A242-742 - F 2020 - HWQ-2-Solution

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1 Name ACCOUNTING 242/742 Homework / Quiz 1 Fall 2020 Instructions  Please print or type your name in the space provided above.  You have two hours from the time you download the Quiz to return your answers via Gradescope on Canvas. Be sure to budget enough time to scan your answers into a pdf file and complete the upload before the two-hour time limit expires.  This Quiz is open book and open notes. You are welcome to use information from non-class sources as well (i.e. look things up on the internet)  You are not allowed to contact other people (or Siri or Alexa!)  Sign the HONOR CODE statement at the bottom of the page and return this page with your answers.  Show your work to receive partial credit. If you feel you need to make an assumption to answer a question, state that assumption with your answer.  Note than not all of the information presented in the problems is necessarily relevant!  Upload your answers in the form of a pdf file via Gradescope in Canvas by the end of the time limit.  Also separately send me a copy of your answers (lambertr@wharton.upenn.edu) Maximum Points Points Scored Question 1 - What Does Operating Mean? 5 Question 2 - Interest Cost 6 Question 3 - PPE 14 Question 4 – Compare Free Cash Flow 10 Question 5 – Calculate Free Cash Flow 12 Question 6 – Revenue Recognition 10 TOTAL 57 The Wharton School Honor Code applies to this exam. In particular, you may not talk about the exam with other people. By signing below, you agree to abide by the Honor Code. Signature

2 1. (5 pts) How are the terms “operations” or “operating” used differently on the cash flow statement versus how they’re used on the income statement and how we used them when we decomposed and re-formulated the balance sheet? That is, how are items classified differently on the statements? I’m not looking for a long, detailed list of specific differences, but a higher-level discussion. The term operations or operating generally has a more narrow definition on the cash flow statement than on the other two statements. On the balance sheet and income statement, we classified things as “Operating” vs “Financial.” But the cash flow statement uses three categories: Operating, Investing and Financing. There are also some other classification differences across the statements. Some of the things in the Operating category of Income and the Balance Sheet are in the Investing section, not the Operating section of the Cash Flow statement. For example, Long term assets like PPE are considered operating assets, and the expenses associated with them (like depreciation and amortization) are considered part of operating income. But Operating Cash Flow excludes these things – they are in the Investing Section. (This is why Cash From Operations is not a measure of profitability – it omits relevant costs). Cash flows from financial assets are mixed across the operating and Investing sections of the cash flow statement. Interest cost is in the operating section, not the financial section. (Note that the Financing Section of the Cash Flow Statement only contains flows associated with the right hand side of the balance sheet – financial liabilities and shareholders’ equity. It does not mix flows from / to financial assets with ones associated with financial liabilities – there is no section on the cash flow statement comparable to Net Financial Assets on the balance sheet or Net Financial Income. The Operating section of the Cash Flow statement includes interest expense, which should be properly classified in the financing section.) (Note that R&D is in the Operating section of the CF statement, but it is also considered an operating expense on the income statement. To the extent it appears on the balance sheet, it is considered an Operating Asset.) Note that Free Cash Flow (appropriately defined) is more analogous to the (Net) Operating Assets on the balance sheet and Net Operating Income from the income statement. In fact, one definition of Free Cash Flow is Net Operating Income – Change in Net Operating Assets.

3 2. (6 pts) The cost of interest appears in the Operating Section of the Cash Flow Statement under GAAP. Many analysts feel this is not where it belongs. Suppose a firm has  $9,000 of Interest Expense  $8,000 of Cash Paid for Interest  A Tax Rate of 20% (4 pts) What adjustment would you make to Cash From Operations to better reflect the proper placement of interest? (Give me a magnitude and a direction; e.g., I would adjust CFO downwards by $1). Since it’s the CASH flow statement, we need to adjust the CASH PAID for interest out of the Operating section. This would increase Cash from Operations by (1-.2) x 8,000 = $6,400 (2 pts) To what section (if any) of the cash flow statement would you move the cost of interest? We’d move it to the Financing Section. (where it would be matched with principal paid on interest, as well as inflows and outflows to shareholders).

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