Chapter 11, Problem 5AP

1.

To determine

Calculate operating cash flows using the financial statements provided by Person L.

Explanation of Solution

Statement of cash flows: Statement of cash flow is a financial statement that shows the cash and cash equivalents of a company for a particular period of time. It shows the net changes in cash, by reporting the sources and uses of cash as a result of operating, investing, and financing activities of a company.

Indirect method: Under indirect method, net income is reported first, and then non-cash expenses, losses from fixed assets, and changes in opening balances and ending balances of current assets are adjusted to reconcile the net income balance.

Calculate operating cash flows of Corporation A for the year ended December 31, 2021 using indirect method.

Corporation A
Statement of cash flow (Partial)  - Indirect method
For the year ended December 31, 2021
Particulars	Amount	Amount
Cash flow from operating activities:
Net Income	$65,000
Adjustments to reconcile net income to  net cash provided by operating activities:
Depreciation Expense	$10,000
Changes in current assets and liabilities (Refer Table (2))
Add: Increase in accounts payable	$25,000
Add: Increase in interest payable	$10,000
Net Cash flow from operating activities		$110,000

Table (1)

Conclusion

Hence, the operating cash flows of Corporation A for the year ended December 31, 2021 are $110,000.

2.

To determine

Calculate operating cash flows without the two assumptions made by Person L.

Explanation of Solution

Statement of cash flows: Statement of cash flow is a financial statement that shows the cash and cash equivalents of a company for a particular period of time. It shows the net changes in cash, by reporting the sources and uses of cash as a result of operating, investing, and financing activities of a company.

Indirect method: Under indirect method, net income is reported first, and then non-cash expenses, losses from fixed assets, and changes in opening balances and ending balances of current assets are adjusted to reconcile the net income balance.

Calculate operating cash flows of Corporation A without the two assumptions.

Corporation A
Statement of cash flow (Partial) - Indirect method
For the year ended December 31, 2021
Particulars	Amount	Amount
Cash flow from operating activities:
Net Income	(1) $30,000
Adjustments to reconcile net income to  net cash provided by operating activities:
Depreciation Expense	$10,000
Changes in current assets and liabilities (Refer Table (2))
Add: Increase in accounts payable	$25,000
Add: Increase in interest payable	$10,000
Less: Increase in accounts payable	(2) ($60,000)
Less: Increase in inventory	(3) ($40,000)
Net Cash flow from operating activities		$(25,000)

Table (2)

Working note:

Determine the net income after adjustments.

$\begin{array}{c}\begin{array}{l}\text{Net income after }\\ \text{adjustments}\end{array}\}=\left(\begin{array}{l}\text{Retained earnings reported}\\ \text{ in balance sheet}\end{array}\right)-\left(\begin{array}{l}\text{Sales revenue}-\\ \text{Cost of goods sold}\end{array}\right)\\ =\$65,000-\left(\$75,000-\$40,000\right)\\ =\$65,000-\$35,000\\ =\$30,000\end{array}$ (1)

Determine the net income after adjustments.

$\begin{array}{c}\begin{array}{l}\text{Increase in }\\ \text{accounts receivable}\end{array}\}=\left(\begin{array}{l}\text{Ending accounts}\\ \text{ receivable}\end{array}\right)-\left(\begin{array}{l}\text{Beginning accounts}\\ \text{ receivable}\end{array}\right)\\ =\$60,000-\$0\\ =\$60,000\end{array}$ (2)

Determine the net income after adjustments.

$\begin{array}{c}\begin{array}{l}\text{Increase in }\\ \text{inventory}\end{array}\}=\text{Ending inventory}-\text{Beginning inventory}\\ =\$40,000-\$0\\ =\$40,000\end{array}$ (3)

Conclusion

Hence, the operating cash flows without the two assumptions of Corporation A for the year ended December 31, 2021 are $(25,000).

3.

To determine

Identify the impact if Person L's assumption affects Person M’s decision for the bank to lend an additional $100,000 to Person L.

Explanation of Solution

Yes. Person L‘s assumption would affect Person M’s decision for the bank to lend an additional $100,000 to Person L.

When the assumptions are taken into account, the net income and operating cash flows are overstated. In this situation net income is overstated by $35,000 (the assumed sale of inventory) and the Operating cash flows are overstated by $135,000$\left(\$60,000\left(\text{Accounts receivable}\right)+\$75,000\left(\text{Assumed sales revenue}\right)\right)$.

The actual net income and operating cash flows during the year are $30,000 and ($25,000) respectively. The actual cash balance at the end of the year would be $15,000$\left[\left(\$15,000\right)+(\$160,000)+\$200,000\right]$ . If the trends of negative cash flows continue, Corporation A would face difficulties to pay back the loan. Thus, Person M should consider the assumptions made by Person L because the assumptions would increase the operating cash flows, which would improve the company’s ability to pay back the loan.

4.

To determine

Explain whether Person M should use assumptions of Person L in analysing the loan for Corporation A.

Explanation of Solution

No, Person M should not use the assumptions made by Person L for analysing the loan for Corporation A.

Then loan of $100,000 should not be approved by Person M for the personal gain of future employment in Corporation A. Person L wants to influence Person M by providing employment in Corporation A. Person M should thoroughly examine the financial statements of Corporation A and then approve the loan. Thus, Person M should not use the assumptions made by Person L for analysing the loan for Corporation A.