Statement of Cash Flow Tom and Company reports the following income statement for the year ended December 31, 2012: See attachment. Required: a. Prepare, in good form, the operating section of the statement of cash flow, using the direct method for Tom and Company for December 31, 2012. b. Prepare, in good form, the operating section of the statement of cash flow, using the indirect method for Tom and Company for December 31, 2012. 
PROBLEM # 1: Statement of Cash Flow Tom and Company reports the following income statement for the year ended December 31, 2012: Sales Cost of goods sold Gross profit Depreciation expense Selling and administrative expense $2,100,000 831,600 1,268,400 88,000 758,000 Income before tax 422,400 Income tax expense 168,960 Net income $ 253,440 The company also reports the following information from the balance sheet: December 31, December 31, 2012 2011 Cash $ 90,000 $ 24,000 Accounts receivable 80,000 60,000 Inventory 14,000 16,000 150,000 170,000 Accrued selling and admin expenses 12,000 8,000 Taxes payable 204,000 82,000 Dividends payable 20,000 44,000 Accounts payable Required: a. Prepare, in good form, the operating section of the statement of cash flow, using the direct method for Tom and Company for December 31, 2012. b. Prepare, in good form, the operating section of the statement of cash flow, using the indirect method for Tom and Company for December 31, 2012. Workspace for Problem 1: Example 1: Solution: Example 2: Example 3: Merrimack: "So the last will be first, and the first will be last." Let's look at the valuation of inventory in more detail. Please read the case study: Merrimack Tractors and Mowers, Inc.: LIFO or FIFO? in your coursepack. (Let me know if you want me to send you the case study) In 2008 Merrimack Tractors and Mowers found itself in a situation where product manufacturing costs were increasing faster than competitors' costs, and as a result earnings were likely to fall below those reported in 2007. The company president and the company controller discussed this problem, and the controller mentioned the idea that if the company changed from LIFO to FIFO it might be possible to maintain earnings growth in 2008. He prepared a memo to the president explaining how inventory flow assumptions work and provides pro-forma income statements that show that for one product (reel mower units) adopting FIFO would allow Merrimack to report higher income in 2008 than it did in 2007, but higher income taxes would have to be paid. As a group assignment you have to answer the following questions: 1) Study the financial information for reel mower units that James Colburn prepared for Rick Martino. (Assume that reel mower units are typical of all classes of inventory at Merrimack.) Prepare a pro-forma income statement assuming no changes in accounting policy for 2008 assuming that the company sells 10,000 units each quarter at a price of $2,000 per unit with Sales General and Administration costs the same as for 2007. Do you think that Martino will keep his job if he reports this result? 2) How would this change if the unit sales pattern was Q1 10000; Q2 5000; Q3 20000; and Q4 5000 units in the four quarters? Why? Tip: Remember we manufactured/purchased, 10,000 units each quarter. So the purchase/manufacturing pattern is the same as for 2007 with increasing prices, but the sales pattern is not matching the purchase pattern. So for Q4 that means we sold less than we made. This gets at the idea of "dipping" into LIFO layers. 3) If Merrimack Tractors and Mowers were to adopt FIFO as of January 1, 2008, how would this affect the financial statements (Balance Sheets, Income Statement, and Cash Flow)? You may assume the 10,000 per quarter of unit sales for 2008. Tip: If we use FIFO in 2008, we have to retroactively adjust to FIFO in 2007. This is called an "accounting principle change." In other words, if we make changes going forward we need to show investors what the numbers would have looked like if we would have used the FIFO method all along. So be careful what you choose as starting value for inventory in 2008. 4) In the pro forma income statements that James Colburn prepared for Rick Martino, the costs of reel mower units and transportation were rising for 2007 and 2008. How would Merrimack Mowers and its accounting choices have differed if inventory purchase prices and transportation costs had been stable or falling over the two-year period? (For example, if Merrimack were a computer assembly firm.) Please assume a sales price of $2,000 per unit, a beginning inventory price of $1,300, Q1 price of $1,200, Q2 price of $1,100, Q3 price of $1,000, and Q4 price of $900. 5) Is James Colburn suggesting to Rick Martino that they should be managing earnings rather than managing the company and its business? Although such changes are clearly permitted by the law, do you consider them to be ethical? 6) Assuming that Rick Martino recommends to his Board of Directors that they should switch from LIFO to FIFO for 2008, prepare a draft of the note to the financial statements that will explain the change and why Merrimack is making the change. Example 1: Solution: Example 2: Example 3: Merrimack: "So the last will be first, and the first will be last." Let's look at the valuation of inventory in more detail. Please read the case study: Merrimack Tractors and Mowers, Inc.: LIFO or FIFO? in your coursepack. (Let me know if you want me to send you the case study) In 2008 Merrimack Tractors and Mowers found itself in a situation where product manufacturing costs were increasing faster than competitors' costs, and as a result earnings were likely to fall below those reported in 2007. The company president and the company controller discussed this problem, and the controller mentioned the idea that if the company changed from LIFO to FIFO it might be possible to maintain earnings growth in 2008. He prepared a memo to the president explaining how inventory flow assumptions work and provides pro-forma income statements that show that for one product (reel mower units) adopting FIFO would allow Merrimack to report higher income in 2008 than it did in 2007, but higher income taxes would have to be paid. As a group assignment you have to answer the following questions: 1) Study the financial information for reel mower units that James Colburn prepared for Rick Martino. (Assume that reel mower units are typical of all classes of inventory at Merrimack.) Prepare a pro-forma income statement assuming no changes in accounting policy for 2008 assuming that the company sells 10,000 units each quarter at a price of $2,000 per unit with Sales General and Administration costs the same as for 2007. Do you think that Martino will keep his job if he reports this result? 2) How would this change if the unit sales pattern was Q1 10000; Q2 5000; Q3 20000; and Q4 5000 units in the four quarters? Why? Tip: Remember we manufactured/purchased, 10,000 units each quarter. So the purchase/manufacturing pattern is the same as for 2007 with increasing prices, but the sales pattern is not matching the purchase pattern. So for Q4 that means we sold less than we made. This gets at the idea of "dipping" into LIFO layers. 3) If Merrimack Tractors and Mowers were to adopt FIFO as of January 1, 2008, how would this affect the financial statements (Balance Sheets, Income Statement, and Cash Flow)? You may assume the 10,000 per quarter of unit sales for 2008. Tip: If we use FIFO in 2008, we have to retroactively adjust to FIFO in 2007. This is called an "accounting principle change." In other words, if we make changes going forward we need to show investors what the numbers would have looked like if we would have used the FIFO method all along. So be careful what you choose as starting value for inventory in 2008. 4) In the pro forma income statements that James Colburn prepared for Rick Martino, the costs of reel mower units and transportation were rising for 2007 and 2008. How would Merrimack Mowers and its accounting choices have differed if inventory purchase prices and transportation costs had been stable or falling over the two-year period? (For example, if Merrimack were a computer assembly firm.) Please assume a sales price of $2,000 per unit, a beginning inventory price of $1,300, Q1 price of $1,200, Q2 price of $1,100, Q3 price of $1,000, and Q4 price of $900. 5) Is James Colburn suggesting to Rick Martino that they should be managing earnings rather than managing the company and its business? Although such changes are clearly permitted by the law, do you consider them to be ethical? 6) Assuming that Rick Martino recommends to his Board of Directors that they should switch from LIFO to FIFO for 2008, prepare a draft of the note to the financial statements that will explain the change and why Merrimack is making the change
