Topic Two

Financial Statements
The Income Statement
The income statement provides a financial summary of the firm’s operating
results during a specified period. It measures performance over some period of
time, usually a year.
The income statement summarizes a firm's revenue and expenses over a
period of time. You generally report revenues first and then deduct any expenses
for the period.
Income Statement Equation

𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠 = 𝐼𝑛𝑐𝑜𝑚𝑒

Table 1 presents Bartlett Company’s income statement for the year ended
December 31, 2022

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 Table 1: Bartlett Company Income Statement ($000)
For the year ended December 31, 2022
Sales revenue 3,074
Less: Cost of goods sold (2,088)
Gross profits 986
Less: Operating expenses
Selling expense 100
General and administrative expenses 194
Lease expense 35
Depreciation expense 239
Total operating expense (568)
Operating profits 418
Less: Interest expense (93)
Net profits before taxes 325
Less: Taxes (94)
Net profits after taxes 231
Less: Preferred stock dividends (10)
Earnings available for common stockholders 221
Less: Common stock dividends (98)
Addition to retained earnings 123
Note that:

− Sales revenue represents the total dollar amount of sales during the period
− Cost of goods sold is also called cost of sales.

− Gross profit represents the amount remaining to satisfy operating, financial,

and tax costs.

− Operating profits represent the profits earned from producing and selling
products; this amount does not consider financial and tax costs.

− Operating profit is often called earnings before interest and taxes, or EBIT.
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− Interest expense represents the financial cost

− Taxes = Net profits before taxes × Tax rate

− Net profits before taxes are also called pretax profits or taxable income.
− Net profits are also called earnings.

− Net profits (or earnings) after taxes, also referred to as net income.

− If there are no preferred stock dividends, earnings available for common

stockholders are equal to net profits after taxes.

− Earnings available for common stockholders = Common stock dividends +

Addition to retained earnings

− If there is no preferred stock dividends,

Net profits after taxes = Common stock dividends + Addition to retained

earnings

− Earnings per share (EPS) and dividends per share (DPS):

𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 (𝐸𝑃𝑆)
𝐸𝑎𝑟𝑛𝑖𝑛𝑔𝑠 𝑎𝑣𝑎𝑖𝑙𝑎𝑏𝑙𝑒 𝑓𝑜𝑟 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠
=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

− Earnings available for common stockholders = Earnings per Share (EPS) ×

Number of shares of common stock outstanding

𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑒𝑟 𝑆ℎ𝑎𝑟𝑒 (𝐷𝑃𝑆)

𝐶𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
=
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔

− Common stock dividends = Dividends per Share (DPS) × Number of shares

of common stock outstanding

3
Questions and Problems
MULTIPLE CHOICE. Choose the one alternative that best
completes the statement or answers the question. Please
Show your calculations
1. Which one of the following is the financial statement that summarizes a
firm's revenue and expenses over a period of time?
A. income statement
B. balance sheet
C. statement of cash flows
D. market value report

Answer: A
2. A(n) ________ provides a financial summary of a firm's operating results
during a specified period.
A. balance sheet
B. income statement
C. statement of cash flows
D. statement of retained earnings

Answer: B
3. Gross profit is ________.
A. operating profits minus depreciation
B. operating profits minus cost of goods sold
C. sales revenue minus operating expenses
D. sales revenue minus cost of goods sold

Answer: D

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4. Andre's Bakery has sales of $687,000 with costs of $492,000. Interest
expense is $26,000 and depreciation is $42,000. The tax rate is 35%. What is
the net income?
A. $42,750
B. $44,450
C. $82,550
D. $86,450

Answer: C

Andre's Bakery Income Statement

Sales revenue 687,000
Less: Cost of goods sold (492,000)
Gross profits 195,000
Less: Operating expenses
Depreciation expense 42,000
Total operating expense (42,000)
Operating profits 153,000
Less: Interest expense (26,000)
Net profits before taxes 127,000
Less: Taxes (35%) (44,450)
Net income 82,550
5. Operating profit is ________.
A. gross profit minus operating expenses
B. sales revenue minus cost of goods sold
C. earnings before depreciation and taxes
D. sales revenue minus depreciation expense

Answer: A

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6. Net profit after taxes is ________.
A. gross profits minus operating expenses
B. sales revenue minus cost of goods sold
C. EBITDA minus interest
D. EBIT minus interest and taxes

Answer: D
7. Operating profit is known as ________.
A. earnings after interest and taxes
B. earnings before interest and taxes
C. earnings before depreciation and taxes
D. earnings after tax

Answer: B
8. Earnings available for common stockholders is calculated as net profits
________.
A. before taxes minus preferred dividends
B. after taxes minus preferred dividends
C. after taxes minus common dividends
D. before taxes minus common dividends

Answer: B
9. A firm has the following accounts and financial data for 2022:

The firm's earnings per share for 2022 is ________.

A. $0.5335
B. $0.5125
C. $0.3204
D. $0.3024

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 Answer: D

The firm's Income Statement

Sales revenue 3,060
Less: Cost of goods sold (1,800)
Gross profits 1,260
Less: Total operating expense (600)
Operating profits 660
Less: Interest expense (126)
Net profits before taxes 534
Less: Taxes (40%) (213.6)
Net profits after taxes 320.4
Less: Preferred stock dividends (18)
Earnings available for common stockholders 302.4
÷ Number of common shares outstanding 1,000
Earnings per Share (EPS) 0.3024
10. Firm ABC had operating profits of $100,000, taxes of $17,000, interest
expense of $34,000, and preferred dividends of $5,000. What was the firm's
net profit after taxes?
A. $66,000
B. $49,000
C. $44,000
D. $83,000

Answer: B

ABC Income Statement

Operating profits 100,000
Less: Interest expense (34,000)
Net profits before taxes 66,000
Less: Taxes (17,000)
Net profits after taxes 49,000

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11. Candy Corporation had pretax profits of $1.2 million, an average tax rate of
34%, and it paid preferred stock dividends of $50,000. There were 100,000
shares outstanding and no interest expense. What was Candy Corporation's
earnings per share?
A. $3.91
B. $4.52
C. $7.42
D. $7.59

Answer: C

Candy Corporation Income Statement

Pretax profits (1.2 × 1,000,000) 1,200,000
Less: Taxes (34%) (408,000)
Net profits after taxes 792,000
Less: Preferred stock dividends (50000)
Earnings available for common stockholders 742,000
÷ Number of common shares outstanding 100,000
Earnings per Share (EPS) 7.42

8
TRUE/FALSE. State whether the following statements are
true or false.
12. Common stock dividends paid to stockholders is equal to the earnings
available for common stockholders divided by the number of shares of
common stock outstanding.
Answer: FALSE
13. Earnings per share represent the amount earned during the period on each
outstanding share of common stock.
Answer: TRUE
14. Earnings per share results from dividing earnings available for common
stockholders by the number of shares of common stock authorized.
Answer: FALSE
15. Depreciation deductions, like any other business expenses, reduce the
income that a firm reports on its income statement.
Answer: TRUE

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PROBLEMS. Solve the following problems.
16. At the end of 2022, Long Life Light Bulb Corporation announced a gross
profit of $1 million. The company has also established that over the course
of this year, it has incurred $345,000 in operating expenses and $125,000 in
interest expenses. The company is subject to a 30% tax rate and has declared
$57,000 of total preferred stock dividends.
a. Calculate the earnings available for common stockholders
b. Compute the increased retained earnings for 2022 if the company
were to declare a $4.25 common stock dividend. The company has
15,000 shares of common stock outstanding.
Answer:
Long Life Light Bulb Corporation Income Statement
For the year ended December 31, 2022
Gross profits (1 × 1,000,000) 1,000,000
Less: Operating expenses (345,000)
Operating profits 655,000
Less: Interest expense (125,000)
Net profits before taxes 530,000
Less: Taxes (30%) (159,000)
Net profits after taxes 371,000
Less: Preferred stock dividends (57,000)
Earnings available for common stockholders → (a) 314,000
Less: Common stock dividends (4.25 × 15,000) (63,750)
Increased retained earnings → (b) 250,250

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17. Ag Silver Mining, Inc. has $500,000 of earnings before interest and taxes at
the year end. Interest expenses for the year were $10,000. The firm expects
to distribute $100,000 in dividends. Calculate the earnings after taxes for the
firm assuming a 40% tax on ordinary income.
Answer:

Ag Silver Mining, Inc. Income Statement

Earnings before interest and taxes 500,000
Less: Interest expense (10,000)
Net profits before taxes 490,000
Less: Taxes (40%) (196,000)
Earnings after taxes 294,000

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The Balance Sheet
The balance sheet presents a summary statement of the firm’s financial
position at a given time. It balances the firm’s assets (what it owns) against its
financing, which can be either debt (what it owes) or equity (what was provided by
owners).
The balance sheet is a convenient means of organizing and summarizing what
a firm owns (its assets), what a firm owes (its liabilities), and the difference
between the two (the firm’s equity) at a given point in time.
Balance Sheet Equation

𝐴𝑠𝑠𝑒𝑡𝑠 = 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒 + 𝑆𝑡𝑜𝑐𝑘ℎ𝑜𝑙𝑑𝑒𝑟𝑠’ 𝑒𝑞𝑢𝑖𝑡𝑦

Table 2 presents Bartlett Company’s balance sheets for the years ended
December 31, 2021, and 2022

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 Table 2: Bartlett Company Balance Sheets ($000)
for the years ended December 31, 2021, and 2022
December 31
Assets 2021 2022
Current assets
Cash 363 288
Marketable securities 68 51
Accounts receivable 503 365
Inventories 289 300
Total current assets 1,223 1,004
Fixed assets
Land and buildings 2,072 1,903
Machinery and equipment 1,866 1,693
Furniture and fixtures 358 316
Vehicles 373 410
Total gross fixed assets (at cost) 4,669 4,322
Less: Accumulated depreciation (2,295) (2,056)
Net fixed assets 2,374 2,266
Total assets 3,597 3,270
Liabilities and Stockholders’ Equity
Liabilities (Debt)
Current liabilities
Accounts payable 382 270
Notes payable 79 99
Accruals 159 114
Total current liabilities 620 483
Long-term debt (such as bonds) 1,023 967
Total liabilities 1,643 1,450
Stockholders’ Equity
Preferred stock 200 200
Common stock 191 190
Paid-in capital in excess of par (paid-in surplus) 428 418
Retained earnings 1,135 1,012
Total stockholders’ equity 1,954 1,820
Total liabilities and stockholders’ equity 3,597 3,270

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Assets:
Assets are normally listed on the balance sheet in order of decreasing
liquidity, meaning that the assets are listed from the most liquid asset down to the
least liquid asset.
Liquidity refers to the speed and ease with which an asset can be converted to
cash without significant loss of value.
Assets are classified as either current or fixed.
Current Assets:
Current assets are short-term assets that have a life of less than one year. This
means that they are expected to be converted into cash within 1 year or less (they
are expected to remain on the firm’s books for less than 1 year).
Current assets are relatively liquid and include:
− Cash is considered the most liquid asset.

− Marketable securities are very liquid short-term investments, such as

Treasury bills or certificates of deposit, held by the firm. Because they are
highly liquid, marketable securities are viewed as a form of cash (near cash).

− Accounts receivable represent the amounts not yet collected from customers
on sales already made.

− Inventories include raw materials, work in process (partially finished goods),

and finished goods held by the firm. Inventory is probably the least liquid of
the current assets, at least for many businesses.

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Fixed Assets:
Fixed assets are long-term assets that have a relatively long life (more than
one year). This means that they don’t convert to cash at all in normal business
activity (they are expected to remain on the firm’s books for more than 1 year).
Fixed assets are, for the most part, relatively illiquid and can be either
tangible, such as land and buildings, machinery and equipment, furniture and
fixtures, vehicles or intangible that have no physical existence, such as a
trademark, patent, or copyrights.
The entry for gross fixed assets is the original cost of all fixed (long-term)
assets owned by the firm.
Net fixed assets represent the difference between gross fixed assets and
accumulated depreciation, the total expense recorded for the depreciation of fixed
assets.
Note that:

− The net value of fixed assets is called their book value.

− Accumulated depreciation is really not a fixed asset, but a charge against a

fixed asset, better known as a contra-asset.

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Liabilities and Stockholders’ Equity
Liabilities and stockholders’ equity accounts are normally listed on the
balance sheet according to their maturity date, meaning that they are listed from
short-term to long-term.
The firm’s liabilities are listed first on the balance sheet because of having a
maturity date, that is followed by stockholders’ equity, which is assumed to have
an infinite life.
Liabilities (Debt)
Liabilities are classified as either current or long-term.
Current Liabilities (Short-term Debt):
Current liabilities are short-term liabilities that have a life of less than one
year. This means that they are expected to be paid within 1 year or less and are
listed before long-term liabilities.
Current liabilities include:
− Accounts payable represent the amounts not yet paid to suppliers on
purchases already made.

− Notes payable represent the outstanding short-term loans, typically from

commercial banks.
− Accruals, such as taxes due the government and wages due employees
Long-term Debt:
Long-term debt represents debt for which payment is not due in the current
year.

16
Stockholders’ Equity
Stockholders’ equity is the difference between the total value of the assets
(current and fixed) and the total value of the liabilities (current and long-term)
Stockholders’ equity represents the owners’ claims on the firm and includes:

− Preferred stock shows the historical proceeds from the sale of preferred
stock.
− Common stock is the par value of common stock.

− Paid-in capital in excess of par (paid-in surplus) represents the amount of

proceeds in excess of the par value received from the original sale of
common stock.

− Retained earnings represent the cumulative total of all earnings, net of

dividends, that have been retained and reinvested in the firm since its
inception.

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Note that:

Depreciation expense = Change in accumulated depreciation

Depreciation expense = ∆ Accumulated depreciation
For example, based on Bartlett Company Balance Sheets,

Depreciation expense2022
= Accumulated depreciation2022 − Accumulated depreciation2021
= 2,295 − 2,056
= 239 → see Bartlett Company income statement (part 1, page 3)

Addition to retained earnings = Change in retained earnings

Addition to retained earnings = ∆ Retained earnings
For example, based on Bartlett Company Balance Sheets,

Addition to retained earnings2022

= Retained earnings2022 − Retained earnings2021
= 1,135 − 1,012
= 123 → see Bartlett Company income statement (part 1, page 3)
Net Working Capital
Net working capital represents the difference between a firm’s current assets
and its current liabilities.

𝑁𝑒𝑡 𝑊𝑜𝑟𝑘𝑖𝑛𝑔 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐴𝑠𝑠𝑒𝑡𝑠 − 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝐿𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠

Note that:

− Net working capital is positive when current assets exceed current liabilities.
− Net working capital is usually positive in a healthy firm.

18
Questions and Problems
MULTIPLE CHOICE. Choose the one alternative that best completes the
statement or answers the question. Show your calculations.
18. Which one of the following is the financial statement that shows the
accounting value of a firm's equity as of a particular date?
A. income statement
B. balance sheet
C. statement of cash flows
D. dividend statement

Answer: B
19. Total assets less net fixed assets equals ________.
A. gross assets
B. current assets
C. depreciation
D. liabilities and equity

Answer: B
20. Which of the following is a current liability?
A. accounts receivable
B. cash
C. notes payable
D. inventory

Answer: C
21. Which of the following represents a current asset?
A. automobiles
B. buildings
C. marketable securities
D. equipment

Answer: C

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22. Which of the following is a fixed asset?
A. land
B. accounts payable
C. accruals
D. notes payable

Answer: A
23. The net value of fixed assets is also called its ________.
A. market value
B. par value
C. book value
D. intrinsic value

Answer: C
24. Retained earnings on the balance sheet represents the ________.
A. net profit after taxes
B. amount of proceeds in excess of the par value received from the original
sale of common stock
C. net profit after taxes minus preferred dividends
D. cumulative total of all earnings reinvested in the firm

Answer: D
25. The ________ represents a summary statement of a firm's financial position
at a given point in time.
A. income statement
B. balance sheet
C. statement of cash flows
D. statement of retained earnings

Answer: B

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26. On the balance sheet, net fixed assets represent ________.
A. gross fixed assets at cost minus depreciation expense
B. gross fixed assets at market value minus depreciation expense
C. gross fixed assets at cost minus accumulated depreciation
D. gross fixed assets at market value minus accumulated deprecation

Answer: C
27. Paid-in capital in excess of par represents the amount of proceeds ________.
A. in deficit of the par value from the original sale of common stock
B. in excess of the par value from the original sale of common stock
C. in excess of the par value from the current value of common stock
D. in excess of the par value from the intrinsic value of common stock

Answer: B
28. Net working capital is defined as:
A. total liabilities minus shareholders' equity.
B. current liabilities minus shareholders' equity.
C. fixed assets minus long-term liabilities.
D. current assets minus current liabilities.

Answer: D
29. Which one of the following is classified as an intangible fixed asset?
A. accounts receivable
B. production equipment
C. building
D. trademark

Answer: D

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30. Which of the following are current assets?
I. patent
II. Inventory
III. accounts payable
IV. cash
A. I and III only
B. II and IV only
C. I, II, and IV only
D. I, II and III only

Answer: B
31. Which of the following are included in current liabilities?
I. note payable to a supplier in eight months
II. amount due from a customer next month
III. account payable to a supplier that is due next week
IV. loan payable to the bank in fourteen months
A. I and III only
B. II and III only
C. I, II, and III only
D. I, III, and IV only

Answer: A
32. Which one of the following will increase the value of a firm's net working
capital?
A. using cash to pay a supplier
B. collecting an accounts receivable
C. purchasing inventory on credit
D. selling inventory at a profit

Answer: D

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33. Which one of the following accounts is the most liquid?
A. Inventory
B. building
C. accounts receivable
D. land

Answer: C
34. Which one of the following represents the most liquid asset?
A. $100 account receivable that is discounted and collected for $96 today
B. $100 of inventory which is sold today on credit for $103
C. $100 of inventory which is discounted and sold for $97 cash today
D. $100 of inventory that is sold today for $100 cash

Answer: D
35. Depreciation:
A. reduces both taxes and net income.
B. increases the net fixed assets as shown on the balance sheet.
C. reduces both the net fixed assets and the costs of a firm.
D. is a noncash expense which increases the net income.

Answer: A
36. A firm has $520 in inventory, $1,860 in net fixed assets, $190 in accounts
receivables, $210 in accounts payable, and $70 in cash. What is the amount
of the current assets?
A. $710
B. $780
C. $990
D. $2,430

Answer: B
Current assets = Cash + Accounts receivable + Inventory

= 70 + 190 + 520 = 780

23
37. A firm has net working capital of $640. Long-term debt is $4,180, total
assets are $6,230, and net fixed assets are $3,910. What is the amount of the
total liabilities?
A. $2,050
B. $2,690
C. $4,130
D. $5,860

Answer: D
∵ Total assets = Current assets + Net fixed assets

6,230 = Current assets + 3,910

∴ Current assets = 6,230 − 3,910 = 2,320

∵ Net working capital = Current assets − Current liabilities

640 = 2,320 − Current liabilities

∴ Current liabilities = 2,320 − 640 = 1,680

∵ Total liabilities = Current liabilities + Long term debt

∴ Total liabilities = 1,680 + 4,180 = 5,860

38. A firm has common stock of $6,200, paid-in surplus of $9,100, total
liabilities of $8,400, current assets of $5,900, and net fixed assets of
$21,200. What is the amount of the shareholders' equity?
A. $6,900
B. $15,300
C. $18,700
D. $23,700

Answer: C
Total assets = Current assets + Net fixed assets

= 5,900 + 21,200 = 27,100

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 ∵ Total assets = Total liabilities + Shareholders′ equity

∴ Shareholders′ equity = Total assets − Total liabilities

= 27,100 − 8,400 = 18,700

Note:
The amounts of preferred stock and retained earnings are not provided, so you
must use total assets minus total liabilities to derive the correct answer.
39. Your firm has total assets of $4,900, net fixed assets of $3,200, long-term
debt of $2,900, and short-term debt of $1,400. What is the amount of net
working capital?
A. -$100
B. $300
C. $600
D. $1,700

Answer: B
∵ Total assets = Current assets + Net fixed assets

∴ Current assets = Total assets − Net fixed assets

= 4,900 − 3,200 = 1,700

Net working capital

= Current assets − Current liabilities(short term debt)

= 1,700 − 1,400 = 300

25
TRUE/FALSE. State whether the following statements are true or
false.

40. The income statement is a financial summary of a firm's operating results

during a specified period while the balance sheet is a summary statement of
a firm's financial position at a given point in time.
Answer: TRUE
41. The common stock entry in the balance sheet is the par value of common
stock.
Answer: TRUE
42. Net fixed assets represent the difference between gross fixed assets and
accumulated depreciation of fixed assets.
Answer: TRUE
43. Retained earnings represent the cumulative total of all earnings, net of
dividends, that have been retained and reinvested in the firm since its
inception.
Answer: TRUE
44. The income statement is a statement which balances a firm's assets (what it
owns) against its debt (what it owes) or its equity (what is provided by
owners).
Answer: FALSE
45. Paid-in capital in excess of par represents a firm's book value received from
the original sale of common stock.
Answer: FALSE
46. The balance sheet is a statement which balances a firm's assets (what it
owns) against its debt (what it owes) or its equity (what is provided by
owners).
Answer: TRUE
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47. The amount paid in by the original purchasers of common stock is shown by
two entries in the firm's balance sheet—common stock and paid-in capital in
excess of par on common stock.
Answer: TRUE
48. 2The original price per share received by the firm on a single issue of
common stock is equal to the sum of the common stock and paid-in capital
in excess of par accounts divided by the number of shares outstanding.
Answer: TRUE

27
PROBLEMS. Solve the following problems.
49. Mark each of the accounts listed in the following table as follows:
a. In column (1), indicate in which statement—income statement (IS) or
balance sheet (BS)—the account belongs.
b. In column (2), indicate whether the account is a current asset (CA),
current liability (CL), expense (E), fixed asset (FA), long-term debt
(LTD), revenue (R), or stockholders’ equity (SE).

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 Answer:

(a) (b)
Account Name Statement Type of Account
Accounts payable BS CL
Accounts receivable BS CA
Accruals BS CL
Accumulated depreciation BS FA*
Administrative expense IS E
Buildings BS FA
Cash BS CA
Common stock (at par) BS SE
Cost of goods sold IS E
Depreciation IS E
Equipment BS FA
General expense IS E
Interest expense IS E
Inventories BS CA
Land BS FA
Long-term debt BS LTD
Machinery BS FA
Marketable securities BS CA
Notes payable BS CL
Operating expense IS E
Paid-in capital in excess of par BS SE
Preferred stock BS SE
Preferred stock dividends IS E
Retained earnings BS SE
Sales revenue IS R
Selling expense IS E
Taxes IS E
Vehicles BS FA
*
This is really not a fixed asset, but a charge against a fixed asset, better known as
a contra-asset.

29
50. A firm has current assets of $5,100, net fixed assets of $23,800, current
liabilities of $4,300, and long-term debt of $7,400. What is the value of the
owner’s equity account for this firm? How much is net working capital?
Answer:
Total assets = Current assets + Net fixed assets

= 5,100 + 23,800 = 28,900

Total liabilities = Current liabilities + long term debt

= 4,300 + 7,400 = 11,700

∵ Total assets = Total liabilities + Owner’s equity

∵ Owner’s equity = Total assets − Total liabilities

= 28,900 − 11,700 = 17,200

Net working capital = Current assets − Current liabilities

= 5,100 − 4,300 = 800

30
Unsolved Problems
1. Reliable Auto Parts has 5,000 shares of common stock outstanding. The
company also has the following amounts in revenue and expense accounts.

Calculate
a. gross profits.
b. operating profits.
c. net profits before taxes.
d. net profits after taxes (assume a 40% tax rate).
e. earnings available to common stockholders.
f. earnings per share.
2. Use the appropriate items from the following list to prepare Mellark’s Baked
Goods balance sheet at December 31, 2022
Value ($000) at Value ($000) at
December 31, 2022 December 31, 2022

31
The Statement of Retained Earnings
The statement of retained earnings reconciles the net income earned during a
given year, and any cash dividends paid, with the change in retained earnings
between the start and the end of that year.
Statement of Retained Earnings Equation
𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒) + 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠
− 𝑃𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 − 𝐶𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘 𝑑𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠
= 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝐸𝑛𝑑𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒)

𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝐵𝑒𝑔𝑖𝑛𝑛𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒) + 𝑁𝑒𝑡 𝑝𝑟𝑜𝑓𝑖𝑡𝑠 𝑎𝑓𝑡𝑒𝑟 𝑡𝑎𝑥𝑒𝑠

− 𝐷𝑖𝑣𝑖𝑑𝑒𝑛𝑑𝑠 𝑝𝑎𝑖𝑑 = 𝑅𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔𝑠 (𝐸𝑛𝑑𝑖𝑛𝑔 𝑏𝑎𝑙𝑎𝑛𝑐𝑒)

Table 3 presents Bartlett Company’s statement of retained earnings for the

year ended December 31, 2022

Table 3: Bartlett Company Statement of Retained Earnings ($000)

For the year ended December 31, 2022
Retained earnings (Beginning balance) 1,012
Plus: Net profits after taxes 231
Less: Preferred stock dividends (10)
Less: Common stock dividends (98)
Retained earnings (Ending balance) 1,135

Note that: The ending balance for a period equals the beginning balance
for the subsequent period

32
Questions and Problems
MULTIPLE CHOICE. Choose the one alternative that best completes the
statement. Show your calculations.
51. When preparing the retained earnings statement, ________ is(are) subtracted
in order to derive at the ending balance of retained earnings.
A. net profits after taxes
B. interest expense
C. depreciation
D. dividends

Answer: D
52. A firm's year-end retained earnings balances are $670,000 and $560,000, for
2021 and 2022 respectively. The firm paid $10,000 in dividends in 2022.
The firm's net profit after taxes in 2022 was ________.
A. -$100,000
B. -$110,000
C. $100,000
D. $110,000

Answer: A
∵ Retained earnings (Beginning balance) + Net profits after taxes
− Dividends paid = Retained earnings (Ending balance)
Retained earnings2021 + Net profits after taxes2022 − Dividends paid2022
= Retained earnings2022
∴ 670,000 + Net profits after taxes2022 − 10,000 = 560,000
Net profits after taxes2022 = 560,000 − 670,000 + 10,000
∴ Net profits after taxes2022 = −100,000

33
53. A firm's year-end retained earnings balances are $320,000 and $400,000, for
2021 and 2022 respectively. The firm reported net profits after taxes of
$100,000 in 2022. The firm's dividend payment for 2022 is ________.
A. $0
B. $20,000
C. $80,000
D. $100,000

Answer: B
∵ Retained earnings (Beginning balance) + Net profits after taxes
− Dividends paid = Retained earnings (Ending balance)
Retained earnings2021 + Net profits after taxes2022 − Dividends paid2022
= Retained earnings2022
∴ 320,000 + 100,000 − Dividends paid2022 = 400,000
−Dividends paid2022 = 400,000 − 320,000 − 100,000
−Dividends paid2022 = −20,000
∴ Dividends paid2022 = 20,000

34
54. A firm has a year-end retained earnings balance of $220,000 for 2021. The
firm reported net profits after taxes of $50,000 and paid dividends of
$30,000 in 2022. The firm's retained earnings balance at 2022 year end is
________.
A. $240,000
B. $250,000
C. $270,000
D. $300,000

Answer: A
∵ Retained earnings (Beginning balance) + Net profits after taxes
− Dividends paid = Retained earnings (Ending balance)
Retained earnings2021 + Net profits after taxes2022 − Dividends paid2022
= Retained earnings2022
∴ 220,000 + 50,000 − 30,000 = Retained earnings2022
∴ Retained earnings2022 = 240,000

35
TRUE/FALSE. State whether the following statements are true or
false.

55. The statement of cash flows reconciles the net income earned during a given
year, and any cash dividends paid, with the change in retained earnings
between the start and end of that year.
Answer: FALSE

36
PROBLEMS. Solve the following problems
1. Colonial Furniture's net profits before taxes for 2022 totalled $354,000. The
company's total retained earnings were $338,000 for 2021 year-end and
$389,000 for 2022 year-end. Colonial is subject to a 26% tax rate. What was
the cash dividend declared by Colonial Furniture in 2022?
Answer:
a. Calculate net profits after taxes for 2022

Net profits before taxes 354,000

Less: Taxes (26%) (920,40)
Net profits after taxes 261,960

b. Calculate the cash dividend paid in 2022

∵ Retained earnings (Beginning balance) + Net profits after taxes
− Dividends paid = Retained earnings (Ending balance)
Retained earnings2021 + Net profits after taxes2022 − Dividends paid2022
= Retained earnings2022
∴ 338,000 + 261,960 − Dividends paid2022 = 389,000
−Dividends paid2022 = 389,000 − 338,000 − 261,960
−Dividends paid2022 = −210,960
∴ Dividends paid2022 = 210,960

37
2. On December 31, 2021, Bradshaw Corporation had $485,000 as an ending
balance for its retained earnings account. During 2022, the corporation
declared a $3.50/share dividend to its stockholders. The company has 35,000
shares of common stock outstanding. When the books were closed for 2022
year end, the corporation had a final retained earnings balance of $565,000.
What was the net profit earned by Bradshaw Corporation during 2022?
Answer:

a. Calculate the dividend paid in 2022

∵ Common stock dividends
= Dividends per Share (DPS)
× Number of shares of common stock outstanding
∴ Common stock dividends = 3.50 × 35,000
= 122,500
b. Calculate net profits after taxes for 2022
∵ Retained earnings (Beginning balance) + Net profits after taxes
− Dividends paid = Retained earnings (Ending balance)
Retained earnings2021 + Net profits after taxes2022 − Dividends paid2022
= Retained earnings2022
∴ 485,000 + Net profits after taxes2022 − 122,500 = 565,000
Net profits after taxes2022 = 565,000 − 485,000 + 122,500
∴ Net profits after taxes2022 = 202,500

38
3. Sunshine Corporation had a retained earnings balance of $850,000 at the
beginning of 2022. By the end of 2022, the company's retained earnings
balance stood at $950,000. During 2022, the company earned $245,000 as
net profits after paying its taxes. The company was then able to pay its
preferred stockholders a sum of $45,000. Compute the common stock
dividend per share in 2022 assuming 10,000 shares of common stock
outstanding.
Answer:

a. Calculate common stock dividends paid in 2022

∵ Retained earnings (Beginning 2022 ) + Net profits after taxes2022
− Preferred stock dividends2022
− Common stock dividends2022
= Retained earnings (Ending 2022 )
∴ 850,000 + 245,000 − 45,000 − Common stock dividends2022 = 950,000
−Common stock dividends2022 = 950,000 − 850,000 − 245,000 + 45,000
−Common stock dividends2022 = −100,000
∴ Common stock dividends2022 = 100,000
b. Calculate common stock dividend per share in 2022 (DPS)
Common stock dividends
∵ Dividends per Share =
Number of shares of common stock outstanding
100,000
∴ Dividends per Share2022 = = 10
10,000

39
4. Hayes Enterprises began 2022 with a retained earnings balance of $928,000.
During 2022, the firm earned $377,000 after taxes. From this amount,
preferred stockholders were paid $47,000 in dividends. At year-end 2022,
the firm’s retained earnings totalled $1,048,000. The firm had 140,000
shares of common stock outstanding during 2022.
a. Prepare a statement of retained earnings for the year ended
December 31, 2022, for Hayes Enterprises. (Note: Be sure to
calculate and include the amount of cash dividends paid in
2022.)
b. Calculate the firm’s 2022 earnings per share (EPS).
c. How large a per-share cash dividend did the firm pay on
common stock during 2022?
Answer:

a. Prepare a statement of retained earnings for the year ended

December 31, 2022, for Hayes Enterprises
− Calculate common stock dividends paid in 2022
∵ Retained earnings (Beginning 2022 ) + Net profits after taxes2022
− Preferred stock dividends2022
− Common stock dividends2022
= Retained earnings (Ending 2022 )
∴ 928,000 + 377,000 − 47,000 − Common stock dividends2022 = 1,048,000
−Common stock dividends2022 = 1,048,000 − 928,000 − 377,000 + 47,000
−Common stock dividends2022 = −210,000
∴ Common stock dividends2022 = 210,000

40
− Prepare a statement of retained earnings.

Hayes Enterprises Statement of Retained Earnings

For the year ended December 31, 2022
Retained earnings (Beginning balance 2022) 928,000
Plus: Net profits after taxes (for 2022) 377,000
Less: Preferred stock dividends (paid during 2022) (47,000)
Less: Common stock dividends (paid during 2022) (210,000)
Retained earnings (Ending balance 2022) 1,048,000

b. Calculate the firm’s 2022 earnings per share (EPS).

− Calculate earnings available for common stockholders.

Net profits after taxes 377,000

Less: Preferred stock dividends (47,000)
Earnings available for common stockholders 330,000
− Calculate earnings per share (EPS).
Earnings available for common stockholders
∵ Earnings per Share =
Number of shares of common stock outstanding
330,000
∴ Earnings per Share2022 = = 2.36
140,000
c. Calculate per-share cash dividend in 2022 (DPS)
Common stock dividends
∵ Dividends per Share =
Number of shares of common stock outstanding
210,000
∴ Dividends per Share2022 = = 1.5
140,000

41
The statement of cash flows
The statement of cash flows provides a summary of the firm’s operating,
investment, and financing cash flows and reconciles them with changes in its cash
and marketable securities during the period.
Note that:
Analysts typically lump cash and marketable securities together when
assessing the firm’s liquidity because both cash and marketable securities represent
a reservoir of liquidity. That reservoir is increased by cash inflows and decreased
by cash outflows.

Exercise (1):
Given the following income statement for the year ended December 31, 2022,
and balance sheets at the years ended December 31, 2021, and 2022

2022

(EBIT)

42
 Magna Fax, Inc. Balance Sheet
For the Years Ended December 31, 2021, and 2022
2022 2021

Prepare a statement of cash flows for the year ended December

31, 2022.

43
Answer:
a. Calculate the change in the key balance sheet accounts between 2021
and 2022 and classify each as a source (inflow) or a use
(outflow)………………Step One
For each account on the company’s balance sheet, calculate the change in
the account during the recent year and note whether this change was a source
of cash (Inflow) or use of cash (Outflow).

− Sources of cash: A firm’s activities that bring in or generate cash.

− Uses of cash: A firm’s activities that involve spending cash.

44
Note that:

− You should ignore totals.

− You should account only for the change in gross fixed assets rather than the
change in net fixed assets.

− You should ignore the change in retained earnings.

Balance Sheet Changes and Classification of Key Accounts
between 2021 and 2022
Account 2022 2021 Change Classification
Cash 24,000 21,000 + 3,000 Outflow (Use)
Accounts receivable 45,000 39,000 + 6,000 Outflow (Use)
Inventory 30,000 27,000 + 3,000 Outflow (Use)
Gross fixed assets 42,000 40,000 + 2,000 Outflow (Use)
Accounts payable 25,000 30,000 − 5,000 Outflow (Use)
Notes payable 50,000 40,000 + 10,000 Inflow (Source)
Accruals 1,000 2,000 − 1,000 Outflow (Use)
Long-term debts 10,000 8,000 + 2,000 Inflow (Source)
Common stock at par 1,000 1,000 0 ---
Paid-in capital in excess of par 4,000 4,000 0 ---

45
 b. Prepare a summary of cash inflows and cash outflows for the year
ended December 31, 2015………………Step Two

Summary of cash inflows (Sources) and cash outflows (Uses)

Cash Inflows (Sources) Cash Outflows (Uses)

− Decrease in any asset − Increase in any asset

− Increase in any liability − Decrease in any liability
− Increase in any stockholders’ − Decrease in any stockholders’
equity except retained earnings equity except retained earnings
− Net profit after taxes − Net loss after taxes
− Depreciation expense − Dividends paid
↓ ↓
Plus (+) Minus (−)
Note that:

− Depreciation expense is a noncash charge, an expense that is deducted on the

income statement but does not involve an actual outlay of cash. Therefore,
when measuring the amount of cash flow generated by a firm, we have to
add depreciation back to net profit after taxes; if we don’t, we will
understate the cash that the firm has truly generated. For this reason,
depreciation appears as a source of cash in the previous table

− Remember that change in retained earnings is not included in the statement

of cash flows. Instead, entries for items that affect retained earnings appear
as net profits or losses after taxes and dividends paid.
− Depreciation expense = Change in accumulated depreciation
= ∆ Accumulated depreciation
∴ Depreciation expense2015
= Accumulated depreciation2022 − Accumulated depreciation2021
= 22,000 − 18,000
= 4,000
46
 − Dividends paid = Net profit after taxes − Addition to retained earnings
= Net profit after taxes − Change in retained earnings
= Net profit after taxes − ∆ retained earnings
∴ Dividends paid2015
= Net profit after taxes2022
− (Retained earnings2022 − Retained earnings2021 )
= 10,500 − (28,000 − 24,000)
= 10,500 − 4,000
= 6,500
OR
∵ Retained earnings2021 + Net profits after taxes2022 − Dividends paid2022
= Retained earnings2022
∴ 24,000 + 10,500 − Dividends paid202 = 28,000
−Dividends paid2022 = 28,000 − 24,000 − 10,500
−Dividends paid2022 = −6,500
∴ Dividends paid2022 = 6,500
Summary of cash inflows and cash outflows
for the year ended December 31, 2015
Cash Inflows (Sources) Cash Outflows (Uses)
Increase in notes payable 10,000 Increase in cash 3,000
Increase in long-term debts 2,000 Increase in accounts receivable 6,000
Net profit after taxes 10,500 Increase in inventory 3,000
Depreciation expense 4,000 Increase gross fixed assets 2,000
Decrease in accounts payable 5,000
Decrease in accruals 1,000
Dividends paid 6,500
Total Cash Inflows 26,500 Total Cash Outflows 26,500
Note that: Total cash inflows should be equal to total cash outflows.

47
c. Prepare a statement of cash flows for the year ended December 31,
2022………………Step Three
The firm’s cash flows fall into three categories: (1) cash flow from
operating activities, (2) cash flow from investment activities, and (3) cash flow
from financing activities.

− Cash flow from operating activities: Cash flows directly related to the sale
and production of the firm’s products and services. It includes:
• Net profit after taxes
• Depreciation expense
• Change in any current asset except cash.
• Change in any current liability except notes payable.
− Cash flow from investment activities: Cash flows associated with the
purchase and sale of fixed assets. It includes:
• Change in gross fixed assets.
− Cash flow from financing activities: Cash flows that result from debt and
equity financing transactions. It includes:
• Change in notes payable.
• Change in long-term debt.
• Change in any stockholders’ equity.
• Dividends paid.
Note that:
The items in each category—operating, investment, and financing—are
totalled, and the three totals are added to get the “Net increase (decrease) in cash”
for the period. As a check, this value should reconcile with the actual change in
cash for the year, which is obtained from the beginning- and end-of-period balance
sheets.

48
 Statement of cash flows
for the year ended December 31, 2022
Cash flow from operating activities
Net profit after taxes 10,500
Depreciation expense 4,000
Increase in accounts receivable (6,000)
Increase in inventory (3,000)
Decrease in accounts payable (5,000)
Decrease in accruals (1,000)
Cash provided by operating activities … …(1) (500)
Cash flow from investment activities
Increase gross fixed assets (2,000)
Cash provided by investment activities ……(2) (2,000)
Cash flow from financing activities
Increase in notes payable 10,000
Increase in long-term debts 2,000
Dividends paid (6,500)
Cash provided by financing activities … …(3) 5,500
Change in cash … ……………….…(1+2+3) 3,000

49
Exercise (2):
Given the following balance sheets for Baker Corporation at the years ended
December 31, 2021, and 2022:
Baker Corporation Balance Sheets ($000)
at the years ended December 31, 2021 and 2022
December 31
Assets 2022 2021
Cash and marketable securities 1,000 500
Accounts receivable 400 500
Inventories 600 900
Total current assets 2,000 1,900
Gross fixed assets (at cost) 2,500 2,200
Accumulated depreciation (1,300) (1,200)
Net fixed assets 1,200 1,000
Total assets 3,200 2,900
Liabilities and Stockholders’ Equity
Accounts payable 700 500
Notes payable 600 700
Accruals 100 200
Total current liabilities 1,400 1,400
Long-term debt 600 400
Total liabilities 2,000 1,800
Preferred stock 100 100
Common stock 120 120
Paid-in capital in excess of par 380 380
Retained earnings 600 500
Total stockholders’ equity 1,200 1,100
Total liabilities and stockholders’ equity 3,200 2,900

For the year ended December 31, 2022, Baker Corporation had operating
profits of $370,000, net profits after taxes of $180,000, an average tax rate of 40%,
and it paid preferred stock dividends of $10,000. There were 100,000 shares
outstanding and $70,000 interest expense.

50
a. Calculate the depreciation expense for 2022.
b. Calculate common stock dividends for 2022.
c. Prepare a statement of retained earnings for 2022.
d. What was Baker Corporation's earnings per share (EPS).
e. What was Baker Corporation's dividends per share (DPS).
f. Prepare a statement of cash flows for 2022, organized by cash flow.
from operating activities, cash flow from investment activities, and
cash flow from financing activities.

51
Answer:
a. Calculate the depreciation expense for 2022 ($000)
∵ Depreciation expense = ∆ Accumulated depreciation
∴ Depreciation expense2022 = Acc. depreciation2022 − Acc. depreciation2021
= 1,300 − 1,200
= 100
b. Calculate common stock dividends for 2022 ($000)
∵ Retained earnings2021 + Net profits after taxes2022
− Preferred stock dividends2022
− Common stock dividends2022 = Retained earnings2022
∴ 500 + 180 − 10 − Common stock dividends2022 = 600
Common stock dividends2022 = 500 + 180 − 10 − 600
∴ Common stock dividends2022 = 70
c. Prepare a statement of retained earnings for 2022

Baker Corporation Statement of Retained Earnings ($000)

For the year ended December 31, 2022
Retained earnings (Beginning balance) 500
Plus: Net profits after taxes 180
Less: Preferred stock dividends (10)
Less: Common stock dividends (70)
Retained earnings (Ending balance) 600

52
d. What was Baker Corporation's earnings per share (EPS)

− Calculate earnings available for common stockholders ($000)

Net profits after taxes 180

Less: Preferred stock dividends (10)
Earnings available for common stockholders 170
− Calculate earnings per share (EPS)
Earnings available for common stockholders
∵ Earnings per Share =
Number of shares of common stock outstanding
170
∴ Earnings per Share2022 = = $1.70
100
e. What was Baker Corporation's dividends per share (DPS)
Common stock dividends
∵ Dividends per Share =
Number of shares of common stock outstanding
70
∴ Dividends per Share2022 = = $0.70
100

53
 f. Calculate the change in the key balance sheet accounts between 2021
and 2022 and classify each as a source (inflow) or a use (outflow)
Balance Sheet Changes and Classification of Key Accounts
between 2021 and 2022 ($000)
Account 2022 2021 Change Classification
Cash and marketable securities 1,000 500 + 500 Outflow (Use)
Accounts receivable 400 500 − 100 Inflow (Source)
Inventories 600 900 − 300 Inflow (Source)
Gross fixed assets 2,500 2,200 + 300 Outflow (Use)
Accounts payable 700 500 + 200 Inflow (Source)
Notes payable 600 700 − 100 Outflow (Use)
Accruals 100 200 − 100 Outflow (Use)
Long-term debt 600 400 + 200 Inflow (Source)
Preferred stock 100 100 0 ---
Common stock 120 120 0 ---
Paid-in capital in excess of par 380 380 0 ---

54
 g. Prepare a summary of cash inflows and cash outflows for 2022

Summary of cash inflows and cash outflows for 2022($000)

Cash Inflows (Sources) Cash Outflows (Uses)

Dec. in accounts receivable 100 Inc. in cash and marketable securities 500
Dec. in inventories 300 Increase gross fixed assets 300
Inc. in accounts payable 200 Dec. in notes payable 100
Inc. in long-term debt 200 Dec. in accruals 100
Net profit after taxes 180 Dividends paid (10 + 70) 80
Depreciation expense 100
Total Cash Inflows 1,080 Total Cash Outflows 1,080

55
h. Prepare a statement of cash flows for 2022, organized by cash flow
from operating activities, cash flow from investment activities, and
cash flow from financing activities

Statement of cash flows for 2022 ($000)

Cash flow from operating activities
Net profit after taxes 180
Depreciation expense 100
Dec. in accounts receivable 100
Dec. in inventories 300
Inc. in accounts payable 200
Dec. in accruals (100)
Cash provided by operating activities … …(1) 780
Cash flow from investment activities
Increase gross fixed assets (300)
Cash provided by investment activities ……(2) (300)
Cash flow from financing activities
Dec. in notes payable (100)
Inc. in long-term debt 200
Dividends paid (80)
Cash provided by financing activities … …(3) 20
Change in cash and marketable securities …….…(1+2+3) 500

56
Exercise (3):
The following statements pertain to Bridgewater Corporation which
is subjected to a 40% tax rate:
Bridgewater Corporation selected income statement data as of
December 31st (Amounts in $000,000)
2017 2016
Sales revenue $120 $80
Cost of Goods Sold $80 $60
Operating expenses excluding depreciation $8 $6
Interest expense $2 $1

Bridgewater Rehab balance sheet as of December 31 st

(Amounts in $000,000)
2017 2016
Cash and Marketable securities $10 $6
Accounts receivables 13 11
Inventories 16 14
Total Current assets $39 $31
Gross Plant and Equipment $100 $100
Less: Accumulated Depreciation ($41) ($30)
Net plant and equipment $59 $70
Total assets $98 $101
Accounts payable $7 $5
Accruals $3.7 1.7
Notes payable $8.3 6.3
Total Current liabilities $19 $13
Long-term debt 18 18
Total liabilities $37 $31
Common stock (50 million shares) $43 43
Retained earnings $18 27
Total stockholders’ equity $61 $70
Total liabilities and net assets $98 $101

Required:
Prepare the statement of cash flows for Bridgewater Corporation.

57
Answer:
Step (1): Calculate the change in the key balance sheet accounts between
2017 and 2016 and classify each as a source (inflow) or a use (outflow)
Balance Sheet Changes and Classification of Key Accounts
between 2017 and 2016 ($000,000)
Account 2017 2016 Change Classification
Cash and marketable 10 6 +4 Outflow (Use)
securities
Accounts receivable 13 11 +2 Outflow (Use)
Inventories 16 14 +2 Outflow (Use)
Gross fixed assets (Plant 100 100 0 ---
and Equipment)
Accounts payable 7 5 +2 Inflow (Source)
Accruals 3.7 1.7 +2 Inflow (Source)
Notes payable 8.3 6.3 +2 Inflow (Source)
Long-term debt 18 18 0 ---
Common stock 43 43 0 ---

Step (2): Prepare a summary of cash inflows and cash outflows for 2017.
i. Calculate the depreciation expense for 2017 ($000,000)
∵ Depreciation expense = ∆ Accumulated depreciation
∴ Depreciation expense2017 = Acc. depreciation2017 − Acc. depreciation2016
= 41 − 30
= 11

58
 j. Calculate net profits after taxes for 2017 ($000,000)
The firm's Income Statement
Sales revenue 120
Less: Cost of goods sold (80)
Gross profits 40
Operating expenses
Operating expenses excluding depreciation 8
Depreciation expense 11
Less: Total operating expense including depreciation (19)
Operating profits (EBIT) 21
Less: Interest expense (2)
Net profits before taxes 19
Less: Taxes (40%) (7.6)
Net profits after taxes 11.4
k. Calculate dividends distribution for 2017 ($000,000)
∵ Retained earnings2016 + Net profits after taxes2017
− Dividends distribution 2017 = Retained earnings2017
∴ 27 + 11.4 − Dividends distribution 2017 = 18
Dividends distribution 2017 = 27 + 11.4 − 18
∴ Dividends distribution 2017 = 20.4

Summary of cash inflows and cash outflows for 2017 ($000,000)

Cash Inflows (Sources) Cash Outflows (Uses)
Inc. in accounts 2 Inc. in Cash and marketable 4
payable securities
Inc. in accruals 2 Inc. in accounts receivable 2
Inc. in notes payable 2 Inc. in inventories 2
Net profit after taxes 11.4 Dividends distribution 20.4
Depreciation expense 11
Total Cash Inflows 28.4 Total Cash Outflows 28.4

59
Step (3): Prepare a statement of cash flows for 2017.

Statement of cash flows for 2017 ($000,000)

Cash flow from operating activities
Net profit after taxes 11.4
Depreciation expense 11
Inc. in accounts payable 2
Inc. in accruals 2
Inc. in accounts receivable (2)
Inc. in inventories (2)
Cash provided by operating activities … …(1) 22.4
Cash flow from investment activities
Change in gross fixed assets 0
Cash provided by investment activities ……(2) 0
Cash flow from financing activities
Inc. in notes payable 2
Dividends distribution (20.4)
Cash provided by financing activities … …(3) (18.4)
Change in cash and marketable securities …….…(1+2+3) 4

60
Exercise (4):
Consider the balance sheets and selected data from the income
statement of Keith Medical Center that follow. Prepare its
statement of cash flows for the year ended December 31, 2021.
Keith Medical Center balance sheet as of December 31 st (Amounts
in $000)
2021 2020
Cash and Marketable securities $3300 $2200
Accounts receivables 2000 1800
Inventories 2900 2800
Total Current assets $8200 $6800
Gross fixed assets $29,500 $28,100
Less: Accumulated depreciation 14,700 13,100
Net fixed assets $14,800 $15,000
Total assets $23,000 $21,800
Accounts payable $1600 $1500
Accruals 2800 2200
Notes payable 200 300
Total Current liabilities $4600 $4000
Long-term debt $5000 5000
Common stock $10,000 $10,000
Retained earnings 3400 2800
Total stockholders’ equity $18,400 $17,800
Total liabilities and net assets $23,000 $21,800

Income statement data for 2021 (amounts in $000):

Depreciation expense $1600
Net income 1400

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Answer:
Step (1): Calculate the change in the key balance sheet accounts between
2021 and 2020 and classify each as a source (inflow) or a use (outflow)
Balance Sheet Changes and Classification of Key Accounts
between 2021 and 2020 ($000)
Account 2021 2020 Change Classification
Cash and marketable 3300 2200 + 1100 Outflow (Use)
securities
Accounts receivable 2000 1800 + 200 Outflow (Use)
Inventories 2900 2800 + 100 Outflow (Use)
Gross fixed assets 29,500 28,100 + 1400 Outflow (Use)
Accounts payable 1600 1500 + 100 Inflow (Source)
Accruals 2800 2200 + 600 Inflow (Source)
Notes payable 200 300 − 100 Outflow (Use)
Long-term debt 5000 5000 0 ---
Common stock 10,000 10,000 0 ---

Step (2): Prepare a summary of cash inflows and cash outflows for 2021.
• Calculate dividends paid for 2021 ($000)
∵ Retained earnings2020 + Net profits after taxes2021
− Dividends paid 2021 = Retained earnings2021
∴ 17,800 + 1400 − Dividends paid 2017 = 18,400
Dividends paid 2021 = 17,800 + 1400 − 18,400
∴ Dividends paid 2021 = 800

62
 Summary of cash inflows and cash outflows for 2021 ($000)
Cash Inflows (Sources) Cash Outflows (Uses)
Inc. in accounts 100 Inc. in Cash and 1100
payable marketable securities
Inc. in accruals 600 Inc. in accounts receivable 200
Net profit after taxes 1400 Inc. in inventories 100
Depreciation expense 1600 Inc. in gross fixed assets 1400
Dec. in notes payable 100
Dividends paid 800
Total Cash Inflows 3700 Total Cash Outflows 3700

Step (3): Prepare a statement of cash flows for 2021.

Statement of cash flows for 2021 ($000)

Cash flow from operating activities
Net profit after taxes 1400
Depreciation expense 1600
Inc. in accounts payable 100
Inc. in accruals 600
Inc. in accounts receivable (200)
Inc. in inventories (100)
Cash provided by operating activities … …(1) 3400
Cash flow from investment activities
Increase gross fixed assets (1400)
Cash provided by investment activities ……(2) (1400)
Cash flow from financing activities
Dec. in notes payable (100)
Dividends paid (800)
Cash provided by financing activities … …(3) (900)
Change in cash and marketable securities …….…(1+2+3) 1100

63
Exercise (5):
Consider the following summary of Summer Breeze Corporation's financial
statements:
Summer Breeze Corporation Balance Sheets (amounts in $000)
December 31st
Assets
2022 2021
Cash and cash equivalents $6400 $5300
Accounts receivables $3200 $3000
Inventories $4,600 $3900
Total current assets $14,200` $12,200
Gross Fixed Assets $31,900 $29,500
Less: Accumulated depreciation ($17,300) ($14,700)
Net fixed assets $14,600` $14,800
Total Assets $28,800 $27,000
Liabilities and stockholders’ equity
Accounts payable $2700 $2600
Notes payable $4400 $3800
Accruals $1100 $1200
Total current liabilities $8200` $7600
Long term debt $6600 $6000
Total liabilities $14,800` $13,600
Common stock $10,000 $10,000
Retained earnings $4000 $3400
Total liabilities and stockholders’ equity $28,800 $27,000

Summer Breeze Corporation Income Statement

data for 2022 (amounts in $000)
EBIT $3666
Interest expense $333
Tax rate 40%
Required:
Prepare the statement of cash flows for Bridgewater Corporation.

64
Answer:
Step (1): Calculate the change in the key balance sheet accounts between
2022 and 2021 and classify each as a source (inflow) or a use (outflow)
Balance Sheet Changes and Classification of Key Accounts
between 2022and 2021 ($000)
Account 2022 2021 Change Classification
Cash and cash 6400 5300 + 1100 Outflow (Use)
equivalents
Accounts receivable 3200 3000 + 200 Outflow (Use)
Inventories 4,600 3900 + 700 Outflow (Use)
Gross fixed assets 31,900 29,500 + 2400 Outflow (Use)
Accounts payable 2700 2600 + 100 Inflow (Source)
Notes payable 4400 3800 + 600 Inflow (Source)
Accruals 1100 1200 − 100 Outflow (Use)
Long-term debt 6600 6000 + 600 Inflow (Source)
Common stock 10000 10,000 0 ---

Step (2): Prepare a summary of cash inflows and cash outflows for 2022.
a. Calculate the depreciation expense for 2022 ($000)
∵ Depreciation expense = ∆ Accumulated depreciation
∴ Depreciation expense2022 = Acc. depreciation2022 − Acc. depreciation2021
= 17,300 − 14,700
= 2600
b. Calculate net profits after taxes for 2022 ($000)

Operating profits (EBIT) 3666

Less: Interest expense (333)
Net profits before taxes 3333
Less: Taxes (40%) (1333.2)
Net profits after taxes 1999.8

65
c. Calculate dividends distribution for 2022 ($000)
∵ ∵ Retained earnings2021 + Net profits after taxes2022
− Dividends paid 2022 = Retained earnings2022
∴ 3400 + 1400 − Dividends paid 2022 = 4000
Dividends paid 2022 = 3400 + 1999.8 − 4000
∴ Dividends paid 2022 = 1399.8

Summary of cash inflows and cash outflows for 2022 ($000)

Cash Inflows (Sources) Cash Outflows (Uses)
Inc. in accounts 100 Inc. in ash and cash 1100
payable equivalents
Inc. in notes payable 600 Inc. in accounts receivable 200
Inc. in long-term debt 600 Inc. in inventories 700
Net profit after taxes 1999.8 Inc. in gross fixed assets 2400
Depreciation expense 2600 Dec. in accruals 100
Dividends paid 1399.8
Total Cash Inflows 5899.8 Total Cash Outflows 5899.8

66
Step (3): Prepare a statement of cash flows for 2022.

Statement of cash flows for 2022 ($000)

Cash flow from operating activities
Net profit after taxes 1999.8
Depreciation expense 2600
Inc. in accounts payable 100
Inc. in accounts receivable (200)
Inc. in inventories (700)
Dec. in accruals (100)
Cash provided by operating activities … …(1) 3699.8
Cash flow from investment activities
Increase gross fixed assets (2400)
Cash provided by investment activities ……(2) (2400)
Cash flow from financing activities
Inc. in notes payable 600
Inc. in long-term debt 600
Dividends paid (1399.8)
Cash provided by financing activities … …(3) (199.8)
Change in cash and cash equivalents …….…(1+2+3) 1100

67
Questions and Problems with Answer Key
MULTIPLE CHOICE. Choose the one alternative that best completes
the statement or answers the question.
1) The statement of cash flows ________.
A) shows the financial position of a firm at a given point of time.
B) summarizes all the purchase and sale of fixed assets and raw materials
C) provides insight into a firm's operating, investment, and financing cash flows
D) classifies a firm's cash flows as operating, investing, financing, and other activities
Answer: C

2) Which of the following is an example of noncash charges?

A) depreciation
B) accruals
C) interest expense
D) dividends paid
Answer: A

3) Which of the following is a source of cash flows?

A) increase in marketable securities
B) increase in accounts payable
C) decrease in notes payable
D) repurchase of stock
Answer: B

4) ________ is a noncash charge.

A) Labor expense
B) Depreciation
C) Salaries
D) Rent
Answer: B

5) In the statement of cash flows, retained earnings are handled through the adjustment of
________.
A) "Revenue" and "Cost" accounts
B) "Current Assets" and "Current Liabilities" accounts
C) "Depreciation" and "Purchases" accounts
D) "Net Profits After Taxes" and "Dividends Paid" accounts
Answer: D

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 6) The cash flows from operating activities section of the statement of cash flows includes
________.
A) principal received
B) cost of raw materials
C) dividends paid
D) stock repurchases
Answer: B

7) The cash flows from operating activities section of the statement of cash flows includes
________.
A) labor expense
B) proceeds from the sale of fixed assets
C) principal paid
D) dividends paid
Answer: A

8) The cash flows from financing activities section of the statement of cash flows includes
________.
A) labor expense
B) cost of raw materials
C) purchase of long-term assets
D) dividends paid
Answer: D

9) The three categories of a firm's statement of cash flows are ________.

A) cash flow from operating activities, cash flow from investment activities, and cash flow
from noncash activities
B) cash flow from operating activities, cash flow from noncash activities, and cash flow from
financing activities
C) cash flow from equity activities, cash flow from investment activities, and cash flow from
financing activities
D) cash flow from operating activities, cash flow from investment activities, and cash flow
from financing activities
Answer: D

10) Which of the following is a cash inflow?

A) a decrease in accounts payable
B) a decrease in accounts receivable
C) an increase in dividend payment
D) a decrease in accrued liabilities
Answer: B

69
11) Which of the following is a cash outflow?
A) an increase in accounts payable
B) a decrease in notes receivable
C) an increase in accounts receivable
D) an increase in accrued liabilities
Answer: C

12) Cash flows directly related to the production and sale of a firm's products and services are
called ________.
A) cash flow from operating activities
B) cash flow from investment activities
C) cash flow from financing activities
D) cash flow from equity activities
Answer: A

13) Cash flows associated with the purchase and sale of fixed assets and business interests are
called cash flow from ________.
A) operating activities
B) investment activities
C) financing activities
D) equity activities
Answer: B

14) Cash flows that result from debt and equity financing transactions, including incurrence and
repayment of debt, cash inflows from the sale of stock, and cash outflows to pay cash
dividends or repurchase stock are called cash flow from ________.
A) operating activities
B) investment activities
C) financing activities
D) miscellaneous activities
Answer: C

70
 Table 1
True Sandpaper Co.
Balance Sheets
For the Years Ended 2021 and 2022
2022 2021

15) The largest single source of funds for the firm in 2022 is ________. (See Table 1)
A) an increase in net profits after taxes
B) an increase in notes payable
C) an increase in long-term debt
D) an increase in inventory
Answer: C

16) Common stock dividends paid in 2022 amounted to ________. (See Table 1)
A) $100
B) $50
C) $600
D) $150
Answer: B

17) The firm may have increased long-term debts to finance ________. (See Table 1)
A) an increase in net fixed assets
B) an increase in current assets
C) accounts receivable payments
D) an increase in dividends
Answer: B

71
18) The firm ________ fixed assets worth ________. (See Table 4.1)
A) purchased; $0
B) purchased; $200
C) sold; $0
D) sold; $200
Answer: B

19) The firm's cash flow from operating activities is ________. (See Table 1)
A) $50
B) $350
C) $150
D) $200
Answer: A

20) The depreciation expense for 2022 is ________. (See Table 1)

A) $0
B) $200
C) $50
D) $1,000
Answer: B

21) A corporation sold a fixed asset for $100,000. This is ________.

A) an investment cash flow and a source of funds
B) an operating cash flow and a source of funds
C) an operating cash flow and a use of funds
D) an investment cash flow and a use of funds
Answer: A

22) A corporation raises $500,000 in long-term debt to acquire additional plant capacity. This is
considered as ________.
A) an investment cash flow
B) a financing cash flow
C) a financing cash flow and investment cash flow, respectively
D) a financing cash flow and operating cash flow, respectively
Answer: C

23) Which of the following is a cash flow from financing activities?

A) purchase of a long-term asset
B) decrease in accounts payable
C) increase in accounts payable
D) repurchasing stock
Answer: D

72
24) Which of the following represents a cash flow from operating activities?
A) dividends paid
B) increase or decrease in current liabilities
C) increase or decrease in fixed assets
D) repurchasing stock
Answer: B

25) For the year ended December 31, 2021, a corporation had cash flow from operating activities
of -$10,000, cash flow from investment activities of $4,000, and cash flow from financing
activities of $9,000. The statement of cash flows would show a ________.
A) net decrease of $3,000 in cash and marketable securities
B) net decrease of $5,000 in cash and marketable securities
C) net increase of $3,000 in cash and marketable securities
D) net increase of $5,000 in cash and marketable securities
Answer: C

26) For the year ended December 31, 2021, a corporation had cash flow from operating activities
of $20,000, cash flow from investment activities of -$15,000, and cash flow from financing
activities of -$10,000. The statement of cash flows would show a ________.
A) net increase of $5,000 in cash and marketable securities
B) net decrease of $5,000 in cash and marketable securities
C) net decrease of $15,000 in cash and marketable securities
D) net increase of $25,000 in cash and marketable securities
Answer: B

27) For the year ended December 31, 2021, a corporation had cash flow from operating activities
of $12,000, cash flow from investment activities of - $10,000, and cash flow from financing
activities of $4,000. The statement of cash flows would show a ________.
A) net decrease of $18,000 in cash and marketable securities
B) net decrease of $6,000 in cash and marketable securities
C) net increase of $6,000 in cash and marketable securities
D) net increase of $2,000 in cash and marketable securities
Answer: C

28) A firm has just ended the calendar year making a sale in the amount of $200,000 of
merchandise purchased during the year at a total cost of $150,500. Although the firm paid in
full for the merchandise during the year, it has yet to collect at year end from the customer.
One possible problem this firm may face is ________.
A) low profitability
B) insolvency
C) inability to receive credit
D) high leverage
Answer: B

73
 TRUE/FALSE. State whether the following statements are true or
false.
29) In the statement of cash flows, the cash flows from financing activities result from debt and
equity financing transactions; including incurrence and repayment of debt, cash inflow from
the sale of stock, and cash outflows to repurchase stock or pay cash dividends.
Answer: TRUE

30) In the statement of cash flows, cash flows from operating activities are cash flows directly
related to purchase and sale of fixed assets.
Answer: FALSE

31) Depreciation is considered to be an outflow of cash.

Answer: FALSE

32) The statement of cash flows provides insight into a firm's operating, investment, and financing
cash flows and reconciles them with changes in its cash and marketable securities during the
period of concern.
Answer: TRUE

33) Non-cash charges are expenses that involve an actual outlay of cash during the period but are
not deducted on the income statement.
Answer: FALSE

74
 PROBLEMS. Solve the following problems.
34) Calculate the change in the key balance sheet accounts between 2014 and 2015 and classify
each as a source (S), a use (U), or neither (N), and indicate which type of cash flow it is: an
operating cash flow (O), and investment cash flow (I) or a financing cash flow (F).
ABC Corp.
Balance Sheet Changes and Classification
of Key Accounts between 2014 and 2015

Answer: ABC Corp.

Balance Sheet Changes and Classification
of Key Accounts between 2014 and 2015

75
 Table 2

2022

Magna Fax, Inc.

Balance Sheet
For the Years Ended December 31, 2021 and 22

2022 2021

76
35) The credit manager at First National Bank has just received the income statement and balance
sheet for Magna Fax, Inc. for the year ended December 31, 2022. (See Table 2.) The bank
requires the firm to report its earnings performance and financial position quarterly as a
condition of a loan agreement. The bank's credit manager must prepare two key financial
statements based on the information sent by Magna Fax, Inc. This will be passed on to the
commercial loan officer assigned to this account, so that he may review the financial condition
of the firm.
(a) Prepare a statement of retained earnings for the year ended December 31, 2022.
(b) Prepare a statement of cash flows for the year ended December 31, 2022, organized by cash
flow from operating activities, cash flow from investment activities, and cash flow from
financing activities.

Answer:
(a)
Magna Fax, Inc.
Statement of Retained Earnings
For the Year Ended December 31, 2022
2021

2022

Magna Fax, Inc.

Summary of cash inflows and cash outflows
For the Year Ended December 31, 2022

77
(c)
Magna Fax, Inc.
Statement of Cash Flows
For the Year Ended December 31, 2022

78