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“Why can’t we pay our shareholders a dividend?” shouted your new boss. “This income statement you prepared for me says we earned $5 million in our first half-year!”

You were hired last month as the chief accountant for Enigma Corporation which was organized on July 1 of the year just ended. You recently prepared the financial statements below:

ENIGMA CORPORATION
Income Statement
For the Six Months Ended December 31, 2011
($ in millions)

Sales Revenue

$75

Cost of goods sold

($30)

Depreciation expense

($5)

Remaining expenses

($35)

Net income

$5

ENIGMA CORPORATION
Balance Sheet
December 31, 2011
($ in millions)

Cash

$1

Accounts receivable (net)

$20

Merchandise inventory

$15

Machinery (net)

44

TOTAL

$80

Accounts Payable

$2

Accrued expenses payable

$7

Notes payable

$36

Common stock

$30

Retained earnings

$5

TOTAL

$80

You have just explained to your boss, Robert James, that although net income was $5 million, operating activities produced a net decrease in cash. Unable to understand your verbal explanation, he has asked you to prepare a written report.

Required:

Prepare a 300-500 word report explaining the apparent discrepancy between Engima’s profitability and its cash flows. To increase the chances of your boss’s understanding the situation, include in your report a determination of net cash flows from operating activities by both the direct and indirect methods. Your report should also include a narrative explanation of how it is possible for operating activities to simultaneously produce a positive net income and negative net cash flows.

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