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Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094

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BuyFindarrow_forward

Accounting

27th Edition
WARREN + 5 others
ISBN: 9781337272094
Textbook Problem

Dillip Lachgar is the president and majority shareholder of Argon Inc., a small retail chain store. Recently, Dillip submitted a loan application for Argon Inc. to Compound Bank. It called for a $600,000, 9%, 10-year loan to help finance the construction of a building and the purchase of store equipment, costing a total of $750,000. This will enable Argon Inc. to open a store in the town of Compound. Land for this purpose was acquired last year. The bank's loan officer requested a statement of cash flows in addition to the most recent income statement, balance sheet, and retained earnings statement that Dillip had submitted with the loan application.

As a close family friend, Dillip asked you to prepare a statement of cash flows. From the records provided, you prepared the following statement:

Argon Inc.
Statement of Cash Flows
For the Year Ended December 31, 20Y7
Cash flows from operating activities:
Net income.................................................... $ 300,000  
Adjustments to reconcile net income to net cash flow from operating activities:
Depreciation................................................ 84,000  
Gain on sale of investments.................................. (30,000)  
Changes in current operating assets and liabilities:
Decrease in accounts receivable............................ 21,000  
Increase in inventories..................................... (42,000)  
Increase in accounts payable............................... 30,000  
Decrease in accrued expenses payable...................... (6,000)  
Net cash flow from operating activities..........................   $ 357,000
Cash flows from (used for) investing activities:
Cash from investments sold..................................... $ 180,000  
Cash used for purchase of store equipment..................... (120,000)  
Net cash flow from investing activities...........................   60,000
Cash flows from (used for) financing activities:
Cash used for dividends........................................ $ (126,000)  
Net cash flow used for financing activities........................   (126,000)
Increase (decrease) in cash.........................................   $ 291,000
Cash at the beginning of the year...................................   108,000
Cash at the end of the year.........................................   $ 399,000

After reviewing the statement, Dillip telephoned you and commented, “Are you sure this statement is right?" Dillip then raised the following questions:

1. “How can depreciation be a cash flow?"

2. “Issuing common stock for the land is listed in a separate schedule. This transaction has nothing to do with cash! Shouldn't this transaction be eliminated from the statement?"

3. “How can the gain on the sale of investments be a deduction from net income in determining the cash flow from operating activities?”

4. “Why does the bank need this statement anyway? They can compute the increase in cash from the balance sheets for the last two years."

After jotting down Dillip's questions, you assured him that this statement was “right." But to alleviate Dillip's concern, you arranged a meeting for the following day.

a. How would you respond to each of Dillip's questions?

b. Do you think that the statement of cash flows enhances the chances of Argon Inc. receiving the loan? Discuss.

a)

To determine

Statement of cash flows:

Statement of cash flow is a financial statement that shows the cash and cash equivalents of a company for a particular period of time. It shows the net changes in cash, by reporting the sources and uses of cash as a result of operating, investing, and financing activities of a company.

Cash flows from investing activities:

Cash provided by or used in investing activities is a section of statement of cash flows. It includes the purchase or sale of equipment or land, or marketable securities, which is used for business operations.

Cash flows from financing activities:

Cash provided by or used in financing activities is a section of statement of cash flows. It includes raising cash from long-term debt or payment of long-term debt, which is used for business operations.

Cash flows from operating activities:

These refer to the cash received or cash paid in day-to-day operating activities of a company.  In this direct method, cash flow from operating activities is computed by using all cash receipts and cash payments during the year.

To respond: To each of the questions asked by Person D.

Explanation

1.

Generally, in order to determine the amount of cash flows from the operating activities, some of the items which affect the cash flows must be added to or deducted from the net income of the company. Though many operating expenses tend to decrease cash, depreciation expense does not decrease the cash. The amount of cash flows will be understated by the net income to the extent to which the depreciation expense will be deducted from the revenue. When an asset is purchased, it is said to be a cash outflow, and it will be reported as a cash outflow from the investing activities. Hence, to arrive at the cash flows from operating activities, the depreciation expense must be added back to the net income of the company.

2.

According to Generally Accepted Accounting Principles (GAAP), though if the transaction does not affect the cash flow in the present period,but it affects the future cash flow, then such transaction should be reported in a separate schedule.

Hence, even though issuance of common stock for land does not affect cash, it must be reported in a separate schedule as it will affect the future cash flow...

b.

To determine

To discuss: The statement of cash flows enhances the chances of receiving the loan.

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