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C17-3. Opus One, Inc.: Preparing and analyzing the cash flow statement
Requirement 1:
Notes:
1) Since the company did not declare or pay any cash or stock dividends
1) The T-accounts for property and equipment and accumulated depreciation
Accumulated Depreciation
$6,822,553 Balance as of 6/30/16
($57,107 + $7,377)
Balance as of 6/30/17 $22,182,371
First, by crediting the accumulated depreciation T-account with the
depreciation expense for the year, we find that the accumulated depreciation
new property and equipment acquired during the year.
4) The words “deferred credits” suggest that the liability account “Other
5) To calculate the financing cash flows from long-term debt, it is useful to
Long-Term Debt: 6/30/17 6/30/16 Borrowing Repayments
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- Current installments (681 ,716) (21 ,348)
6) Although revolving credit agreements appear as a current liability, they are
Opus One, Inc.
Statement of Cash Flows
For the Year Ended 6/30/2017
Operating Activities:
Net income for the year $ 1,127,664
Decrease in prepaid expenses 254,183
Increase in other liabilities & deferred credits 763 ,872
Cash flow from operations 12 ,165,338
Investing Activities:
Purchase of property and equipment ( 1 ,608,943)
Borrowing on term loan 3,600,000
Repayment of term loan (180,000)
Repayment of mortgage note (20,980)
Change in cash 31,404
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Education.
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Education.
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Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.
Requirement 2:
Caveat: The analysis is limited by the information available in the problem. The
learning objective of this assignment is to enable the students to evaluate the
cash flow statement rather than perform a comprehensive analysis of the
financial performance of Opus One, Inc.
The cash flow from operations (CFO) of Opus One, Inc., is almost 11 times the
net income of the company. Given the Wall Street adage that “Cash Flow is
King and Earnings Don’t Matter,” does this mean that the financial performance
of Opus One is really 11 times better than that indicated by its net income? Let
us examine the sources of the high CFO to see whether Opus One can sustain
this level of cash flow in the future.
First of all, the company’s receivables decreased by more than $1.5 million,
meaning the company collected that much more cash than the revenue
booked in the income statement. This might be good news if the company has
improved its collection efforts. Even so, this is unlikely to happen year after
year. Consequently, this is likely to be a temporary phenomenon.
A second source of the higher cash flow is the drop in the level of inventory.
One possibility is that the drop is due to an unexpected sale at the end of the
year. However, this is unlikely since the company experienced a drop in the
receivables also; i.e, if there were unexpectedly large sales at the end of the
year, we might expect the accounts receivable to have gone up. More
importantly, inventory level provides a signal about future demand; i.e,
companies are likely to build up (decrease) inventories when they expect a
surge (fall) in demand. Therefore, another possibility is that the company saved
some cash in the current year by buying less inventory, but it might generate
less cash during the next year by selling less inventory. In any case, it is
unlikely that inventory levels can continue to decrease when companies are
growing. (In fact, in the following year, the company built up almost $10 million
of inventory which resulted in a negative CFO.) The main message here is that
neither cash flows nor accounting income by itself can tell the whole story. A
joint examination of the two is likely to be instructive.
A third factor is the increase in accounts payable by more than $3 million. More
credit from suppliers is not necessarily a bad sign; i.e, suppliers are unlikely to
extend credit when they believe their customers have impending financial
difficulties. However, an increase in accounts payable often coincides with a
buildup of inventory. Consequently, one should examine why Opus One’s
accounts payable are increasing when its inventory level is falling. One
possibility is that the company was “forced” to pay off its revolving credit under
the current agreement (see financing cash flow). This might have delayed
payments to suppliers.
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A fourth item is the cash received from the decrease in the income tax refund
receivable. When is it likely for a company to have an asset called income tax
refund receivable? There are two possibilities. First, the company paid more
taxes during a year when compared to what it owed the IRS based on its
actual taxable income; i.e, the actual income was less than the anticipated
income. A second possibility is that the company incurred a net loss in the
recent past, and, using the loss carryback provision, the company is expecting
to receive a tax refund. Either scenario suggests that the company has
encountered difficulties in the recent past. (In fact, Opus One incurred a net
loss of almost $2.5 million during the next year.)
Similar comments can be made on other operating assets and liabilities.
The fact that the company arranged a term loan of $3.6 million is a positive
signal. First of all, the company has convinced a creditor to lend it money.
Secondly, the loan is a long-term one, and therefore, a substantial portion of
the principal payments are unlikely to be due in the near term. The company
has paid back about 5% of the term over a 4-month period. On an annual
basis, this translates into 15% of the loan; i.e, the company has the potential to
use the term loan to finance a part of its working capital needs over the next
several years.
C17-4. Capitalizing software development costs
Requirement 1:
Some analysts believe that the amount of capitalized software costs should be
deducted from operating cash flows to improve inter-firm comparability and to
correct for a firm’s possible attempt to improve operating cash flows by
lowering the technological feasibility threshold in the current period relative to
prior periods. In keeping with this belief, no adjustment is needed because
Take-Two already includes capitalized software costs among its operating cash
flow items.
Requirement 2:
Some analysts believe that the amount of capitalized software costs should be
deducted from operating cash flows to improve inter-firm comparability and to
correct for a firm’s possible attempt to improve operating cash flows by
lowering the technological feasibility threshold in the current period relative to
prior periods. Thus, capitalized software costs—which originally appeared in
the investing section of ESCO’s cash flow statement—have been moved to the
operating section in the following restatement of ESCO’s cash flow statement.
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Requirement 3:
Healthy companies generate (1) positive operating cash flows, and (2)
operating cash flows that typically exceed income due to the inclusion of
non-cash expenses (e.g., depreciation, amortization, losses on asset sales,
etc.) in income. This expected pattern appears in ESCO’s original financial
statements, but disappears when operating cash flows are adjusted to include
capitalized software costs as shown below. Note that ESCO’s seemingly
healthy cash flows (as reported) appear to be rapidly deteriorating when
restated.
Requirement 4:
ESCO’s reported income (ignoring income taxes) may be adjusted to what it
would have been if software costs were expensed as follows:
Clearly, ESCO’s software capitalization policies result in a significant increase
in reported net income, an effect that will continue as long as the company’s
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software expenditures keep increasing each year (as they have during the
three year period ended FY2007).
Requirement 5:
Both companies appear to establish technological feasibility (the point at which
they begin to capitalize software costs) upon completion of program design
which—as Take-Two notes—tends to be early in the development cycle.
Consequently, the impact on income—at least in the short run—is to defer
considerable software development costs by capitalizing them and then
amortizing them over the life of the software instead of expensing them
immediately as research and development costs.
Note to Instructor: The best-known and oldest software development
process is the “waterfall model” where developers (roughly) follow these steps
in order:
1. state requirements
2. analyze requirements
3. design a solution approach
4. architect a software framework for that solution
5. develop code
6. test
7. deploy, and
8. Post Implementation.
After each step is finished, the process proceeds to the next step. From each
company’s software capitalization footnote, it appears that both companies
capitalize costs incurred after the completion of step 3. Companies taking a
more conservative approach could justify not declaring establishment of
“technological feasibility” until after testing is complete, thereby capitalizing few,
if any, development costs.
Requirement 6:
Software Development Costs and Licenses
Beginning balance 2007 $ 116,561 $
109,891
Amortization in 2007 per
cash flow statement
Capitalized costs during 163,859
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2007 per cash flow
statement
Unidentified debit 5,377
Ending balance 2007 175,906
From the above account analysis, the following journal entries were made:
a. DR Software Development Costs and
Licenses
163,859
CR Cash 163,859
b. DR Amortization expense--software 109,891
CR Software Development Costs and
Licenses
109,891
The “unidentified debit” represents a discrepancy between working capital
components of net accrual adjustments on the cash flow statement and
changes in those accounts on the balance sheet. In this case, the discrepancy
is most likely due to the effects of purchases and disposals of businesses
given (1) that Take-Two reports changes in assets and liabilities net of such
effects on its cash flow statement, and (2) that Take-Two’s cash flow statement
investing section reports an outflow in 2007 related to purchases of businesses
of $5,795.
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