedly accomplished because of the selling effort of the underwriting group.

2. Underwriters provide insurance against a failed offering. This is true. If the market price goes below the offer price, the firm does not lose, because the underwriter has bought the shares at an agreed-upon price. However, this insurance cannot be worth much, because the offer price is not set (in most cases) until within 24 hours of the offering, when the final arrangements are made and underwriters have made a careful assessment of the market for the shares.

3. Other arguments include the following: (a) the proceeds of underwritten issues are available sooner than those of a rights offer, (b) underwriters provide a wider distribution of ownership than would be possible with a rights offering, and (c) consulting advice from investment bankers may be beneficial. All of the preceding arguments are pieces of the puzzle, but none seems very convincing. One study found that firms making underwritten rights offers suffered substantially larger price drops than did firms making underwritten cash offers.9 This is a hidden cost, and it may be part of the reason that underwritten rights offers are uncommon in the United States.

C O N C E P T Q U E S T I O N S

a How does a rights offering work?

b What are the questions that financial management must answer in a rights offering?

c How is the value of a right determined?

d When does a rights offering affect the value of a company’s shares?

e Does a rights offering cause share prices to decrease? How are existing shareholders affected by a rights offering?