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Solution Manual for Financial Accounting in an Economic Context, 9th Edition

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    1 CHAPTER 1 FINANCIAL ACCOUNTING IN AN ECONOMIC CONTEXT ISSUES FOR DISCUSSION ID1 – 1 Security analysts and stockholders: These users would use financial statements to try to estimate the future earnings and cash flow potential of the company, which would be used to project a value for the company’s stock. Bank loan officers: These users would use the financial statements to determine the ability of a company to repay loans to the bank. A company’s customers and suppliers: These users would use financial statements to determine whether to extend credit to the company (suppliers) or whether to rely upon the company to be a supplier (customers). Both suppliers and customers would also use the financial statements to monitor the company’s profit margins. Public utilities: This group would use the financial statements to determine the company’s growth rate and how that might impact upon the company’s utility needs. Also, they would evaluate the company’s ability to pay its bills. Labor unions: These groups would use the financial statements to monitor the profitability of the company to help determine the amount of pay raises and benefits that it will negotiate for from the company. A company’s managers: The company’s managers will use the financial statements to assess the overall financial health of the company. This could impact the managers in a number of ways: raises, promotion opportunities, performance of other departments, etc. ID1 – 2 The board of directors serves various functions for a company. One is to represent and protect the interests of the stockholders who are not on the board. Another is to provide oversight and input to management. The managers are involved in running the business on a day to day basis whereas the board is more focused on the bigger, long term picture. A weak board may not ask probing questions of management but instead may take everything at face value and believe anything that management says to them. A healthy management team would want a strong board that delivers valuable input. A management team that wants a weak board of directors may be trying to hide something (management fraud). Auditors are concerned with management fraud because, if there is a problem, in many cases the auditors will be sued by the stockholders on the basis that the auditors should have detected the fraud.

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    2 ID1 – 3 The function of the audit committee is to provide a channel whereby the auditors report their findings and concerns, if any, to the board of directors. Typically there are outside members of the board that are on the audit committee so that if the auditors have concerns about management’s financial statements or activities, then the auditors have a way to speak directly to the board of directors. The auditors are in a sensitive position because the financial statements and activities that they are auditing are prepared by the same people who hire and pay the auditors. Therefore, they may be reluctant to jeopardize their relationship with the company by being too negative. ID1 – 4 Banks make loans to customers and depend on those customers to repay the loans (called the “principal”) plus interest for the banks to earn a profit. If customers are not able to pay the interest, the banks cannot make a profit; further, if the customers are not able to repay the principal the banks will show a loss that reduces the equity on the balance sheet. Banks look at a number of factors, both “macro” and “micro” in nature. Banks will look at the overall strength of the economy and the likelihood for future growth; these are the macro issues a bank considers. Banks will also examine the specifics of a company’s individual performance within the economy; these micro issues often are seen in the financial statements of companies. Issues such as the amount of debt, the level of profits, the amount of cash on hand and the amount of cash generated by the business, and the quality and size of the assets can all be seen from the financial reporting system. Banks require borrowers to submit financial statements to show these performance measures. During the 2008 - 2009 recession and related credit crunch, banks were concerned about the macro issues shown in general economic data, as well as the micro issues shown in companies’ individual financial reports. The reluctance of banks to lend has been cited as one of the reasons for the length of the economic downturn. ID1 – 5 Sales for Home Depot in crease d during the time period because of the slow rebound of the econom y after the worst of the “Great Recession” . As conditions improved, home owners and to a lesser extent home builders purchased more materials from Home Depot to improve and construct houses. P rofits in creased because the bump in sales was not offset with an equal increase in expenses , probably due to some economies of scale experienced by the large hardware retailer . Assets in creased as the company boosted inventory in stores to meet the higher sales, as well as the company increasing its total number of stores . Equity remained flat because the company rewarded its owners by paying out dividends equal to its profits . Finally, the cash balance slightly increased due to the fact that the improved operations (from the stronger economy) generated more cash than what was needed to invest in new stores and pay out to the providers of capital . ID1 – 6 Creditors would impose these types of restrictions on United Continental so that the creditors would be protected for their loans. These types of restrictions are fairly common and act as a trip wire to warn the creditors that business may not be going well. The cash restriction would force United Continental to have enough cash to pay the interest on the debt and the minimum cash flow coverage assures that the airline’s operations a re functioning well enough to generate sufficient cash flow to meet obligations. . These restrictions act as trip wires in that as soon as a restriction is violated the creditors can call the debt and force the company to pay back the loans. What is more typical is for the loans to be

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    3 restructured. This usually means higher interest rates and fees to do the restructuring. These all put the creditors in a better position to protect their loans. ID1 – 7 Companies would usually engage in this type of behavior to try to improve their stock price. By showing higher revenues or lower expenses investors are more likely to reward the company with a higher stock price. Companies that have negative cash flow are under a lot of pressure to maintain a high stock price since selling stock is the only way to fund the business. This type of incentive can lead to questionable behavior. The ethical implications are significant because if investors lose faith in the financial statements that are reported this would severely impact the stock market. A strong driver to a robust economy is access to capital (stock markets). If this source is reduced because investors don’t believe the numbers that are reported, a very bad impact on the overall economy would result. ID1 – 8 This is the normal statement that an auditor would make about a company whose books it had audited and found no significant problems. This would be part of what is called a “non - qualified opinion”. If there was a particular item that the auditors did not agree with they would issue a “qualified opinion” – they would agree with everything except the qualified item that would be identified. “In our opinion”, shows that the statement represents the auditor’s opinion and not a fact ; “fairly, in all material respects” means that the auditors can not say that every single number is exactly accurate to the penny but that the numbers are generally accurate . This reflects the concept of materiality ; t he auditors believe that all material items have been presented accurately. Finally, “ in conformity with accounting principles generally accepted in the United States of America ” means that the financial statements have been compiled in a way that meets all of the accounting principles that are called GAAP in the U.S but not necessarily in conformance with international standards . ID1 – 9 Corporate governance describes the relationship among the stakeholders of a company, mainly : the shareholders, the Board of Directors, management and the company’s auditors. Corporate governance mechanisms encourage management and the Board of Directors to act in the best interest of the shareholders and to provide the shareholders with accurate and timely financial information. The Sarbanes - Oxley Act was passed to upgrade the financial transparency of corporate operations, requiring increased financial disclosures and management responsibilities for the intergrity of the financial statements. Improved information provided to shareholders and other providers of capital

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    4 will strenghten the confidence in the financial system, ultimately benefitting both providers and users of capital. ID1 – 10 Management is charged with the responsibility to benefit the shareholders’ investment in the company. Choosing investments that will boost the short - term results of the company in lieu of long - term gains does not meet this requirement. While satisfying the needs of Wall Street analysts for short term results, a management decision to forego larger long term returns violates the relationship between the owners of the company and the management of the company. Many observers feel that short term profit pressures from analysts have caused management to ignore its responsibility to work for the long term benefit of the shareholder. ID1 – 11 Financial analysts are charged with the task of following companies in specified industries and evaluating the past financial performance of those companies, as well as providing guidance for expectations for future financial performance. Until financial reporting is consistent across global lines, analysts must be in a position to understand, interpret, analyze and forecast financial performance using different financial systems. An analyst following the pharmaceutical industry needs to understand how companies compare against each other, how Novartis stacks up against Johnson & Johnson. Now, not only does an analyst have to understand two sets of financial reporting systems (IFRS and GAAP), but that analyst then has to perform some type of conversion, so the companies can be compared under the same (“apples to apples”) basis. Fluency in GAAP is not sufficient; an analyst must also speak the language of IFRS and be able to translate back and forth between the two systems. ID1 – 1 2 Accounting guidelines that are established based on a number of general principles have th e advantage of being simplified and easier to understand and document. On the other hand, guidelines that are principle - based are more ripe to be exploited by companies desiring to present their financial statements in good light. Guidelines that are based on a detailed set of rules are, by definition, lengthy and complicated, trying to anticipate every possible business situation. However, some argue that the more detailed rules - based approach allows the users of financial statements to review companies’ financial performance from a consistent perspective. ID1 – 1 3 Manage rial accounting is the accounting system that generates information that is used exclusively by the managers of the company. Financial accounting refers to the financial statements that are prepared and distributed outside of the company. So in many cases management accounting information is the operational information used by the managers of the company. This can be very proprietary to the company and so is not made public. Management accounting numbers are not subject to audit and therefore are prepared in whatever form is helpful to the manager.

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    5 Financial accounting information is audited and therefore has to follow GAAP. Its primary purpose is to be used by people outside of the company. ID1 - 1 4 a. Google is primarily a service business, providing internet search functions and selling targeted online advertising. However, due to a recent acquisition of part of Motorola’s cell phone business, the company also is a manufacturing company. b. The firm of Ernst & Young audits the financial statements of Google . The audit report states what years and financial statements were audited and therefore being commented upon by th e audit or . The second paragraph explains what an audit is intended to do and how the company has gone about doing this audit. The company’s internal control procedures are discussed. Finally, the report states the auditors’ opinion regarding the financial statements that have been audited. The auditors do not evaluate the financial strength of the company; the auditor states that the financial statements “present fairly” the position of Google ; it is up to the user of the financial statements to analyze the company’s performance. c. Net income in 20 10 was $ 8,505 , 0 00,000, for 20 11 net income was $ 9 , 737 , 0 00,000 and for 20 12 net income was $ 1 0 , 737 , 0 00,000. d. The amounts shown below are in millions: 20 12 20 11 . Total liabilities $ 22,083 $ 14,429 Total assets $ 93,798 $ 72,574 TL/TA (%) 23.54 % 19.88 % Total liabilities include both Current and Long Term liabilities. From 20 111 to 20 12 Google in creased the percentage of its assets that were financed by liabilities . This fact, of course, means that the company de creased the percentage of its assets that were financed by equity. e. Cash from operating activities was $ 1 1 , 081 , 0 00,000 in 20 1 0, in 20 11 it was $ 1 4 , 565 , 0 00,000 and in 20 12 it was $ 1 6 , 619 , 0 00,000. f. Google in creased its profitability (in both raw dollars ) but as a percentage of revenue the company was slightly less profitable, 2012 versus 2010. The addition of the Motorola business might be an explanation behind the margin shift. As noted above, the company used slightly more leverage than previously, but debt levels are still quite low in comparison to other companies. Finally, the cash generated by the company’s core operations grew significantly from 2010 to 2012. T he company is quite strong and well - positioned for the future.

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    1 CHAPTER 2 THE FINANCIAL STATEMENTS BRIEF EXERCISES BE2 – 1 20 12 20 12 20 12 Beginning Ending Retained 20 12 20 12 20 12 Retained Earnings + Revenues – Expenses – Dividends = Earnings $ 40.3 + $ 65.5 – $ 59.3 – X = $ 43.2 X = $ 3.3 20 12 Dividends as a percentage of 20 12 net income: 20 12 Dividends = $ 3.3 = 53.2 % 20 12 Net income ($ 65.5 - $ 59.3 ) $ 6.2 BE2 – 2 (1) Current Liabilities financed $ 45 billion of the assets. Current Liabilities divided by Total assets = $ 45 /$ 8 9 = 50.6 % (2) Long - term debt financed $ 3 8 billion of the assets. Long - term debt divided by total assets = $ 3 8 /$ 8 9 = 42.7 % (3) Stockholders’ equity financed $ 6 billion of the assets. Stockholders’ equity divided by total assets = $ 6 /$ 8 9 = 6.7 % BE2 – 3 (a) Working capital = current assets – current liabilities. Boeing’s current assets total $ 5 7 billion, less $ 45 billion of current liabilities, gives the company working capital of $ 12 billion. Another measure of solvency would be the current ratio. The current ratio is current assets divided by current liabilities or $ 57 billion divided by $ 45 billion = 1.27 . Both measures indicate that Boeing appears to have reasonable solvency. Current assets are sufficient to cover current liabilities. (b) No, Boeing has $ 1 9.1 billion of liquid current assets (cash, short term investments, and accounts receivable) but it has $ 45 billion of current liabilities. (c) Boeing would be more solvent if accounts receivable were $ 37.8 billion and inventory was $ 5 . 6 billion. Accounts receivable are closer to cash than inventory. This means that accounts receivable are expected to be converted to cash in a shorter period of time than inventory.

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    BE2 - 4 20 12 20 11 20 10 Net cash flow from operating activities ......................... $ 3 6 , 100 $ 34 , 743 $ 35,222 Net cash flow from investing activities .......................... ( 1 9 , 680 ) ( 21,250 ) ( 21,449 ) Net cash flow from financing activities .......................... ( 17 ,6 73 ) ( 11 , 649 ) ( 15,849 ) Net change in cash ................................ ......................... $ ( 1,253 ) $ 1,844 $ (2,076) Cash at beginning of period ................................ ........... 3,045 1,201 3,277 Cash at end of period………………………………. ................... $ 1,792 $ 3,045 $ 1,201 AT & T ’s cash management activities over the three - year period of 20 10 - 20 12 appear to be extremely strong . The company is generating significant amounts of cash flow from operating activities , with all three years in excess of $34.5 billion . AT & T is then able to reinvest substantial amounts in its asset base. At the same time AT & T is also able to fund its financing activities from its operating cash flow. The large amount of funds being used in investing activities indicate s that AT & T is growing its capital - intensive business. BE2 – 5 IFRS Format Non - current assets 154,073 Current assets 115,397 Less: Current liabilities (94,384) Total 175,086 Non - current liabilities 49,118 Equity 125,968 Total 175 , 086 GAAP Format Non - current assets 154,073 Current assets 115,397 Total 269,470 Current liabilities 94,384 Non - current liabilities 49,118 Equity 125,968 Total 269,470 Many non - US companies begin with non - current assets, add current assets, and then subtract current liabilities to reflect the resources available to generate revenues and profits. The IFRS balance sheet then lists non - current liabilities and shareholders’ equity, which represent the financing sources of company resources ; this amount is often labeled “capital employed.” GAAP balance sheets, on the other hand, list all assets owned (current and long - term) and then categorizes the financing sources (current and long - term liabilities, as well as shareholder equity) for those assets.

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    EXERCISES E2 – 1 Operating, Investing, or Financing Balance Sheet Income Statement Statement of Cash Flows Statement of Stockholders Equity 1 Financing Yes No Yes Yes 2 Operating Yes Yes Cannot tell Yes 3 Operating Yes Yes Yes Yes 4 Investing Yes No Cannot tell No 5 Financing Yes No Yes No 6 Financing Yes No Yes Yes 7 Investing Yes No Yes No 8 Operating Yes No Yes No E2 – 2 Operating, Investing, or Financing Balance Sheet Income Statement Statement of Cash Flows Statement of Shareholders Equity 1 Financing Yes No Yes No 2 Operating Yes No No No 3 Operating Yes Yes Yes Yes 4 Operating Yes Yes No Yes 5 Investing Yes No Yes No 6 Investing Yes Cannot tell Yes Cannot tell 7 Financing Yes No Yes No 8 Operating Yes No Yes No E2 – 3 a. Balance sheet g. Balance sheet m. Balance sheet b. Income statement h. Balance sheet n. Balance sheet c. Balance sheet i. Balance sheet o. Balance sheet d. Income statement j. Balance sheet p. Income statement e. Balance sheet k. Income statement q. Balance sheet f. Income statement l. Income statement r. Balance sheet E2 – 4

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    1. Statement of Stockholders’ Equity (Retained Earnings); Statement of Cash Flow, Income Statement 2 . Income Statement 3 . Balance Sheet 4 . Statement of Cash Flow, Balance Sheet 5 . Statement of Stockholders’ Equity; Statement of Cash Flow 6 . Income Statement, Balance Sheet 7 . Income Statement 8 . Balance Sheet, Income Statement E2 – 5 20 10 20 10 20 10 Beginning Ending Retained 20 10 20 10 20 10 Retained Earnings + Revenues – Expenses – Dividends = Earnings $ 1.5 + $ 14.3 – $ 13.0 – X = $ 1.5 X = $ 1.3 20 11 * 20 11 20 11 Beginning Ending Retained 20 11 20 11 20 11 Retained Earnings + Revenues – Expenses – Dividends = Earnings $ 1.5 + $ 14.5 – X – $ 1.3 = $ 1. 9 X = $ 12.8 20 12 20 12 20 12 Beginning Ending Retained 20 12 20 12 20 12 Retained Earnings + Revenues – Expenses – Dividends = Earnings X + $ 19.6 – 1 7 .8 – $ 1 . 8 = $ 1. 9 X = $ 1.9 *you must calculate the 20 12 equation before you can calculate the 20 11 equation 20 12 20 11 20 10 Sales growth ($) $ 5.1 $ 0.2 N/A Sales growth (%) 35.2 % 1 . 4 % N/A Profits ($) $ 1 . 8 $ 1 . 7 $ 1 . 3 Profits (% of sales) 9.2 % 11.7 % 9.1 % Dividends (% of net income) 100 % 7 6 . 5 % 100 % The company saw significant sales growth, but profits grew relatively less . Dividends are a consistently high percentage of profits, which is common in the utility industry .

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    E2 – 6 20 10 20 10 Ending Retained Earnings 20 10 Beginning Retained Earnings or = + Revenues for 20 10 20 11 Beginning Retained Earnings – Expenses for 20 10 – Dividends for 20 10 ($523) = ($499) + $1,383 – X – $0 X = $1,407 Expenses for 20 10 are $1,407. 20 11 ($758) = ($523) + $1,522 – $1,608 – X X = $149 Dividends declared for 20 11 are $149. 20 12 ($596) = ($758) + X – $1,550 – $5 X = $1,717 Revenue for 20 12 is $1,717. 20 10 20 11 20 12 Sales growth (%) ................................ .......................... N/A 10.0% 12.8% Profits ................................ ................................ ............ ($24) ($86) $ 167 Profits as a percentage of sales ................................ ...... (1.7%) (5.7%) 9.7% Dividends ................................ ................................ ........ $ 0 $ 149 $ 5 Dividends as a percentage of net income ...................... N/A N/A 3.0% The advertising agency had modest sales growth from 20 10 to 20 12 . However, from 20 11 to 20 12 , the Company was able to go from losses to a profit. Even though the Company had a loss in 20 11 the Company paid a healthy dividend. Then in 20 12 , when the Company showed a profit, it virtually eliminated the dividend. There is reason to be optimistic going forward. In 20 12 the Company was able to show a nice growth in its sales while at the same time showing a reduction in its expenses.

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    E 2 – 7 Solvency primarily indicates a company’s ability to meet its debt payments as they come due. Current liabilities are obligations that will be settled within one year or the company’s operating cycle, whichever is longer, through the use of current assets or the creation of new current liabilities. Current assets are those assets that will be consumed or converted to cash within one year or the company’s operating cycle, whichever is longer. Consequently, comparing current assets to current liabilities provides an indication of a company’s ability to meet its short - term debts. In this case, current assets were 3.33 ($ 500 /$ 1 50 ) and 3.27 ($ 4 32 /$ 1 32 ) times greater than current liabilities as of December 31, 20 12 and December 31, 20 11 , respectively. Although comparing current assets to current liabilities provides a measure of a company’s solvency, this measure is not perfect. A true test of a company’s short - term solvency would be to compare the cash value of its current assets to the cash value of its current liabilities. For current liabilities, the book value is usually a good approximation of the cash value, since a company cannot, from a legal viewpoint, unilaterally change its debts. The situation is different for current assets though. The book value may or may not bear any relation to the cash value. Consequently, comparing the book value of current assets to current liabilities may not give an accurate measure of a company’s solvency. E2 – 8 Method 1 Method 2 Working capital as of 12/31/20 12 ($ 500 – $ 1 50 ) ................................ ................................ . $ 350 $ 350 Impact of method on current assets .............................. 0 0 Impact of method on current liabilities ......................... ( 2 00) 0 New working capital as of January 20 1 3 ........................ $ 150 $ 350 It seems that only the second method would be acceptable to the company in terms of maintaining compliance with the minimum working capital covenant. E2 – 9 20 12 20 11 20 10 Beginning cash balance ................................ .................. $ 7,662 $ Y* $ 5,718 Net cash flow from operating activities ......................... 11,491 X 10,1 73 Net cash flow from investing activities .......................... ( 3,815 ) ( 2,934 ) X Net cash flow from financing activities .......................... X ( 4,064 ) 62 1 Ending cash balance ................................ ....................... $ 9, 799 $ 7,662 $ 4,581 X equals ................................ ................................ . $ (5,53 9 ) $ 10,079 $ ( 11,931 ) *Beginning cash balance for 20 11 = Ending cash balance for 20 10 . Cisco Systems’ cash management activities over the three - year period of 20 10 , 20 11 , and 20 12 appear to be strong. The Company is generating a significant amount of net cash flow from operations each year and then is investing in its business. Financing activities (including dividends and/or share repurchases) reduced cash in 20 12 and 20 11 , but were positive in 20 10 .

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    E2 – 10 20 12 20 11 20 10 Beginning cash balance ................................ .................. $ 829 ** $ 1, 261 $ X Net cash flow from operating activities ......................... 2,064 1,356 1, 561 Net cash flow from investing activities .......................... X ( 1, 022 ) ( 1, 26 5 ) Net cash flow from financing activities .......................... (947) X ( 149 ) Ending cash balance ................................ ....................... $ 1, 113 $ 829 $ 1, 261 * X equals ................................ ................................ . $ ( 833 ) $ ( 766 ) $ 1,114 *20 11 Beginning balance = 20 10 Ending balance **20 12 Beginning balance = 20 11 Ending balance. Southwest Airlines’ cash management activities appear to be very good for the years 20 10 and 20 11 , but even better in 20 12 (due to the economic rec overy ) . The company generat ed a net cash inflow from its operating activities for the years shown . A look at its investing activities reveals that the company is expanding its asset base, as necessary in such a capital intensive industry . During 20 11 and 2012 , the company increased its cash out flow s due to financing activities. Overall, Southwest Airlines is a strong company emerging from a difficult time in its cyclical business . E2 – 1 1 Lana & Son s Statement of Cash Flows For the Year Ended Cash flows from operating activities: Cash collection from services provided ................................ .................. $4,000 Cash payment for expenses ................................ ................................ ... (3,000 ) Net cash increase (decrease) from operating activities .................. $1,000 Cash flows from investing activities: Purchase of machinery ................................ ................................ ........... $(3,000 ) Net cash increase (decrease) from investing activities ................... (3,000) Cash flows from financing activities: Proceeds from stockholders’ contributions ................................ ........... $7,000 Payment of dividends ................................ ................................ ............. (1,500 ) Net cash increase (decrease) from financing activities ................... 5,500 Increase (decrease) in cash balance ................................ .............................. $ 3,500 Beginning cash balance ................................ ................................ ................. 13,000 Ending cash balance ................................ ................................ ...................... $ 16,500 Based on just one year’s statement of cash flows it is difficult to comment adequately on Lana & Son’s cash management activities. However, one can observe that most of the cash during the year was generated as a result of issuing equity. The company seems to be investing in its asset base. That will certainly help it grow in the future. Cash flows from operations is positive, which certainly is a good sign.

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    E2 – 1 2 Emory Inc. Statement of Cash Flows For the Year Ended Cash flows from operating activities: Cash collection from services provided ................................ .................. $40,000 Cash payment for expenses ................................ ................................ ... (23,000 ) Net cash increase (decrease) from operating activities .................. $17,000 Cash flows from investing activities: Purchase of equipment ................................ ................................ .......... $(23,000 ) Net cash increase (decrease) from investing activities ................... (23,000) Cash flows from financing activities: Proceeds from the bank loan ................................ ................................ . $30,000 Payment of dividends (24,000 ) Net cash increase (decrease) from financing activities ................... 6,000 Increase (decrease) in cash balance ................................ .............................. $ 0 Beginning cash balance ................................ ................................ ................. 25,000 Ending cash balance ................................ ................................ ...................... $ 25,000 Based on just one year’s statement of cash flows, it is difficult to comment adequately on Emory’s cash management activities. However, it seems that the company is generating a substantial portion of its cash flows from operating activities. The company is taking some loans to finance its asset base which would be helpful in the future. Return on total assets and return on equity would probably increase. E2 – 1 3 George’s Business Income Statement For the Year Ended Lease revenue ................................ ................................ ................................ ... $3,000 Expenses ................................ ................................ ................................ ........... 2,500 Net income ................................ ................................ ................................ ....... $ 500 George’s Business Statement of Stockholders’ Equity For the Year Ended Contributed Retained Capital Earnings Beginning Balance $ 0 $ 0 Stock Issue 6,000 Net Income 500 Cash Dividends _____ (800) Ending Balance $6,000 $ (300)

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    E2 – 1 3 Concluded George’s Business Balance Sheet As of Assets Cash ................................ ................................ ................................ ................ $ 2,700 Land ................................ ................................ ................................ ................ 8,000 Total assets ................................ ................................ ................................ ....... $ 10,700 Liabilities & Stockholders’ Equity Note payable ................................ ................................ ................................ .... $ 5,000 Contributed capital ................................ ................................ ........................... 6,000 Retained earnings ................................ ................................ ............................. (300 ) Total liabilities & stockholders’ equity ................................ ............................. $ 10,700 George’s Business Statement of Cash Flows For the Year Ended Cash flows from operating activities: Cash collections from customers ................................ .................. $ 3,000 Cash payments for expenses ................................ ......................... (2,500 ) Net cash flow from operating activities ................................ ... $ 500 Cash flows from investing activities: Purchase of land ................................ ................................ ............ $ (8,000 ) Net cash flow from investing activities ................................ .... (8,000) Cash flows from financing activities: Proceeds from equity investor ................................ ...................... $ 6,000 Proceeds from borrowing ................................ .............................. 5,000 Cash payments for dividends ................................ ........................ (800 ) Net cash flow from financing activities ................................ .... 10,200 Increase in cash ................................ ................................ .................. $ 2,700 Beginning cash balance ................................ ................................ ...... 0 Ending cash balance ................................ ................................ ........... $ 2,700 Upon examining George’s financial statements the bank would certainly be concerned because George paid out more in dividends than the net income he realized during the year. George’s statement of retained earnings shows a negative balance, which means that the payment to equity investors which was disguised as return on capital was in fact a return of capital. Generally, dividend payments cannot exceed the Retained Earnings balance.

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    E2 – 1 4 Mary’s Business Income Statement For the Year Ended Lease revenue ................................ ................................ ................................ ... $ 12,000 Expenses ................................ ................................ ................................ ........... 14,000 Net income ................................ ................................ ................................ ....... $ (2,000 ) Mary’s Business Statement of Stockholders’ Equity For the Year Ended Contributed Retained Capital Earnings Beginning Balance $ 0 $ 0 Stock Issue 30,000 Net Income (Loss) ( 2 ,000) Cash Dividends ______ ( 1 ,000) Ending Balance $30,000 $ (3,000) Mary’s Business Balance Sheet As of Assets Cash ................................ ................................ ................................ ................ $ 2,000 Land ................................ ................................ ................................ ................ 40,000 Total assets ................................ ................................ ................................ ....... $ 42,000 Liabilities & Stockholders’ Equity Note payable ................................ ................................ ................................ .... $ 15,000 Contributed capital ................................ ................................ ........................... 30,000 Retained earnings ................................ ................................ ............................. (3,000 ) Total liabilities & stockholders’ equity ................................ ............................. $ 42,000

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