penses C4-4 Blue Zone, Inc. What was the cash outflow to pay marketing costs in 1998? Blue Zone, Inc. (the "Company") is incorporated in the state of Nevada and is in the busi ness of providing technical and creative expertise and software licensing related to Web site and interactive television development and related Internet strategies to assist the tradi tional mass media corporations in accessing the World Wide Web, through set-top boxes and other interactive devices. The balance sheet, income statement, and cash flow statement found in the Blue Zone Inc. 10K for fiscal year 2000 appear below and on pages 99 and 100. Excerpts from the foot notes are also given. ASSETS Blue Zone, Inc. Consolidated Balance Sheets (Expressed in U.S. dollars) December 31, 2000 1999 Current assets: Cash and cash equivalents $1,844,981 $4,097,869 Accounts receivable (note 3) 221,363 97,600 Work-in-progress 70,581 Prepaid expenses 144,767 93,204 $2,211,111 $4,359,254 Fixed assets (note 4) LIABILITIES AND STOCKHOLDERS' EQUITY 838,897 $3,050,008 $ 4,784,850 425,596 Current liabilities: Accounts payable Accrued liabilities (note 5) Deferred revenue Payable to stockholders (note 6) Stockholders' equity (note 7): Common stock, $.001 par value, authorized 100,000,000 shares; issued and outstanding 24,539,350 shares $ 258,728 $ 191,675 198,077 60,020 178,300 180,143 45,559 $ 516,825 $ 595,677 (1999 21,538,100) Additional paid in capital $ 24,539 8,446,877 $ 21,538 5,626,371 Deficit Accumulated other comprehensive loss: (5,738,665) (1,433,831) Foreign currency translation adjustment (199,568) (24,905) $2,533,183 $4,189,173 $2,533,183 $3,050,008 $4,1 $4,784,850 g CHAPTER 4 STATEMENT OF CASH FLOWS: OPERATING, INVESTING, AND FINANCING ACTIVITIES " 99 Blue Zone, Inc. Consolidated Statements of Operations (Expressed in U.S. dollars) 2000 Years Ended December 31, 1999 1998 Product and service revenue $1,168,842 $ 378,358 $269,132 Exchange product and service revenue [note 2(c)] Cost of revenues 569,332 504,779 370,803 505,698 144,419 Gross profit $ 599,510 $ 512,334 $630,411 Operating expenses: General and administrative $2,725,085 $1,211,606 $101,756 Research and development 836,595 65,158 25,273 Selling and marketing 870,606 105,231 712 Exchange advertising (note 2(c)) 504,779 505,698 Depreciation 197,118 97,755 29,860 $4,629,404 $1,984,529 $663,299 Loss before undernoted $4,029,894 $1,472,195 $ 32,888 Interest income 186,127 Loss before income taxes $3,843,767 49,864 $1,422,331 Income tax recovery (note 9) - Net loss $3,843,767 $1,422,331 $ 32,888 (4,431) $ 28,457 Exchange Agreement Exchange Agreement On August 1, 1997, the Company entered into an agreement to exchange services with a British Columbia television station (BCTV). The Company provided Web site develop- ment and monthly maintenance services in exchange for daily television advertising. The Company recognized the revenues and advertising expenses from the barter transaction at the fair value of the advertising received. Blue Zone recorded no revenue under barter exchange agreements for the year ended December 31, 2000, compared to $505,000 for the year ended December 31, 1999. This decrease was attributable to the completion of our three-year Web site evo- lution project contract with BCTV on December 31, 1999, as discussed above. As a re- sult, revenue for which Blue Zone received cash consideration increased 209%, from $378,000 in 1999 to $1,169,000 in 2000. Exchange advertising dropped from $505,000 in 1999 to nil in 2000 as a result of the termination of the BCTV contract and the change in accounting principles applicable to barter transactions. Research and development and advertising costs are expensed as incurred. Adver- tising costs charged to selling and marketing expenses in 2000 total $4,993 (1999: $513,252; 1998: $505,698). Advertising costs in 1999 and 1998 include the exchange ad- vertising presented separately in the statement of operations Stock Options During the year ended December 31, 2000, the Company recorded non-cash compensa- tion expense of $270,428 (1999: $16,094; 1998: nil) relating to the issuance of 2,083,500 (1999: 1,888,500; 1998: nil) common stock purchase options to certain employees, offi- cers, and directors of the Company, representing the implicit benefit derived from the ex- ercise price being less than fair market value. During the year ended December 31, 2000, the Company recorded non-cash com- pensation expense of $88,745 (1999: $280,917; 1998: nil) relating to the issuance of 6,000 (1999: 106,500; 1998: nil) common stock purchase options to certain contractors of the Company, representing the fair value benefit of the options. 100. MASTERS EDITION-QUESTIONS, EXERCISES, PROBLEMS, AND CASES TO ACCOMPANY FINANCIAL ACCOUNTING Blue Zone, Inc. Consolidated Statements of Cash Flows (Expressed in U.S. dollars) Years Ended December 31, 2000 1999 1998 Cash flows from financing activities: Net loss $(3,843,767) $(1,422,331) $(28,457) Items not involving cash: Stock based compensation 359,173 297,011 Depreciation 197,118 97,755 29,860 Foreign currency translation adjustment (174,663) (25,585) 1,103 Changes in operating assets and liabilities: Accounts receivable (123,763) (97,600) 44,668 Work-in-progress 70,581 (70,581) Prepaid expenses (51,563) (92,646) Accounts payable 67,053 169,845 8,321 Accrued liabilities 19,777 159,267 9,336 Deferred revenue Income taxes payable Net cash provided by (used in) operating activities Cash flows from financing activities: Issue of redeemable equity securities, net of deferred finance costs Redemption of redeemable equity securities Increase in payable to stockholders Repayment of payable to stockholder Issue of common stock (120,123) 180,143 (2,589) - $(3,600,177) $ (807,311) (3,137) $ 61,694 $ 3,538,933 - (4,000,000) - (45,559) 2,464,334 Net cash provided by financing activities $ 1,957,708 Cash flows from investing activities: $ (610,419) Purchase of fixed assets Net cash used in investing activities Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year Supplementary information: Interest paid Income taxes paid Noncash transactions: $ (610,419) $(2,252,888) 4,097,869 $ 1,844,981 $ $ 36,297 - $(28,641) 5,350,886 $ 5,387,183 - $(28,641) $ (482,894) $ (44,537) S (482,894) $ (44,537) 4,096,978 891 $ 4,097,869 - $ $(11,484) 12,375 $ 891 23,984 $ 1,592 1,090 - Noncash transactions: Revenue received in exchange for advertising expense Noncash financing activities: Issuance of stock options $ - $ 504,779 $505,698 $ 359,173 $ 297,011 $ Product and Service The Company generates product and service revenue through the following sources: in- teractive broadcasting development and maintenance, strategic consulting services for broadcasting and media companies, and software licensing from Blue Zone's family of MediaBZ software applications. Consulting service revenues are recognized upon delivery of the service. Interactive broadcasting maintenance is recognized over the term of the contracts, typically month to month. Software licensing revenue is recognized over the term of the license. Blue Zone rec- ognized license fee revenue of $21,000 during the year, and $60,000 is recorded as de- ferred revenue at December 31, 2000, representing the unrecognized portion of the an- nual license fee. CHAPTER 4 STATEMENT OF CASH FLOWS: OPERATING, INVESTING, AND FINANCING ACTIVITIES 101 For long-term development projects such as the BCTV contract, revenue is recog- nized on a percentage completion basis, based upon achievement of specifically identifi- able milestones. A total of $673,000 was earned during the year ended December 31, 2000 relating to long-term Web site development for BCTV. Revenue that has been prepaid or invoiced but does not yet qualify for recognition under the Company's policies is reflected as deferred revenue. There was no deferred rev- enue recorded at December 31, 2000, other than the deferred licensing fee mentioned above. At December 31, 1999 there was unearned revenue of $180,000 relating mainly to payments received on the BCTV contract in advance of the Company satisfying recogni- tion criteria. tion criteria. A significant proportion of Blue Zone's reported revenue for the three years ended December 31, 1999 was earned from a three-year barter exchange agreement with the Vancouver-based broadcaster, BCTV. The Company recorded exchange product and ser- vice revenue and recorded an equal amount as exchange advertising expense in the state- ment of operations. Under the BCTV contract, Blue Zone exchanged product and ser- vices for television airtime on BCTV, rather than receiving cash payment. The exchange revenue and the advertising expense were valued at the fair market value of the television airtime. The Company used this airtime to enhance Blue Zone's name recognition to as- sist in marketing products to current and potential clients. In fiscal 2000, the Company adopted EITF No 99-17 "Accounting for Advertising Barter Transactions." EITF 00-17 provides that the Company recognize revenue and ad- vertising expenses from barter transactions at the fair value only when it has a historical practice of receiving or paying cash for similar transactions. The Company has not recorded barter transactions during the year ended December 31, 2000. FIXED ASSETS 2000 Cost Accumulated Depreciation Net Book Value Equipment and computers Software $ 680,988 $179,775 $501,213 151,705 29,398 122,307 Furniture and fixtures 91,229 23,662 67,567 Leasehold improvements 222,307 74,497 147,810 $1,146,229 $307,332 $838,897 1999 Cost Accumulated Depreciation Net Book Value Equipment and computers $292,249 $ 70,668 $221,581 Software 37,644 8,562 29,082 Furniture and fixtures 42,362 9,343 33,019 Leasehold improvements 172,008 30,094 141,914 $544,263 $118,667 $425,596 Required: 1. Why is the $197,118 of Depreciation added back to net income in the statement of cash flows in order to obtain Net Cash Provided by (used in) Operating Activities? 2. Verify that the changes in Accounts Receivable, Work-in-Progress, and Prepaid Expenses shown as adjustments in the operating section of the cash flow statement agree with the differences between the beginning and ending balances shown in the balance sheets. Is this always true? If yes, why? If no, give an example of when it might not be true. this always true? If yes, why? If no, give an example of when it might not be true. 3. Explain in detail why the prepaid expenses are treated the way they are in the cash flow statement. 4. Why is Stock Based Compensation added to net income in arriving at Cash Provided by (used by) Operating Activities? Provide a journal entry to recognize Stock Based Compensation Expense. 102. MASTERS EDITION-QUESTIONS, EXERCISES, PROBLEMS, AND CASES TO ACCOMPANY FINANCIAL ACCOUNTING 5. In the 2000 fiscal year, how much more or less cash was collected than was recog nized as revenue for those items accounted for in the deferred revenue account? Ex plain. What about during fiscal 1999? 6. To what do Exchange Product and Service Revenue and Exchange Advertising refer to in the 1998 and 1999 income statements? How was this transaction reported in the cash flow statement in 1998 and 1999? In your opinion, is there a better way to have reported this in the cash flow statement? Apparently such transactions would be re- quired to be reported differently in 2000. If they engaged in such barter transactions in 2000, how would they have been reported in the financial statements? 7. Comment in general about the cash flows in each of the categories (operations, in- vesting, and financing) over the three-year period 1998 to 2000. 8. Fill in the question marks in the following T-accounts. Provide a journal entry to generate each of the numbers and an explanation of the transaction. Fixed Assets (Gross) Beginning balance? Accumulated Depreciation ? Beginning balance Increases ? ? Decreases Decreases ? Increases Ending balance ? ? Ending balance