Problem 18 - Accounting

Question

List the errors you find in the following statement of cash flows. The cash balance at the beginning of the year was \(\$ 100,320\). All other amounts are correct, except the cash balance at the end of the year. Devon Inc. Statement of Cash Flows For the Year Ended December 31, 2010 Cash flows from operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . \(148,080 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,000 Gain on sale of investements . . . . . . . . . . . . . . . . . . . . . . . . . 7,200 Changes in current operating assets and liabilities: Increase in accounts receivable . . . . . . . . . . . . . . . . . . . . . . . 11,400 Increase in inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (14,760) Increase in accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . (4,440) Decrease in accrued expenses payable . . . . . . . . . . . . . . . . . . (1,080) ________ Net cash flow from operating activities . . . . . . . . . . . . . . . . . . . . \)188,400 Cash flows from investing activities: Cash received from sale of investments . . . . . . . . . . . . . . . . . . . \( 102,000 Less: Cash paid for purchase of land . . . . . . . . . . . . . . . . . . . . . \) 108,000 Cash paid for purchase of equipment . . . . . . . . . . . . . . . . . 180,200 288,200 _________ ________ Net cash flow used for investing activities . . . . . . . . . . . . . . . . . . (186,200) Cash flows from financing activities: Cash received from sale of common stock . . . . . . . . . . . . . . . . . \(128,400 Cash paid for dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54,000 _________ Net cash flow provided by financing activities . . . . . . . . . . . . . . . 182,400 ________ Increase in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . \)184,600 Cash at the end of the year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 126,300 ________ Cash at the beginning of the year . . . . . . . . . . . . . . . . . . . . . . . . . $310,900 ________ ________

Step-by-Step Solution

Answer

The errors are in the beginning cash balance, listed net increase in cash, and ending cash amount. The correct ending cash balance should be $176,920.

Step 1: Understanding Cash Flow Parts

The statement of cash flows consists of three major sections: operating activities, investing activities, and financing activities. Each section reflects different cash transactions that impact the cash balance.

Step 2: Verify the Opening Balance

According to the problem statement, the cash balance at the beginning of the year is $100,320. However, the statement shows $310,900 under 'Cash at the beginning of the year'. This is incorrect and needs to be changed to $100,320.

Step 3: Calculate the Correct Increase in Cash

The increase in cash is calculated as the sum of net cash flows from operating, investing, and financing activities. This calculation should be: \[ 188,400 \text{ (operating) } - 186,200 \text{ (investing) } + 74,400 \text{ (financing) } = 76,600 \text{(net increase in cash)} \]The statement incorrectly lists the increase as $184,600.

Step 4: Calculate the Ending Cash Balance

The correct ending cash balance should be the beginning cash balance plus the net increase in cash from the previous step: \[ 100,320 + 76,600 = 176,920 \]. Therefore, the 'Cash at the end of the year' should be \(176,920, not \)126,300 as currently listed.

Key Concepts

Operating Activities

Operating activities are the business operations that generate revenue and expenses. They refer to the primary revenue-producing activities of an entity. The cash flows from operating activities are crucial because they indicate the ability of a business to generate cash from its core activities. These activities typically include:

• Sales of goods and services resulting in cash inflows.
• Payments to suppliers for goods and services, leading to cash outflows.
• Payments to employees, contributing to additional cash outflows.

In summary, cash flow from operating activities is often calculated by adjusting net income for non-cash items and changes in working capital accounts, such as receivables and payables. For instance, adjustments for depreciation are commonly made to net income to convert accrual accounting figures into cash flow figures.
When looking at the cash flow statement, it's crucial to differentiate between income and cash flow. Net income includes revenues that may not yet be collected in cash, and expenses that may not have been paid in cash.

Investing Activities

Investing activities relate to transactions for acquiring and disposing of long-term assets and investments. These activities primarily affect the changes in the cash flows related to purchase and sale of assets, such as land, buildings, and equipment. Examples of cash flows from investing activities include:

• Cash paid for purchasing new equipment or property, leading to cash outflows.
• Cash received from selling investments or asset sales, resulting in inflows.

A key point about investing activities is that they usually involve a substantial cash outflow, as companies often spend more on investments than they receive from selling assets. This helps in understanding the long-term strategy of a company, indicating how much money is being put back into the business to ensure future growth.
When analyzing a company, if the cash flows from investing activities are frequently negative, it may not necessarily be a bad sign. Rather, it might indicate proactive investment in capital for business expansion and development.

Financing Activities

Financing activities involve transactions with the company's owners or lenders. This section of the cash flow statement focuses on how a business obtains resources to grow and sustain its operations. Financing activities can include:

• Issuing stock to shareholders, providing cash inflow.
• Paying dividends, resulting in cash outflow.
• Borrowing funds or repaying debt, generating either inflows or outflows depending on the transaction.

By analyzing the financing activities, you can get a clearer picture of how a company is funding its operations and growth. For example, a company growing aggressively might show high levels of cash from debt issuance or stock sales, reflecting the capital raised to expand its operations.
Conversely, if a company repays more debt than it borrows, or pays high dividends relative to its income, this might point to maturity in its business cycle, where profitability is stable enough to sustain significant returns to shareholders. Understanding financing activities is essential when evaluating a company's financial management strategy and its long-term financial health.