Intermediate Accounting Chapter 5 Solutions

SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 5-1 (a)The statement of financial position provides information about a company’s liquidity, solvency, and financial structure. If Wong has poor liquidity, or poor coverage and solvency, or if Wong is financed heavily by debt, lending funds to (and investing in) the company more risky. (b)The statement of cash flows provides information about the company’s sources and uses of cash during the period. If Wong relies significantly on external financing as a result of negative cash flows from operations, lending funds to (and investing in) the company is more risky. The statement of cash flows also helps users assess earnings quality. For example, if Wong’s net income is significantly higher than cash flows from operations, this is a sign of poor earnings quality, and a potential cause for concern to a possible lender to the company. BRIEF EXERCISE 5-2 The statement of cash flows helps users to evaluate the company’s liquidity, solvency, and financial flexibility. Companies that are more financially flexible are better able to survive economic downturns, and have lower risk of business failure. Users of Gator Printers’ statement of cash flows include shareholders, creditors, potential bondholders, management, employees, and customers. Shareholders, creditors, and potential bondholders will analyze the company’s liquidity, solvency, and financial flexibility in making their investment decisions. Management will use the statement of cash flows to analyze sources and uses of cash in deciding whether or not to expand, and in deciding how to fund the expansion, if any. Employees and customers may use the statement of cash flows to assess the company’s liquidity, solvency, and financial flexibility, if they are seeking a long-term employer or supplier. BRIEF EXERCISE 5-3 Three examples of financial statement items which are omitted from the statement of financial position because they cannot be objectively measured, and therefore not recorded, include: 1. Internally-generated goodwill 2. Intellectual capital developed from research 3. Contingent liabilities that cannot be reasonably estimated BRIEF EXERCISE 5-4 Current assets Cash and cash equivalents FV-NI investments Accounts receivable Less allowance for doubtful accounts Inventory Prepaid insurance Total current assets $7,000 11,000 $90,000 (4,000) 86,000 40,000 5,200 $149,200 Cash and cash equivalents and accounts receivable are monetary assets. Fair value-net income investments could be monetary assets depending on the nature of the investments. BRIEF EXERCISE 5-5 Long-term investments FV – OCI investments Land held for speculation Total investments Fair Value-OCI investments are financial instruments. $ 62,000 119,000 $181,000 BRIEF EXERCISE 5-6 Property, plant, and equipment Land Buildings Less accumulated depreciation Equipment Less accumulated depreciation Equipment under lease Less accumulated depreciation Total property, plant, and equipment $71,000 $207,000 (45,000) 190,000 (19,000) 229,000 (103,000) 162,000 171,000 126,000 $530,000 BRIEF EXERCISE 5-7 Intangible assets Intangible assets - patents Intangible assets - franchises Intangible assets - trademarks Total intangible assets $33,000 47,000 10,000 $90,000 Note: Goodwill would be shown separately from intangibles. BRIEF EXERCISE 5-8 (a) Current liabilities Accounts payable Unearned revenue Salaries and wages payable Interest payable Income tax payable Notes payable Total current liabilities $251,000 141,000 127,000 42,000 9,000 __97,000 $667,000 All of the above with the exception of unearned revenue are monetary liabilities. Unearned revenue is non-monetary as it will generally be satisfied by delivery of goods or services, rather than monetary amounts. Note: Any current portion for the Obligation under Lease and the current portion of long term debt, such as Bonds Payable, would be included if listed in the balances. Note: For the notes payable, as at statement of financial position date, there is no unconditional right to defer payment of the financial liability beyond one year. Therefore under IFRS, the financial liability must be shown as a current liability. (b) Under ASPE, since the notes payable are refinanced by the issue date of the financial statements, with payment terms beyond one year as at statement of financial position date, the notes payable may be presented as a non-current liability. BRIEF EXERCISE 5-9 (a) Under IFRS Non-current liabilities Bonds payable Obligations under lease Total non-current liabilities $ 480,000 175,000 $655,000 In each case, these amounts would be shown net of current portion, if any. (b) Under ASPE Non-current liabilities Bonds payable Obligations under lease Notes payable Total non-current liabilities $480,000 175,000 __97,000 $752,000 In each case, these amounts would be shown net of current portion, if any. BRIEF EXERCISE 5-10 Shareholders’ equity Share capital Preferred shares Common shares Contributed surplus Total share capital Retained earnings Accumulated other comprehensive income (loss) Total shareholders’ equity $50,000 700,000 200,000 950,000 120,000 (150,000) $920,000 BRIEF EXERCISE 5-11 The purpose of a statement of cash flows is to provide relevant information about the cash receipts and cash payments of an enterprise during a period, in order for users to determine the significant operating, investing and financing items and amounts. It differs from the statement of financial position and the income statement in that it reports the sources and uses of cash by operating, investing, and financing activity classifications. While the income statement and the statement of financial position are accrual basis statements, the statement of cash flows is a cash basis statement—non-cash items are omitted. BRIEF EXERCISE 5-12 Investing activities: Purchase of fair value through other comprehensive income investments (47,000) ($120,000 - $96,000 + $23,000) = $47,000 Note: The fair value through OCI unrealized loss of $23,000 is not an operating activity as it does not appear on the income statement, and so net income need not be adjusted for this non-cash item. BRIEF EXERCISE 5-13 Operating activities: Adjustments to reconcile net income to net cash provided by operating activities: Amortization expense - patent Loss on impairment - patent BRIEF EXERCISE 5-14 $6,000 20,000 Cash flows from operating activities Net income* Adjustments to reconcile net income to net cash provided by operating activities Increase in accounts receivable (150) Decrease in accounts payable (400) Net cash used by operating activities * Increase in Retained Earnings ($500 - $300) $200 (550) $(350) BRIEF EXERCISE 5-15 Cash flows from operating activities Net income $151,000 Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense $44,000 Increase in accounts receivable (15,000) Increase in accounts payable 9,000 38,000 Net cash provided by operating activities $189,000 BRIEF EXERCISE 5-16 Proceeds from sale of land and building Purchase of land Purchase of equipment Net cash provided by investing activities $176,000 (44,000) (35,000) $ 97,000 BRIEF EXERCISE 5-17 (a) Under ASPE, because payment of cash dividend is charged to retained earnings, it would be treated as a financing activity. Issuance of common shares Repurchase of company’s own shares Payment of cash dividend Retirement of bonds Net cash used by financing activities $140,000 (25,000) (58,000) (200,000) $(143,000) (b) Under IFRS Issuance of common shares Repurchase of company’s own shares Retirement of bonds Net cash used by financing activities $140,000 (25,000) (200,000) $ (85,000) BRIEF EXERCISE 5-18 Free Cash Flow Analysis Net cash provided by operating activities Less: Purchase of equipment Purchase of land* Dividends Free cash flow $400,000 (35,000) (44,000) (58,000) $263,000 *If the land was purchased as an investment, it would be excluded in the computation of free cash flow. BRIEF EXERCISE 5-19 (a) Operating Activities Net income Depreciation expense 4,000 Increase in accounts receivable (10,000) Increase in accounts payable 7,000 Net cash provided by operating activities $40,000 ___1,000 41,000 Investing Activities Purchase of equipment (8,000) Financing Activities Issuance of notes payable 20,000 Dividends paid (5,000) Net cash provided by financing activities 15,000 Net change in cash ($41,000 – $8,000 + $15,000) $48,000 Free Cash Flow = $41,000 (Net cash provided by operating activities) – $8,000 (Purchase of equipment) – $5,000 (Dividends paid) = $28,000. (b) Cash Flow per share = $48,000/100,000 = $0.48 (c) Midwest would be prohibited from providing cash flow per share in its financial statements under ASPE. BRIEF EXERCISE 5-20 Melbourne’s liquidity is improving. The current and acid-test ratios have current liabilities as the denominator in the calculation. A higher multiple of the balance of current liabilities is preferable for liquidity purposes. In the case of the acid-test ratio, both inventory and prepaid expenses are omitted from the numerator. This is because they are assets that are not available to settle current liabilities. Therefore the result is a lower multiple. SOLUTIONS TO EXERCISES EXERCISE 5-1 (15-20 minutes) 1. Long-term investment. Fair Value-OCI investments are not held with the intention of realizing direct investment gains. They are acquired for longer term strategic purposes. Nonmonetary and Financial Instrument. 2. Capital shares in shareholders’ equity. Nonmonetary and Financial Instrument. 3. Current liability. Monetary and Financial Instrument. 4. Property, plant, and equipment (as a deduction or contra asset account). Nonmonetary and not a Financial Instrument. 5. If the warehouse in process of construction is being constructed for another party, it is classified as an inventory account in the current asset section. This account will be shown net of any billings on the construction contract. On the other hand, if the warehouse is being constructed for use by this particular company, it should be classified as a separate item in the property, plant, and equipment section. Nonmonetary and not a Financial Instrument. 6. Current asset. Monetary and Financial Instrument. 7. Current liability. Monetary and Financial Instrument. 8. Retained Earnings with a debit balance in shareholders’ equity. Nonmonetary and not a Financial Instrument. EXERCISE 5-1 (CONTINUED) 9. Current asset. Nonmonetary and Financial Instrument. Fair value-net income investments could be monetary depending on the nature of the investments. 10. Current liability. Monetary and not a Financial Instrument. The income tax payable is an obligation that stems from regulatory requirements and is not contractual in nature. 11. Current liability. Nonmonetary and not a Financial Instrument. 12. Current asset. Nonmonetary and not a Financial Instrument. 13. Current liability. Monetary and Financial Instrument. 14. Current liability. Nonmonetary and not a Financial Instrument. Could be seen as a Monetary Financial Instrument in the event that the company does not provide the goods or services (in which case, the company owes the deposit back to the customer in cash). 15. Current liability. Nonmonetary and not a Financial Instrument. This is a provision accrual for a likely loss. EXERCISE 5-2 (15-20 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) 8 4 6 6 3 1 6 6 1 1 7 (l) (m) (n) (o) (p) (q) (r) (s) (t) (u) (v) 6 1 7 3 2 1 1 6 6 11 10 EXERCISE 5-3 (15-20 minutes) (a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l) (m) (n) (o) (p) (q) (r) (s) Classification 1. 2. 6. 1. 7. 4. 1. 6. 1. 6. 1.* 3. 2. 6. X. 3. 11. 6. 2. Monetary Financial Instrument X X X X X X X X X X X X X X * Under IFRS, a non-current asset would typically be reclassified as a current asset when it meets the criteria to be classified as held for sale. EXERCISE 5-4 (35-40 minutes) (a) Bruno Corp. Statement of Financial Position December 31, 2017 Assets Current assets Cash FV - NI Investments Accounts receivable Less allowance for doubtful accounts Inventory, at lower of cost and net realizable value Prepaid expenses Total current assets Long-term investments Land held for future use Investment in bonds to be held to maturity Property, plant, and equipment Building Less accumulated depreciation —building Equipment Less accumulated depreciation—equipment Goodwill Total assets $ 290,000 120,000 $357,000 17,000 175,000 90,000 340,000 401,000 12,000 1,163,000 265,000 $730,000 160,000 265,000 570,000 105,000 160,000 730,000 80,000 $2,238,000 EXERCISE 5-4 (CONTINUED) (a) (continued) Liabilities and Shareholders’ Equity Current liabilities Accounts payable Bank overdraft Notes payable Rent payable Total current liabilities Long-term liabilities Bonds payable Pension obligation Total liabilities $ 195,000 30,000 125,000 49,000 399,000 $553,000 82,000 635,000 1,034,000 Shareholders’ equity Common shares, unlimited authorized 290,00 issued 290,000 shares 0 Contributed surplus 180,000 Retained earnings* 734,000 Total shareholders’ equity 1,204,000 Total liabilities and shareholders’ equity $2,238,000 *$2,238,000 – $1,034,000 – $290,000 – $180,000 = $734,000 EXERCISE 5-4 (CONTINUED) *(b) The bank overdraft is classified as a current liability, as there is no legal right to offset the bank overdraft against the positive cash balance. The bank accounts are at different banks. Had the bank overdraft been off set (netted) against the cash balance as originally prepared by the bookkeeper, there would have been no effect on working capital. The net amount of current assets, less current liabilities would not change in absolute amount. However, the classification change does affect the current ratio (current assets / current liabilities): Overdraft netted $1,163 – $30 $399 – $30 = 3.07 Proper classification $1,163 $399 = 2.91 Those who prepared the statement of financial position likely did not do the misclassification of the bank overdraft on purpose. The bank account in overdraft is likely one of several bank accounts used by Bruno Corp. This particular account happens to fall in a temporary overdraft position, as allowed by the bank, as of the fiscal year end of the business. EXERCISE 5-5 (35-40 minutes) (a) Garfield Corp. Statement of Financial Position As at July 31, 2017 Assets Current assets Cash Accounts receivable Less allowance for doubtful accounts Inventory Total current assets $ 66,000* $ 46,700** 3,500 Long-term investments Bond sinking fund investment Property, plant, and equipment Equipment Less accumulated depreciation— equipment 43,200 65,300*** 174,500 12,000 112,000 28,0 00 84,00 0 Intangible assets Patents (net) Total assets 21,000 $291,500 Liabilities and Shareholders’ Equity Current liabilities Notes and accounts payable Income tax payable Total current liabilities $ 52,000**** 9,000 61,000 Bonds payable Total liabilities 75,000 136,000 Shareholders’ equity Common shares 105,000 Retained earnings 50,500 __155,500 Total liabilities and shareholders’ equity $291,500 * ($69,000 – $12,000 + $9,000) *** ($60,000 + $5,300) ** ($52,000 – $5,300) ****($44,000 + $8,000) EXERCISE 5-5 (CONTINUED) *(b) Since there is no legal right to offset the credit balances in accounts receivable against any other amounts owing from customers, these balances need to be classified as a current liability, unless the amounts are deemed to be immaterial. Had the credit balances in accounts receivable been offset (netted) against other debit balances as originally presented, there would have been no effect on working capital. The net amount of current assets, less current liabilities would not change in absolute amount. However, the classification change does affect the current ratio (current assets / current liabilities) as demonstrated below: Credit balances netted $174,500 – $8,000 $61,000 – $8,000 = 3.14 Proper classification $174,500 $61,000 = 2.86 The persons preparing the statement of financial position likely did not feel that the credit balances in accounts receivable warranted a reclassification. They likely were not aware of the impact the credit balances would have on the current ratio. Materiality would also be a basis for leaving the credit balances to offset the debit balances in accounts receivable. The credit balances in accounts receivable represent amounts owing to specific customers. Following are possible conditions or situations that would give rise to a credit balance in accounts receivable: 1. Customers have returned goods after paying for a shipment and credit memorandums for the sales returns have been applied subsequent to collection on account. EXERCISE 5-5 (CONTINUED) (b) (continued) 2. A customer has inadvertently overpaid an account. 3. 4. Garfield’s policy on returned items does not allow a cash refund. Instead the policy calls for the credit to be applied to a future purchase on account. Some accounting software packages treat customer prepayments (unearned revenues) as credit balances in accounts receivable, since the customer information is part of the accounts receivable subsidiary ledger. EXERCISE 5-6 (30-35 minutes) Lee Inc. Statement of Financial Position December 31, 20– Assets Current assets Cash Less cash restricted for plant expansion Accounts receivable Less allowance for doubtful accounts Notes receivable Accounts receivable—officers Inventory Finished goods Work in process Raw materials Total current assets Long-term investments FV - OCI Investments Land held for future plant site Cash restricted for plant expansion Total long-term investments Property, plant, and equipment Buildings Less accumulated depreciation—buildings $XXX XXX $XXX XXX XXX XXX XXX XXX XXX XXX XXX XXX $XXX XXX XXX XXX XXX XXX XXX XXX Intangible assets Copyrights XXX Goodwill XXX Total assets $XXX EXERCISE 5-6 (CONTINUED) Liabilities and Shareholders’ Equity Current liabilities Accounts payable Salaries and wages payable Unearned subscriptions revenue Unearned rent revenue Total current liabilities $XXX XXX XXX XXX $XXX Long-term liabilities Bonds payable, due in four years Total liabilities Shareholders’ equity Common shares Retained earnings Total shareholders’ equity Total liabilities and share holders’ equity XXX XXX $XXX XXX XXX $XXX Note to instructor: The question notes that cash includes the cash restricted for plant expansion. If it did not, then a subtraction from cash would not be necessary, or the cash balance would be “grossed up” and then the cash restricted for plant expansion would be deducted. EXERCISE 5-7 (15-20 minutes) (a) 1. Dividends payable of $1,500,000 will be reported as a current liability (1,000,000 X $1.50). 2. No amounts are reported as a current or long-term liability. Stock dividends distributable are reported in the shareholders' equity section. 3. Bonds payable of $25,000,000 and interest payable of $1,750,000 ($100,000,000 X 7% X 3/12) will be reported as a current liability. Bonds payable of $75,000,000 will be reported as a long-term liability. 4. Customer advances of $27,000,000 will be reported as a current liability ($12,000,000 + $40,000,000 – $25,000,000). 5. Demand bank loans must be classified as current liabilities. 6. Although the terms and condition of the guarantee for the DD Ross Ltd. bank loan must be disclosed in the notes to the financial statements, no amount of liability is reportable on Samson’s statement of financial position. (b) Liabilities have two essential characteristics: they represent an economic burden or obligation, and the entity has a present obligation that is enforceable. When Samson accepts an advance from a customer, an economic burden or obligation arises that is satisfied when Samson provides the related goods or services. The obligation is a present and enforceable until the related goods or services are delivered. Earned customer advances of $25 million no longer represent a liability because the economic burden or obligation has been satisfied. EXERCISE 5-7 (CONTINUED) (c) Samson may have a much stronger financial position than its Associate and by providing the guarantee the bank would be more confident that the loan and related interest will be fully repaid on a timely basis. The guarantee would typically lead to lower interest rates being charged on the loan. Since Samson is associated with DD Ross, increased income of the associate will benefit Samson indirectly. EXERCISE 5-8 (35-40 minutes) (a) Zhang Ltd. Statement of Financial Position December 31, 2017 Assets Current assets Cash FV - NI investments Accounts receivable Less allowance for doubtful accounts Inventory Total current assets $205,000 153,000 $515,000 (25,000) Long-term investments Bond investments at amortized cost FV - OCI Investments Total long-term investments Property, plant, and equipment Land Building 1,040,000 Less accumulated (152,000) depreciation Equipment 600,000 Less accumulated (60,000) depreciation Total property, plant, and equipment Intangible assets Intangible Assets-Franchises Intangible Assets-Patents Total intangible assets Total assets 490,000 687,000 $1,535,000 299,000 345,000 644,000 260,000 888,000 540,000 1,688,000 160,000 195,000 355,000 $4,222,000 EXERCISE 5-8 (CONTINUED) (a) (continued) Liabilities and Shareholders’ Equity Current liabilities Accounts payable Commissions payable Notes payable Accrued liabilities Total current liabilities Long-term liabilities Notes payable Bonds payable Total long-term liabilities Total liabilities $ 545,000 136,000 98,000 96,000 $ 875,000 900,000 1,000,000 1,900,000 2,775,000 Shareholders’ equity Common shares $ 809,000 Retained earnings** 490,000 Accumulated other comprehensive income 148,000* Total shareholders’ equity 1,447,000 Total liabilities and shareholders’ equity $4,222,000 * Unrealized gain or loss-OCI ($345,000–$277,000) Add opening balance **Calculation of Retained Earnings: Sales revenue Investment income or loss Gain on sale of land Cost of goods sold Selling expenses Administrative expenses Interest expense Net income Beginning retained earnings Net income (above) Correction of prior year’s error Ending retained earnings $68,000 80,000 $148,000 $8,010,000 13,000 60,000 (4,800,000) (1,860,000) (900,000) (211,000) $ 312,000 $ 218,000 312,000 (40,000) $ 490,000 EXERCISE 5-8 (CONTINUED) (b) A classified statement of financial position requires the reporting of current assets and liabilities, and the classifications are used for measurement of liquidity. The length of the operating cycle will determine what items are classified as current where the operating cycle is longer than one year. Should the business have several segments, such as in the case of Bombardier Inc., (aerospace, transportation and financing services) and the operating cycles are very different, applying one cycle length to all business segments becomes meaningless. In cases such as this, the consolidated statement of financial position may not be classified. EXERCISE 5-9 (15-20 minutes) 1. Because the likelihood of payment is remote, accrual of a liability is not required. Case by case examination is required with respect to all lawsuits. 2. A current liability of $150,000 should be recorded and reported for the year ended December 31, 2017. 3. A current liability for accrued interest of $3,750 ($900,000 X 5% X 1/12) should be reported. Any portion of the $900,000 note that is payable within one year from the statement of financial position date should be shown as a current liability. Otherwise, the $900,000 note payable would be a long-term liability. 4. Although bad debts expense of $200,000 should be debited and the allowance for doubtful accounts credited for $200,000, this does not result in a liability. The allowance for doubtful accounts is a valuation account (contra asset) and is deducted from accounts receivable on the statement of financial position. 5. A current liability of $80,000 ($2 X 40,000) should be reported for the dividends payable. The liability is recorded on the date of the declaration of the dividend. 6. Customer advances of $110,000 ($160,000 – $50,000) will be reported as a current liability if the advances are expected to be earned within one year. 7. Income tax payable in the amount of $6,000 should be recorded and reported as a current liability. EXERCISE 5-10 (20-25 minutes) (a) Current assets Cash Less cash restricted for plant expansion FV - NI investments Accounts receivable (of which $50,000 is pledged as collateral on a bank loan) Less allowance for doubtful accounts Notes receivable Interest receivable ** Inventory at lower of FIFO cost and net realizable value Finished goods Work-in-process Raw materials Total current assets *($50,000 + $50,000 – $8,000) ** [($40,000 X 6%) X 8/12] $ 92,000* (50,000) 161,00 0 (12,000) 152,000 34,000 187,000 $42,000 29,000 149,000 40,000 1,600 373,000 $634,600 EXERCISE 5-10 (CONTINUED) (b) An alternative to the presentation of the details (for example of the three categories of inventory) as shown above is to provide disclosure in a table within the notes to the financial statements. This provides a more condensed format of the statement of financial position. This allows easier comparisons of balances, especially when presented on a comparative basis. References to the notes containing the detail would be added to the captions appearing on the face of the statement of financial position as a cross-reference. A second possible alternative to the presentation of information is parenthetical disclosure on the face of the statement of financial position. Although not a required disclosure, the balance of accounts receivable could be presented: “net of allowance for doubtful accounts of $12,000.” An acceptable alternative for cash is to report cash of $42,000 and report the cash restricted for plant expansion in the noncurrent investments section of the statement of financial position. EXERCISE 5-11 (40-45 minutes) (a) Uddin Corp. Statement of Financial Position December 31, 2017 Assets Current assets FV – OCI Investments Property, plant, and equipment Land Buildings ($1,120,000 + $31,000) $1,151,000 Less accumulated depreciation ($130,000 + $4,000) (134,000) Equipment ($320,000 – $20,000) 300,000 Less accumulated depreciation ($11,000 – $8,000 + $9,000) (12,000) Total Intangible assets - Patents, net ($40,000 – $3,000) $1,380,500a 20,500 $ 30,000 1,017,000 288,000 1,335,000 37,000 Total assets $2,773,000 Liabilities and Shareholders’ Equity Current liabilities ($1,020,000 + $13,000) Long-term liabilities Bonds payable ($1,100,000 + $75,000) Total liabilities Shareholders’ equity Common shares Retained earnings* Total shareholders’ equity Total liabilities and shareholders’ equity $1,033,000 1,175,000 2,208,000 $180,000 385,000 565,000 $2,773,000 * ($174,000 + $391,000 – $180,000) a The amount determined for current assets is calculated last and is a derived or forced figure. That is, total liabilities, shareholders’ equity and other asset balances are calculated because information is available to determine these amounts. EXERCISE 5-11 (CONTINUED) (b) Uddin Corp. Statement of Cash Flows For the Year Ended December 31, 2017 Cash flows from operating activities Net income $391,000 Adjustments to reconcile net income to net cash provided by operating activities: Loss on sale of equipment [($20,000 – $8,000) – $10,000] $ 2,000 Depreciation expense ($4,000 + $9,000) 13,000 Patent amortization expense 3,000 Increase in current liabilities 13,000 Increase in current assets (other than cash) (29,000) 2,000 Net cash provided by operating activities 393,000 Cash flows from investing activities Proceeds from sale of equipment Addition to building Purchase of FV- OCI investments Net cash used by investing activities Cash flows from financing activities Issuance of bonds Payment of dividends Net cash used by financing activities Net increase in cash b 10,000 (31,000) (20,500) (41,500) 75,000 (180,000) (105,000) $246,500b An additional proof to arrive at the increase in cash is provided as follows: Total current assets—end of period [from part (a)] Total current assets—beginning of period Increase in current assets during the period Increase in current assets other than cash Increase in cash during year $1,380,500 1,105,000 275,500 29,000 $ 246,500 EXERCISE 5-12 (30-35 minutes) (a) Agincourt Corp. Partial Statement of Financial Position As at December 31, 2017 Current assets Cash Accounts receivable Less allowance for doubtful accounts Inventory Prepaid expenses Total current assets $30,476* $91,300** 7,000 Current liabilities Accounts payable Notes payable Total current liabilities * Cash balance Add: Cash disbursement after discount [$35,000 X 98%)] Less: Cash sales in January ($30,000 – $21,500) Cash collected on account Bank loan proceeds ($35,324 – $23,324) Adjusted cash ** Accounts receivable balance Add: Accounts reduced from January collection ($23,324 plus 2% discount of $476) Deduct: Accounts receivable in January Adjusted accounts receivable 84,300 161,000*** 9,000 $284,776 $113,000a 55,000b $168,000 $ 40,000 34,300 74,300 (8,500) (23,324) (12,000) $30,476 $ 89,000 23,800 112,800 (21,500) $ 91,300 EXERCISE 5-12 (CONTINUED) (a) (continued) *** Inventory Less: Consignment inv. included in count Adjusted inventory a b *(b) Accounts payable balance Add: Cash disbursements Purchase invoice omitted ($27,000 – $10,000) Adjusted accounts payable $ 61,000 $35,000 17,000 Notes payable balance Less: Proceeds of Jan. 2018 bank loan Adjusted notes payable 52,000 $113,000 $ 67,000 (12,000) $ 55,000 Current ratio – Deteriorated dramatically Before Restatement $302,000 $128,000 = 2.36 (c) $171,000 (10,000) $161,000 Restated $284,776 $168,000 = 1.70 Adjustment to retained earnings balance: Add: January sales discounts [($23,324 ÷ 98%) X .02] Deduct: January sales $30,000 January purchase discounts ($35,000 X 2%) 700 December purchases ($27,000 – $10,000) 17,000 Consignment inventory 10,000 Decrease to retained earnings $ 476 (57,700) $(57,224) EXERCISE 5-12 (CONTINUED) (d) Agincourt’s bank manager is relying on the information in the statement of financial position as at December 31, 2017 to assess whether a new bank loan should be extended to the company. Before restatement, Agincourt’s current ratio is 2.36, and after restatement, Agincourt’s current ratio is 1.70. The adjustments are material because they result in a current ratio that is much closer to the minimum required current ratio, and would likely affect the bank manager’s decision to extend a new bank loan to Agincourt. In order for financial statements to be useful, relevant, and faithfully representative, they must be free from error and bias. Recording of the adjustments is necessary in order to provide financial statement users with useful and complete information for their investment and credit decisions. (e) The likelihood that the bank manager will suspect the statement of financial position is incorrect is quite strong. Two of the balances reported on the statement of financial position represent accounts with the bank. One is the Cash balance and the other is the Notes Payable balance which is a loan from the bank. Both balances would not be in line with the records of the bank at December 31, 2017, and the most noticeable one would be the Notes Payable balance. This is the case because an additional $12,000 loan was made in the first few days of January 2018 (refer to part (a) above). In the case of the Cash account balance, it would less noticeable as the bank understands that there are outstanding cheques which make the bank and book balances different. The manager is nonetheless aware and monitors the flow of cash in the bank account. EXERCISE 5-13 (20-25 minutes) 1. Contingency. Under IFRS, a provision is recognized in income and as a liability if it is probable (more likely than not) that the confirming future event will occur. In this example, it is not likely that damages will be awarded to the plaintiff, and so it is considered a contingent loss that is not accrued. However, the contingency would be disclosed in the notes to financial statements if the possibility of an outflow of company resources is not remote. 2. Subsequent event. This event provides evidence about conditions that did not exist at the statement of financial position date, but arose subsequent to that date, and therefore adjustment of the statement of financial position as at December 31, 2017 is not required. However, this event may have to be disclosed in the notes to financial statements to keep the financial statements from being misleading. 3. Provision. Under IFRS, a provision is recognized in income and as a liability if it is probable (more likely than not) that the confirming event will occur. According to Janix’s legal counsel, Janix will likely lose the lawsuit; therefore a provision should be recognized. IFRS requires that the “expected value” of the loss be used to measure the liability. If $850,000 payout and $950,000 payout are equally probable, the liability should be measured at $900,000. 4. Commitment. Under IFRS, if the unavoidable costs of completing the contract are higher than the benefits expected from receiving the contracted goods or services, a loss provision is recognized. In this example, the cost per inventory unit has decreased, therefore under IFRS, if the contract is non-cancellable, or if the cancellation provisions are severe, a loss provision should be recognized in the amount of $400,000 (200,000 X [$12 - $10]). EXERCISE 5-13 (CONTINUED) 5. Commitment. Commitments that obligate a company must be disclosed if they are material. A restriction on payment of dividends should be disclosed in the notes to financial statements, because it is likely to be considered material and potential shareholders would be very interested in being aware of this restriction. 6. Subsequent event. This event provides evidence about conditions that did not exist at the statement of financial position date, but arose subsequent to that date, and therefore adjustment of the statement of financial position as at December 31, 2017 is not required. However, this event should be disclosed in the notes to financial statements to keep the financial statements from being misleading. Potential shareholders would be very interested in being aware of the additional share issue and its effect on earnings per share as the issuance of common shares is dilutive. In addition, creditors would be interested in knowing of the additional financing that will likely help Janix’s liquidity and solvency. 7. Subsequent event. Because the lump sum payment is for retroactive pay that covers a period of time that involves an expense in the 2017 and 2018 fiscal periods, an accrual for the portion of the expense that relates to 2017 must be reflected in the statement of comprehensive income for 2017. EXERCISE 5-14 (25-30 minutes) (a) Carmichael Industries Inc. Statement of Cash Flows For the Year Ended December 31, 2017 Cash flows from operating activities Net income $129,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $27,000 Gain on sale of land (5,000) Increase in accounts receivable (50,000) Increase in inventory (31,000) Decrease in accounts payable (7,000) (66,000) Net cash provided by operating activities 63,000 Cash flows from investing activities Purchase of equipment (60,000) Proceeds from sale of land* 44,000 Net cash used by investing activities (16,000) Cash flows used by financing activities Payment of cash dividends (60,000) Net cash used by financing activities (60,000) Net decrease in cash (13,000) Cash at beginning of year 34,000 Cash at end of year $21,000 Note: During the year, Carmichael retired $50,000 in bonds payable by issuing common shares. * ($110,000 - $71,000 + $5,000 gain) = $44,000 (b) Carmichael managed to generate sufficient cash from operations to finance a strong dividend payout ratio of 46.5% ($60,000 divided by $129,000). The cash generated from the sale of land was used to purchase equipment. There are some indications that too much cash is tied up in current assets, from the dramatic increase in both the accounts receivable and the inventory balances over the year. EXERCISE 5-15 (15-20 minutes) Indirect method (a) 3. (b) 2. (c) 3. (d) 2. (e) 1. (f) 1. (g) 4. (h) 3.* (i) 4. (j) 1. (k) 1. (l) 1. (m) 1.* (n) 1.** * Under ASPE, interest and dividends paid are operating activities if recognized in net income. If charged directly to retained earnings, they are presented as financing activities. (Under IFRS, interest and dividends paid may be presented as either operating or financing activities.) ** Under ASPE, interest and dividends received are presented as operating activities. (Under IFRS, interest and dividends received may be presented as either operating or investing activities.) EXERCISE 5-16 (20-25 minutes) (a) Kneale Transport Inc. Partial Statement of Cash Flows For the Year Ended December 31, 2017 Cash flows from operating activities Net income $148,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $70,000 Gain on sale of equipment (25,000) Decrease in accounts receivable 10,000 Increase in prepaid insurance (3,000) Decrease in accounts payable (11,000) Increase in interest payable 1,250 Increase in income taxes payable 3,500 Decrease in unearned revenue (4,000) 41,750 Net cash provided by operating activities $189,750 Although not required in the instructions, the direct method follows: Kneale Transport Inc. Partial Statement of Cash Flows For the Year Ended December 31, 2017 Cash flows from operating activities Cash received from customers (1) Cash payments For operating expenses (2) For interest (3) For income tax (4) Net cash provided by operating activities $551,000 $314,000 8,750 38,500 361,250 $189,750 EXERCISE 5-16 (CONTINUED) (b) (1) Cash received from customers Revenues from services Add: Decrease in accounts receivable ($60,000 – $50,000) Less: Decrease in unearned revenue ($14,000 – $10,000) $545,000 $10,000 (4,000) Cash receipts from customers $551,000 (2) Cash payments for operating expenses Operating expenses Add: Increase in prepaid insurance ($5,000 – $8,000) Decrease in accounts payable ($41,000 – $30,000) Cash payments for operating expenses $300,000* 3,000 11,000 $314,000 * $370,000 – $70,000 = $300,000 (3) Cash payments for interest Interest expense Less: Increase in interest payable ($2,000 – $750) Cash payments for interest $10,000 (1,250) $ 8,750 (4) Cash payments for income tax Income tax expense $42,000 Less: Increase in income tax payable ($8,000 – $4,500) (3,500) Cash payments for income tax $38,500 EXERCISE 5-16 (CONTINUED) (c) Whether the operating activities of the statement of cash flows are reported using the direct or the indirect method, the statement of cash flows allows the external users to assess Kneale’s capacity to generate cash and allows those users to compare the operating performance and cash flows with other businesses. The indirect method focuses on the differences between net income and cash flow from operating activities. A user of Kneale’s financial statements would find this information useful in that it provides a useful link between the statement of cash flows, the statement of income, and the statement of financial position. The direct method shows operating cash receipts and payments, which is more consistent with the objective of the statement of cash flows (that is, to provide information about the company’s sources and uses of cash). An external user of Kneale’s financial statements would find this information useful in estimating future cash flow from operating activities. EXERCISE 5-17 (30-35 minutes) (a) Dropafix Inc. Statement of Cash Flows For the Year Ended June 30, 2017 Cash flows from operating activities Net income $13,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $10,000 Increase in accounts receivable (12,000) Increase in inventory (1,000) Decrease in prepaid expenses 4,000 Increase in accounts payable 15,000 Decrease in income taxes payable (1,000) 15,000 Net cash provided by operating activities 28,000 Cash flows from investing activities Purchase of equipment (6,000)* Net cash used by investing activities (6,000) Cash flows used by financing activities Payment of cash dividends (4,000)** Repayment of notes payable (43,000)*** Issuance of common shares _7,000 Net cash used by financing activities _(40,000) Net decrease in cash (18,000) Cash at beginning of year 38,000 Cash at end of year $20,000 Note: During the year, equipment with a cost of $8,000 was purchased in exchange for a note payable. * Increase in equipment $14,000 less $8,000 non-cash purchase ** Increase in retained earnings, less net income plus dividends payable increase ($4,000 - $13,000 + $5,000) = ($4,000) *** Decrease in notes payable plus non-cash purchase ($35,000 + $8,000) = $(43,000) EXERCISE 5-17 (CONTINUED) (b) As one of Dropafix’s creditors, holding notes receivable of substantial amounts, I would review the statement of cash flow with particular attention to the amount of cash flows generated from operating activities. This section of the cash flow statement provides a perspective on the past performance of Dropafix in generating cash from its main activities and provides some predictive value in the likely amount of cash Dropafix will be able to generate in the future to meet the payment deadlines on its notes payable. The second item of the statement of cash flow which would be of particular interest to the creditor holding notes is the amount of repayment of notes in the financing activities portion of the statement of cash flows. In the case of Dropafix, the amount of $43,000 for the repayment of notes payable stands out as the largest amount on the statement of cash flows. This large repayment was achieved, in part, by the reduction of cash balances by about one third. Some cash was also obtained from the issuance of common shares. If the amounts due on notes payable for the next fiscal year are near the $43,000 level, Dropafix will need to seriously look at the refinancing of the notes or the issuance of additional common shares to meet those repayments. The remaining cash should not be depleted to the point where day-to-day operations are affected by cash shortages. EXERCISE 5-18 (25-30 minutes) Sensify Corporation Statement of Cash Flows For the Year Ended December 31, 2017 Cash flows from operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense $6,000 Gain on sale of equipment (3,000)* Increase in accounts receivable (3,000) Increase in accounts payable 5,000 Net cash provided by operating activities Cash flows from investing activities Proceeds from sale of equipment 8,000 Purchase of equipment (17,000)** Net cash used by investing activities Cash flows from financing activities Issuance of common shares 20,000 Payment of cash dividends (13,000) Net cash provided by financing activities Net increase in cash Cash at beginning of year Cash at end of year * $8,000 - $5,000 ** $27,000 + $12,000 - $22,000 $37,000 5,000 42,000 (9,000) 7,000 40,000 13,000 $53,000 *EXERCISE 5-19 (15-20 minutes) (a) Current Ratio : 2017 $53,000 + $91,000 $20,000 = 7.20 Debt to total assets ratio: 2017 $20,000 $161,000 = 12.4% 2016 $13,000 + $88,000 $15,000 = 6.73 2016 $15,000 $112,000 = 13.4% Free cash flow: Net cash provided by operating activities Less: Purchase of equipment Dividends paid Free cash flow 2017 $42,000 (17,000) * (13,000) $12,000 *Some companies may use the net investing cash outflow of $9,000, which would increase the amount of free cash flow to $20,000. It is important to understand how companies define free cash flow when interpreting the ratio. (b) Sensify’s current ratio has increased slightly from 2016 to 2017, and remains in excess of 6, which is very high. The debt to total assets ratio has declined and remains at a very low percentage. The accounts receivable are climbing slightly and could be investigated. The company has excellent liquidity and financial flexibility. *EXERCISE 5-20 (20-25 minutes) (a) Current ratio* Acid test ratio** 2017 6.63 2.40 2016 4.69 1.49 * 2017: ($21,000 + $104,000 + $220,000)/$52,000 2016: ($34,000 + $54,000 + $189,000)/$59,000 ** 2017: ($21,000 + $104,000)/$52,000 2016: ($34,000 + $54,000)/$59,000 (b) Current cash debt coverage – Net cash provided from operating activities divided by average current liabilities: $63,000 Its current cash debt coverage is 1.14 to 1 $55,500 ($52,000 + $59,000) ÷ 2 = $55,500 (c) Carmichael’s current and acid test ratios are both in excess of 1 and they both exhibit an increasing trend from 2016 to 2017. Its current cash debt coverage is excellent at 1.23 to 1. However, free cash flow ($63,000 - $60,000 - $60,000) is negative in 2017. Note also that accounts receivable and inventories have increased substantially from 2016 to 2017. While these increases might be an indication of growth in sales, if Carmichael has difficulty in collecting receivables or if sales slow and the inventory is not converted to cash, Carmichael’s liquidity and financial flexibility will be negatively affected. (d) Carmichael’s payout ratio of 47% is too high. Cash dividends $60,000 = Payout ratio = = Net income $129,000 47% If we were to use net cash provided by operating activities of $63,000 as the denominator, we would get close to 100% payout. In other words, all of the cash generated by operating activities is used up to satisfy shareholders. Very few growing businesses can afford this high a ratio when inventory and accounts receivable are increasing at such a high pace. A ratio of 30% to 40% is more reasonable. *EXERCISE 5-21 (30-40 minutes) (a) Current ratio* Acid test ratio** 2017 1.73 .87 2016 2.14 1.09 * 2017: ($20,000 + $86,000 + $103,000 +$2,000)/($115,000 + $2,000 + $5,000) 2016: ($38,000 + $74,000 + $102,000 + $6,000)/($100,000 + $3,000) **2017: ($20,000 + $86,000)/($115,000 + $2,000 + $5,000) 2016: ($38,000 + $74,000)/($100,000 + $3,000) (b) Current cash debt coverage – Net cash provided from operating activities divided by average current liabilities: $28,000 Its current cash debt coverage is .25 to 1 $112,500 ($122,000 + $103,000) ÷ 2 = $112,500 (c) Cash debt coverage – Net cash provided from operating activities divided by average total liabilities: $28,000 Its cash debt coverage is .13 to 1 $214,000 [($122,000 + 84,000) + ($103,000 + $119,000)] ÷ 2 = $214,000 (d) Dropafix’s times interest earned ratio is 3.1 times. Income before Times interest = interest and taxes = $28,000 = 3.1 earned Interest expense $9,000 (e) Dropafix’s current and acid test are not very strong and both exhibit a decreasing trend from 2016 to 2017. Accounts receivable have increased substantially from 2016 to 2017. While these increases might be an indication of growth in sales, if Dropafix has difficulty in collecting receivables or if sales slow and accounts receivable are not converted to cash, Dropafix’s liquidity and financial flexibility will be further negatively affected. As at June 30, 2017, even if Dropafix collected all of its receivable, it would not be in a position to pay all of its accounts payable. *EXERCISE 5-21 (CONTINUED) (e) (continued) Dropafix’s ability to repay current and all liabilities from its operations is very poor. Its current cash debt coverage is very low at .25 to 1 and its cash debt coverage is extremely low at .13 to 1. On the other hand its times interest earned ratio is reasonable at 3.1 times. (f) The following recommendation is based on the financial statements as a whole, and the conclusions reached in the analysis of parts (a) though (e) above. To improve Dropafix’s financial performance and particularly its ability to pay liabilities as they come due Dropafix should consider maintaining its investments asFV-NI rather than FV-OCI investments. As at June 30, 2017 Dropafix has cumulative unrealized gains of $11,000. This balance is taken from the accumulated other comprehensive income balance of the statement of financial position. If the maturity dates of the notes payable are large and imminent, it would seem reasonable to actively manage its investments. If these were actively managed and considered FV-NE then some (or all) of the investments could be sold rather than refinancing debt or having shareholders invest more cash into the business in exchange for common shares.