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
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
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. How
many shares do you want to buy? More generally, because of corporate and individual bankruptcy
6. For a successful company that is rapidly expanding, for example, capital outlays will be large, possibly
7. It’s probably not a good sign for an established company to have negative cash flow from operations,
but it would be fairly ordinary for a start-up, so it depends.
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, its
10. The adjustments discussed were purely accounting changes; they had no cash flow or market value
consequences unless the new accounting information caused stockholders to revalue the assets.
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 $ 4,300 CL $ 2,900
NFA 24,000 LTD 10,700
OE ??
TA $28,300 TL & OE $28,300
We know that total liabilities and owners’ equity (TL & OE) must equal total assets of $28,300. We
also know that TL & OE is equal to current liabilities plus long-term debt plus owners’ equity, so
owners’ equity is:
2. The income statement for the company is:
Income Statement
Sales $473,000
Costs 275,000
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
Current assets = $850,000 + 2,200,000
Current assets = $3,050,000
4. Taxes = .10($9,525) + .12($38,700 – 9,525) + .22($82,500 – 38,700) + .24($157,500 – 82,500)
+ .32($189,000 – 157,500)
Taxes = $42,169.50
5. To calculate OCF, we first need the income statement:
Income Statement
Sales $22,400
Costs 11,600
Depreciation 2,200
EBIT $8,600
6. Net capital spending = NFAend – NFAbeg + Depreciation
Net capital spending = $1,430,000 – 1,280,000 + 146,000
Net capital spending = $296,000
7. The long-term debt account will increase by $30 million, the amount of the new long-term debt issue.
Since the company sold 4.5 million new shares of stock with a $1 par value, the common stock account
will increase by $4.5 million. The capital surplus account will increase by $53.5 million, the value of
the new stock sold above its par value. Since the company had a net income of $7.5 million, and paid
$1.7 million in dividends, the addition to retained earnings was $5.8 million, which will increase the
accumulated retained earnings account. So, the new long-term debt and stockholders’ equity portion
of the balance sheet will be:
8. Cash flow to creditors = Interest paid – Net new borrowing
Cash flow to creditors = $170,000 – (LTDend – LTDbeg)
9. Cash flow to stockholders = Dividends paid – Net new equity
Cash flow to stockholders = $335,000 – [(Commonend + APISend) – (Commonbeg + APISbeg)]
Cash flow to stockholders = $335,000 – [($525,000 + 3,750,000) – ($490,000 + 3,400,000)]
10. Cash flow from assets = Cash flow to creditors + Cash flow to stockholders
= $90,000 – 50,000
= $40,000
Cash flow from assets = OCF – Change in NWC – Net capital spending
$40,000 = OCF – (–$96,000) – 735,000
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
$129
Depreciation
92
Changes in other current assets
(17)
Change in accounts payable
17
Total cash flow from operations
$221
Investing activities
Acquisition of fixed assets
Total cash flow from investing activities
Financing activities
Proceeds of long-term debt
$8
Dividends
Total cash flow from financing activities
Change in cash (on balance sheet)
$21
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
Net income
$129
Depreciation
92
Operating cash flow
$221
Capital spending
Ending fixed assets
$417
Beginning fixed assets
Depreciation
92
Capital spending
$111
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
Additions to NWC
Capital spending and NWC cash flow
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 $865,000
Cost of goods sold 455,000
Selling costs 210,000
Depreciation 105,000
EBIT $ 95,000
Interest 27,200
14. To find the OCF, we first calculate net income.
Income Statement
Sales $246,000
Costs 135,000
Other expenses 7,100
Depreciation 19,100
EBIT $84,800
a. OCF = EBIT + Depreciation – Taxes
b. CFC = Interest – Net new LTD
CFC = $10,000 – (–$6,800)
CFC = $16,800
Note that the net new long-term debt is negative because the company repaid part of its long–
term debt.
d. We know that CFA = CFC + CFS, so:
CFA = $16,800 + 1,900
CFA = $18,700
15. The solution to this question works the income statement backwards. Starting at the bottom:
Net income = Dividends + Addition to retained earnings
Net income = $1,720 + 5,300
Net income = $7,020
16. The market value of shareholders’ equity cannot be negative. A negative market value in this case
would imply that the company would pay you to own the stock. The market value of shareholders’
17. Income Statement
Sales $630,000
COGS 465,000
A&S expenses 85,000
Depreciation 135,000
18. A firm can still pay out dividends if net income is negative; it just has to be sure there is sufficient
cash flow to make the dividend payments.
Change in NWC = Net capital spending = Net new equity = 0. (Given)
Cash flow from assets = OCF – Change in NWC – Net capital spending
19. a. The income statement is:
Income Statement
Sales
$24,360
Cost of goods sold
17,600
Depreciation
3,400
EBIT
$ 3,360
b. OCF = EBIT + Depreciation – Taxes
OCF = $3,360 + 3,400 – 525
OCF = $6,235
c. Change in NWC = NWCend – NWCbeg
= (CAend – CLend) – (CAbeg – CLbeg)
Net capital spending = NFAend – NFAbeg + Depreciation
= $21,180 – 18,650 + 3,400
d. Cash flow to creditors = Interest – Net new LTD
= $860 – 0
= $860
Cash flow to stockholders = Cash flow from assets – Cash flow to creditors
= –$140 – 860
Interest
Taxable income
$ 2,500
Taxes
525
Net income
20. a. Total assets 2018 = $1,157 + 5,261 = $6,418
Total liabilities 2018 = $481 + 2,856 = $3,337
Owners’ equity 2018 = $6,418 – 3,337 = $3,081
Total assets 2019 = $1,411 + 6,125 = $7,536
Total liabilities 2019 = $534 + 3,256 = $3,790
So, the company had a net capital spending cash flow of $2,342. We also know that net capital
spending is:
Net capital spending = Fixed assets bought – Fixed assets sold
$2,342 = $2,820 – Fixed assets sold
Fixed assets sold = $2,820 – 2,342
Fixed assets sold = $478
To calculate the cash flow from assets, we must first calculate the operating cash flow. The
Taxes = $1,914
OCF = EBIT + Depreciation – Taxes
OCF = $9,092 + 1,478 – 1,914
OCF = $8,656
Cash flow from assets = OCF – Change in NWC – Net capital spending
21.
Balance sheet as of Dec. 31, 2018
Cash
$4,438
Accounts payable
$4,661
Accounts receivable
4,874
Notes payable
858
Inventory
10,444
Current liabilities
$5,519
Current assets
$19,756
Long-term debt
$14,537
Net fixed assets
$37,211
Owners’ equity
36,911
Total assets
Total liab. & equity
Cash
$5,620
Accounts receivable
6,617
Notes payable
Inventory
10,733
Current liabilities
Current assets
$22,970
Long-term debt
Net fixed assets
Owners’ equity
Total assets
$62,019
Total liab. & equity
Taxes
646.38
Taxes
699.72
Net income
$2,431.62
Net income
$2,632.28
Dividends
$1,032.00
Dividends
$1,135.00
Additions to RE
1,399.62
Additions to RE
1,497.28
22. OCF = EBIT + Depreciation – Taxes
OCF = $3,984 + 1,216 – 699.72
OCF = $4,500.28
Change in NWC = NWCend – NWCbeg = (CA – CL)end – (CA – CL)beg
Change in NWC = ($22,970 – 5,326) – ($19,756 – 5,519)
Change in NWC = $3,407
Cash flow to creditors = Interest – Net new LTD
Net new LTD = LTDend – LTDbeg
Cash flow to creditors = $652 – ($17,334 – 14,537)
Cash flow to creditors = –$2,145
Cash flow to stockholders = $184.28
Sales
$8,462.00
Sales
$9,082.00
2,912.00
Other expenses
690.00
Other expenses
577.00
Depreciation
1,215.00
Depreciation
EBIT
$3,645.00
EBIT
$3,984.00
Interest
567.00
Interest
652.00
EBT
$3,078.00
EBT
$3,332.00
As a check, cash flow from assets is –$1,960.72
Challenge
23. We will begin by calculating the operating cash flow. First, we need the EBIT, which can be calculated
as:
EBIT = Net income + Current taxes + Deferred taxes + Interest
EBIT = $187 + 81 + 11 + 38
EBIT = $317
Now we can calculate the operating cash flow as:
Operating cash flow
Earnings before interest and taxes
$317
Depreciation
Current taxes
Operating cash flow
$310
Cash flow from assets
The net working capital cash flows are all found in the operations cash flow section of the accounting
statement of cash flows. However, instead of calculating the net working capital cash flows as the
change in net working capital, we must calculate each item individually. Doing so, we find:
Net working capital cash flow
Interest
$38
Retirement of debt
145
Debt service
$183
Proceeds from sale of long-term debt
–110
Total
$73
And we can find the cash flow to stockholders in the financing section of the accounting statement of
cash flows. The cash flow to stockholders was:
Cash flow to stockholders
Dividends
$67
Repurchase of stock
Cash to stockholders
$99
Proceeds from new stock issue
Total
$60