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CHAPTER 16
COVERAGE OF LEARNING OBJECTIVES
EXCEL,
FUNDAMENTAL ADDITIONAL COLLAB., &
ASSIGNMENT ASSIGNMENT INTERNET
LEARNING OBJECTIVE MATERIAL MATERIAL EXERCISES
LO1: Recognize and define the A1, B1 36, 37, 41, 42 74, 75
main types of assets in the balance 59, 61, 62, 63
sheet of a corporation.
LO2: Recognize and define the A1, B1 42, 60, 61, 62 74, 75
main types of liabilities in the
balance sheet of a corporation.
LO3: Recognize and define the A1, B1 42, 61, 62 74, 75
main elements of the stockholders’
equity section of the balance sheet
of a corporation.
LO4: Recognize and define the A1 36, 37, 38, 42 74, 75
principal elements in the income 63, 72
statement of a corporation.
LO5: Recognize and define the 61, 72
elements that cause changes in
retained earnings.
LO6: Identify activities that affect A2, B2 43, 44, 45, 46,
cash, and classify them as 49, 52, 53, 64,
operating, investing, or financing 65, 72
activities.
LO7: Assess financing and A2, B2 39, 49, 52, 53
investing activities using the
statement of cash flows.
LO8: Use both the direct method A2, A3, A4, B2, B3 43, 44, 45, 46, 75
and the indirect method to explain 47, 48, 49, 50,
cash flows from operating 52, 53, 65, 66, 67
activities.
LO9: Explain the role of 36, 51
depreciation in the statement of
cash flows.
LO10: Describe and assess the 54, 55, 56, 57, 73, 75
effects of the four main methods of 58, 68, 69, 70, 71
accounting for inventories
(Appendix 16A).
918
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CHAPTER 16
Understanding Corporate Annual Reports: Basic Financial
Statements
919
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920
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LORING COMPANY
Income Statement
For the Year Ended December 31, 20X0
Revenues $800,000
Cost of sales 460,000
Gross profit $340,000
Selling and administrative expenses 150,000
Income from operations $190,000
Other income (expense):
Interest expense $ (55,000)
Interest income 15,000
Total other income (expense) $ (40,000)
Income before income taxes $150,000
Provision for income taxes 60,000
Net income $ 90,000
Earnings per share ($90,000 ÷ 50,000) $1.80
921
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16-A2 (15-20 min.) Although the requirements do not call for it,
many students will find it useful to prepare a balance sheet equation
(without beginning balances, which are not given). Comparing the
entries in the Cash column to those in the Retained Earnings column
shows why net income differs from cash provided by operations.
This understanding is necessary to interpret (or prepare) the
schedule that reconciles net income to net cash provided by
operating activities (see 16-A3).
922
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923
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1. Sales $695,000
Nondepreciation expenses [600,000-90,000] (510,000)
Depreciation (90,000)
Net income $ 95,000
Add back depreciation 90,000
Net cash provided by operating activities $185,000
2. Sales $ 695,000
Nondepreciation expenses [600,000-90,000] (510,000)
Depreciation (270,000)
Net income (loss) $ (85,000)
Add back depreciation 270,000
Net cash provided by operating activities $ 185,000
Direct method:
Sales for cash $ 695,000
Operating expenses in cash (510,000)
Net cash provided by operating activities $ 185,000
924
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925
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16-B2 (25 min.) This is a good exercise in recognizing items that fit in a
Statement of Cash Flows and placing them in the proper section of the
statement. Three items listed in the problem do not appear in a Statement of
Cash Flows: net sales, retained earnings, and total assets.
WALGREEN COMPANY
Statement of Cash Flows
For the Year Ended August 31, 2005
(in millions)
Cash flows from operating activities:
Net earnings $ 1,559.5
Adjustments to reconcile net earning to net cash provided by
operating activities:
Depreciation and amortization 482.1
Deferred income taxes (70.8)
Other non-cash expenses 108.4
Changes in current assets and liabilities:
Increases in inventories (854.0)
Increases in trade accounts payable 276.7
Increases in accrued expenses and other liabilities 97.8
Increases in accounts receivable (224.9)
Increases in other current assets (8.6)
Increases in income taxes payable 5.0
Net cash provided by operating activities 1,371.2
Cash (Used for) Provided by Investing Activities:
Purchases of short-term investments (10,742.0)
Proceeds from sale of short-term investments 11,519.9
Additions to property and equipment (1,237.5)
Disposition of property and equipment 15.5
Proceeds from the surrender of corporate owned life insurance 10.1
Net cash used for investment activities (434.0)
Cash (Used for) Provided by Financing Activities:
Stock purchases for treasury stock (781.8)
Cash dividends paid (214.5)
Net proceeds from employee stock plans 177.5
Other cash provided by financing activities 14.4
Net cash used for financing activities (804.4)
Changes in Cash and Cash Equivalents:
Net increase in cash and cash equivalents 132.8
Cash and cash equivalents at beginning of year 444.0
Cash and cash equivalents at end of year $ 576.8
926
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All of the items listed, except provision for income taxes and
interest expense, are additions to (or deductions from) net income
that are required in computing net cash flow from operating
activities. The main problem is to decide whether each one should
be added to or deducted from net income.
TARGET CORPORATION
Supporting Schedule to Statement of Cash Flows
Reconciliation of Net Income to Net Cash Provided by
Operating Activities
For the Year Ended January 28, 2006
(in millions)
The net cash from operating activities exceeds net income by $4,451
- $2,408 = $2,043 million, primarily due to the add back of $1,409 +
$457 = $1,866 of depreciation and other non-cash expenses.
927
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16-1 The operating cycle is the time span during which cash is
spent to acquire goods and services that are used to produce the
organization's output, which in turn is sold to customers, who in
turn pay for their purchases in cash. For some firms, such as large
construction companies, this may be much longer than one year.
16-8 Yes. Goodwill is simply the excess of the purchase price over
the current value of the separable assets acquired less the liabilities.
928
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929
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930
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16-23 The investing section of the statement of cash flows shows the
total cash received when a company sells an asset. The book value is
irrelevant (except for its impact on income taxes). Thus, the $8,000
cash received would be cash provided by investing activities.
16-25 The direct method and indirect method are the two major
ways of computing net cash provided by operating activities. The
direct method shows cash inflows and outflows directly. The
indirect method begins with net income and adds adjustments to get
net cash provided by operating activities.
931
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16-28 Cash flow from operations does not recognize the investment
necessary to replace the fixed resources used in generating the
period’s revenues. If a company does not generate enough cash to
both carry out its operations and to replace the assets it uses up, it
cannot stay in business long. Free cash flow tells us whether the
cash generated by operations is enough to support the investment
needs of the company.
16-31 Specific identification recognizes the actual cost paid for the
particular physical item sold. First-in, first-out (FIFO) assumes that
the items acquired earliest are sold or used up first. Last-in, last-out
(LIFO) assumes that the items acquired most recently are sold or
used up first. Weighted average assumes that the cost of all items
available for sale during the period are divided by the number of
items to get an average unit cost.
16-32 FIFO will have the highest net income, because the older (and
hence lower cost) items comprise the cost of goods sold, making cost
of goods sold lower and net income higher.
932
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16-34 No. It is true that if replacement cost falls and lower ultimate
sales prices are expected, the inventory is written down. But once
written down, the inventory is never written up again. The cost to
which inventory is written down becomes the "new cost" and is
therefore the ceiling for any future valuation of the inventory.
933
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934
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16-39 The statement of cash flows has three sections. The section on
investing activities generally shows how much cash the company
used for expansion and replacement of facilities. The cash flow from
operations section shows how much cash was generated by the
company’s operating activities that might be available for the
needed investment. If the cash flow from operations is insufficient to
cover the investment needs, then the cash from financing activities
section shows the sources that provided additional capital –
generally from issuing either debt or equity. Or, in the case where
operating cash flows are more than sufficient for the planned
investing activities, the financing activities might reflect
distributions of cash to holders of debt or equity interests in the
company.
935
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936
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HONSHU COMPANY
Balance Sheet
May 31, 20X1
(in millions)
ASSETS:
Current assets:
Cash and equivalents ¥ 35,000
Receivables 22,000
Inventories 29,000
Other current assets 6,000
Total current assets 92,000
Noncurrent assets:
Fixed assets, net 217,000
Capital construction fund 28,000
Intangible assets 21,000
Long-term investments 15,000*
Total noncurrent assets 281,000
Total assets ¥373,000
*To compute the amount for long-term investments, recognize that total
assets must be ¥373,000 (equal to total liabilities and stockholders' equity).
Then:
Total noncurrent assets = Total assets - Total current assets
= ¥373,000 - ¥92,000
= ¥281,000
Long-term investments = Noncurrent assets - Fixed assets, net - Capital
construction fund – Intangible assets
= ¥281,000 - ¥217,000 - ¥28,000 - ¥21,000
= ¥15,000
937
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938
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HONSHU COMPANY
Income Statement
For the Year Ended May 31, 20X1
(in millions except net income per share)
939
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16-43 (5 min.)
Sales $760,000
Less increase in accounts receivable (9,000)
Cash received from customers $751,000
16-44 (5 min.)
940
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GUILLEN COMPANY
Reconciliation of Net Loss to Net Cash Provided by
Operating Activities
For the Year Ended December 31, 20X2
Net loss $(41,000)
Add depreciation 22,000
Add decrease in accounts receivable 4,000
Deduct increase in inventory (2,000)
Add increase in accounts payable 18,000
Add increase in wages and salaries payable 5,000
Net cash provided by operating activities $ 6,000
941
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* $374 + $6
942
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WISCONSIN BOTTLERS
Supporting Schedule to Statement of Cash Flows
Reconciliation of Net Income to Net Cash Provided by
Operating Activities
For the Year Ended December 31, 20X1
(in thousands)
943
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16-51 (10 min.) [Note: In the first printing of the text the sales
number was incorrect. Instead of $316 it should be $226.]
1. Income Statement:
Sales $226
Nondepreciation expenses ($196 - $17) $179
Depreciation 27 206
Net income $ 20
944
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1. SITKA COMPANY
Statement of Cash Flows
For the Year Ended December 31, 20X2
(in millions)
945
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946
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947
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948
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949
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950
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951
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952
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The shame of the matter is that the same business events can
lead to dramatically different measures of performance,
depending on whether LIFO or FIFO is adopted ($.175 versus
$.825). Moreover, the smart decision would be to adopt LIFO,
buy the 600,000 units, and enjoy the significant tax savings.
Yet this decision produces the worst earnings record!
953
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954
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4b. FIFO shows $100,000 higher income before taxes ($60,000 after
taxes) because 100,000 units of old, lower-cost inventory is in cost
of goods sold:
LIFO
1,000,000 units @ $5 = $5,000,000
FIFO
900,000 units @ $5 = $4,500,000
100,000 units @ $4 = 400,000
$4,900,000
4c. The ending LIFO inventory is $1,200,000 higher in column (a)
because the 600,000-unit layer is priced at the second-year
acquisition cost of $5. In column (b), the 600,000 units
purchased @ $5 near the end of the first year were charged
immediately to cost of goods sold, leaving all of the ending
inventory at the old unit cost of $3. Under the LIFO
assumption, this inventory is regarded as untouched in the
second year, so the old $3 unit cost applies to the ending
inventory of the second year.
4d. Alternatives
a b c d
Income tax for the two years $955,000 $355,000 $1,045,000
$1,045,000
Unless the LIFO layers are depleted, the adoption of LIFO will
result in permanent postponement of income taxes. However,
as the layers are depleted, these low-cost layers will cause
higher tax payments in later years than under FIFO.
4e. As far as the financial decision is concerned, the computations
in part (4) substantiate the conclusions in part (3). As far as
EPS is concerned, note that each EPS declines in the second
year, except for the second alternative (a rise from $.175 to
955
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956
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3b. FIFO results in more cash when inventory prices are falling.
Why? Because income tax cash outflow would be more under
LIFO by .40 x ($336,000 - $296,000) = $16,000.
957
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958
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959
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960
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961
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962
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1. The only line for interest on the statement of cash flows will be
under operating activities:
Cash payments for interest ($29,374,000)
963
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964
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1. NORDSTROM, INC.
Cash Flows from Operating Activities
For the Year Ended January 28, 2006
(in millions)
Cash payments:
To suppliers of goods (4,888 + 21 -32) $4,877
For selling, general, and administrative expenses
(2,101 - 276 - 31 + 11 + 32 + 1) 1,838
For interest (45) 45
For income taxes (334 + 34) 368
Cash disbursed for operating activities 7,128
965
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1. Specific
Weighted Identifi-
FIFO LIFO Average cation
Revenue (150 @ $16 + 160 @ $16) $4,960 $4,960 $4,960$4,960
Deduct cost of revenue:
Inventory, December 31, 2005, 100 @ $8 800 800 800 800
Purchases (200 @ $10 + 140 @ $12) 3,680 3,680 3,680 3,680
Cost of goods available for sale 4,480 4,480 4,480 4,480
Deduct: Inventory, June 30, 2006,
130 units:
130 @ $12 1,560
or
100 @ $8 + 30 @ $10 1,100
or
130 @ ($4,480 ÷ 440) or 130 @ 10.18 1,324
or
80 @ $8 + 50 @ $10 1,140
Cost of sales of products 2,920 3,380 3,156 3,340
Gross margin $2,040 $ 1,580 $1,804$1,620
2a. Income before income taxes will be lower under LIFO: $2,040
- $1,580 = $460. The income tax will be lower by .40 x $460 =
$184.
2b. Income before income taxes will be lower under LIFO: $1,804
- $1,580 = $224. The income tax will be lower by .40 x $224 =
$89.60.
966
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967
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Although purchases are $840 higher than before, the new LIFO
ending inventory is only $1,700 - $1,100 = $600 higher. The cost of
sales is $3,620 - $3,380 = $240 higher.
3. Prices were rising during fiscal 2006. The most recent prices
must be higher than the beginning prices because the ending
inventory under FIFO (which contains the most recent prices)
is greater than the ending inventory under LIFO (which
contains older layers of inventory). Alternatively, the cost of
merchandise sold under LIFO (which contains the most recent
prices) is higher than the cost of merchandise sold under FIFO
(which includes older prices).
968
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LIFO FIFO
2006 $1,055 $1,055 + $62 =$1,117
2005 1,037 1,037 + 45 = 1,082
Increase in inventory $ 18 $ 35
Therefore, cost of goods sold would have been $17 million lower
under the FIFO method. Operating income would have been $17
million higher: $1,567 million + $17 million = $1,584 million.
969
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16-73 (30-40 min.) For the solution, see the Prentice Hall Web site,
www.prenhall.com/
970
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971
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6. Lowe’s spent much more ($3,379 million) for fixed assets than it
charged in depreciation and amortization ($1,051 million). This is
the common case for a growing company such as Lowe’s.
972