Question

The text states, "Over sufficiently long time periods, net income equals cash inflows minus cash outflows, other than cash flows with owners." Demonstrate the accuracy of this statement in the following scenario: Two friends contributed $50,000 each to form a new business. The owners used the amounts contributed to purchase a machine for $100,000 cash. They estimated that the useful life of the machine was five years and the salvage value was $20,000. They rented out the machine to a customer for an annual rental of $25,000 a year for five years. Annual cash operating costs for insurance, taxes, and other items totaled $6,000 annually. At the end of the fifth year, the owners sold the equipment for $22,000, instead of the $20,000 salvage value initially estimated. (Hint: Compute the total net income and the total cash flows other than cash flows with owners for the five-year period as a whole.)

	CASH	EQUIPMENT	COMMON STOCK	NET INCOME
cash contributed by owners
purchase of machine for cash
recognition of rent revenue
recognition of operating expenses
recognition of depreciation
sale of machine

totals $ $ $ $

Answer 1

Computation of annual income flow and cash flow as below
Computation of annual depreciation
Depreciation=	Cost of Asset-Salvage Value/useful life of asset
	$100000-$20000/5
	$16,000
Computation of profit from sale of asset at the end of yr 5 as below
Profit	Sale value-Salvage
	$22000-$20000
	$2,000
Computation of annual net income and cash flow as below:
Yr	1	2	3	4	5
Rental Income	$25,000	$25,000	$25,000	$25,000	$25,000			Cash	Equipment	Common stock	Net Income
Less Operating Costs	$6,000	$6,000	$6,000	$6,000	$6,000		Cash Contributed	$100000 Dr		$100000 Cr
Less Depreciation	$16,000	$16,000	$16,000	$16,000	$16,000		Purchase of Machine for Cash	$100000 Cr	$100000 Dr
Add Profit on sale of assets					$2,000		Recognition of Net Revenue =1-5 yrs
Net Income	$3,000	$3,000	$3,000	$3,000	$5,000		$25000 for yr 1-5
Add Depreciation	$16,000	$16,000	$16,000	$16,000	$16,000		Recognition of operating expenses
Add Sale of salvage					$22,000		$6000 for yr 1-5
Less Profit on sale of assets					$2,000		Recognition of Depreciation
Cash Flow	$19,000	$19,000	$19,000	$19,000	$41,000		yr 1-5 for $16000
Thus the net income and cash flow through yr 1-4 are $3000 and $19000							Sale of Machine
whereas the net income and cash flow in yr 5 are $5000 and $41000							$22000 in yr 5