CHAPTER 2
ACCOUNTING STATEMENTS, TAXES,
AND CASH FLOW
Answers to Concepts Review and Critical Thinking Questions
1. True. Every asset can be converted to cash at some price. However, when we are referring to a liquid
2. The recognition and matching principles in financial accounting call for revenues, and the costs
associated with producing those revenues, to be “booked” when the revenue process is essentially
3. The bottom line number shows the change in the cash balance on the balance sheet. As such, it is not
4. The major difference is the treatment of interest expense. The accounting statement of cash flows
treats interest as an operating cash flow, while the financial cash flows treat interest as a financing
cash flow. The logic of the accounting statement of cash flows is that since interest appears on the
income statement, which shows the operations for the period, it is an operating cash flow. In reality,
5. Market values can never be negative. Imagine a share of stock selling for –$20. This would mean
that if you placed an order for 100 shares, you would get the stock along with a check for $2,000.
6. For a successful company that is rapidly expanding, for example, capital outlays will be large,
7. It’s probably not a good sign for an established company to have negative cash flow from operations,
8. For example, if a company were to become more efficient in inventory management, the amount of
inventory needed would decline. The same might be true if the company becomes better at collecting
9. If a company raises more money from selling stock than it pays in dividends in a particular period,
10. The adjustments discussed were purely accounting changes; they had no cash flow or market value
Solutions to Questions and Problems
NOTE: All end-of-chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.
Basic
1. To find owners’ equity, we must construct a balance sheet as follows:
Balance Sheet
CA $ 4,900 CL $ 4,100
We know that total liabilities and owners’ equity (TL & OE) must equal total assets of $29,900. We
also know that TL & OE is equal to current liabilities plus long-term debt plus owners’ equity, so
owners’ equity is:
And net working capital is current assets minus current liabilities, so:
NWC = Current assets – Current liabilities
2. The income statement for the company is:
Income Statement
Sales $435,000
Costs 216,000
Depreciation 40,000
One equation for net income is:
Net income = Dividends + Addition to retained earnings
Rearranging, we get:
3. To find the book value of current assets, we use: NWC = CA – CL. Rearranging to solve for current
assets, we get:
Current assets = Net working capital + Current liabilities
The market value of current assets and net fixed assets is given, so:
Book value CA = $3,200,000 Market value CA = $2,600,000
4. Taxes = .15($50,000) + .25($25,000) + .34($25,000) + .39($198,000 – 100,000)
Taxes = $60,470
The average tax rate is the total tax paid divided by taxable income, so:
5. To calculate OCF, we first need the income statement:
Income Statement
Sales $19,800
Costs 10,900
OCF = EBIT + Depreciation – Taxes
6. Net capital spending = NFAend – NFAbeg + Depreciation
7. The long-term debt account will increase by $30 million, the amount of the new long-term debt
issue. Since the company sold 5 million new shares of stock with a $1 par value, the common stock
account will increase by $5 million. The capital surplus account will increase by $58 million, the
Long-term debt $ 85,000,000
Total long-term debt $ 85,000,000
Shareholders’ equity
Preferred stock $ 3,100,000
8. Cash flow to creditors = Interest paid – Net new borrowing
Cash flow to creditors = $185,000 – (LTDend – LTDbeg)
9. Cash flow to stockholders = Dividends paid – Net new equity
Cash flow to stockholders = $275,000 – [(Commonend + APISend) – (Commonbeg + APISbeg)]
Note, APIS is the additional paid-in surplus.
10. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders
= $80,000 – 10,000
= $70,000
Cash flow from assets = OCF – Change in NWC – Net capital spending
Intermediate
11. a. The accounting statement of cash flows explains the change in cash during the year. The
accounting statement of cash flows will be:
Statement of cash flows
Operations
Net income $120
Depreciation 90
Investing activities
Acquisition of fixed assets $(110)
Total cash flow from investing activities $(110)
Financing activities
b. Change in NWC = NWCend – NWCbeg
= (CAend – CLend) – (CAbeg – CLbeg)
c. To find the cash flow generated by the firm’s assets, we need the operating cash flow, and the
capital spending. So, calculating each of these, we find:
Operating cash flow
Note that we can calculate OCF in this manner since there are no taxes.
Capital spending
Ending fixed assets $405
Now we can calculate the cash flow generated by the firm’s assets, which is:
Cash flow from assets
Operating cash flow $210
12. With the information provided, the cash flows from the firm are the capital spending and the change
in net working capital, so:
Cash flows from the firm
Capital spending $(27,000)
And the cash flows to the investors of the firm are:
Cash flows to investors of the firm
Sale of long-term debt $(17,800)
13. a. The interest expense for the company is the amount of debt times the interest rate on the debt.
So, the income statement for the company is:
Income Statement
Sales $925,000
Cost of goods sold 490,000
Selling costs 220,000
b. And the operating cash flow is:
OCF = EBIT + Depreciation – Taxes
14. To find the OCF, we first calculate net income.
Income Statement
Sales $215,000
Costs 117,000
Other expenses 6,700
Depreciation 18,400
EBIT $72,900
a. OCF = EBIT + Depreciation – Taxes
b. CFC = Interest – Net new LTD
CFC = $10,000 – (–$7,200)
c. CFS = Dividends – Net new equity
d. We know that CFA = CFC + CFS, so:
CFA is also equal to OCF – Net capital spending – Change in NWC. We already know OCF.
Net capital spending is equal to:
Net capital spending = Increase in NFA + Depreciation
Now we can use:
CFA = OCF – Net capital spending – Change in NWC
15. The solution to this question works the income statement backwards. Starting at the bottom:
Net income = Dividends + Addition to retained earnings
Now, looking at the income statement:
EBT – (EBT × Tax rate) = Net income
Recognize that EBT × tax rate is the calculation for taxes. Solving this for EBT yields:
Now we can calculate:
EBIT = EBT + Interest
The last step is to use:
EBIT = Sales – Costs – Depreciation