Scenic Video Transcript Big Picture- EasyLearn s Cash Flow Statements Topics

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1 Cash Flow Statements» What s Behind the Numbers?» Cash Flow Basics» Scenic Video Scenic Video Transcript Big Picture- EasyLearn s Cash Flow Statements Topics Events in EasyLearn Company example Balance Sheet Equation (BSE) matrix with operating, investing, and financing classifications Statement of Cash Flow (SCF) effects- Entry by entry: o Issue stock o Sale on account o Receivable collection o Advertise on account o Payable payment Statement of Cash Flow (SCF) effects- Grouping related entries: o Receivables o Payables Adjustment signs Take-aways Transcript Introduction Welcome to the Big Picture Scenic Route. This video will help you understand how items reporting cash flow statements relate to the purpose of the statement, the underlying business activities and accounting judgments, and to numbers reported in other financial statements. Understanding these connections and interpreting reported numbers is relatively easy for direct cash flow statements, but can be quite challenging for the operating section of indirect statements and in particular the reconciliation adjustments in the operating section. In this video, you're going to learn a two-step process that is the foundation for a framework that will allow you to increasingly penetrate these connections as you work your way through Navigating Accounting. First step, analyze the connections entry-by-entry for all entries that affect the line item you're interpreting. How does this entry relate to the purpose of the statement, or more specifically to the purposes of reconciliation or operating entries? What does it tell us about the underlying business activities? How is it affected by the underlying accounting judgments? How does it relate to numbers reported in other financial statements? Second, determine the net effect of the group of entries that affect the line item by combining what you learned about their individual effects through the entry-by-entry approach. Here's our agenda. We're going to start out by looking at a company that has five events, it's called EasyLearn. They're all events you're familiar with. We're going to show you a few You may translate this work into your local language, as long as you credit G. Peter & Carolyn R. Wilson and respect the Creative Commons Attribution-Noncommercial-Share Alike United States license NavAcc LLC.

2 changes in the BSE matrix. Now that we're studying investing, financing and operating activities, we want to keep them separate in the matrix. Then we're going to go to the statement of cash flow effects, and this is the main part of the video. And then here is our entry-by-entry approach and our grouping approach. And the events that we're going to be looking at are all events you're familiar with: issuing stock for cash, sale on account, receivable collection, advertise on account, and a payable payment. After we look at the entry-by-entry effects and all the connections we talked about earlier, then we're going to group those effects and look at the receivables adjustment and the payables adjustment on the indirect cash flow statement. Literally, every company has these two adjustments. And then we're going to look at the signs of those adjustments because there's kind of an oddity to them, and we want you to understand that, and then finally some takeaways. So let's get started. Events in EasyLearn Company example Here's our timeline for EasyLearn. There's five events: E1, E2, E3, E4, and E5, and then a sixth event which happens in the next month which really isn t going to be relevant to our example here. Now, our reporting period is going to be the month of December. You're going to start a tutoring company called EasyLearn. And what you're going to do is you're going to put in a business plan and you're going to put in a dollar, and that's a fairly standard way to start up a company. And your business plan is going to be worth a lot of money, but you can't measure the value of it reliably so you're not going to report it on the balance sheet. We've seen this before, so all you're going to do is record one dollar for cash coming in and one dollar where the common stock being issued to you, the founder. So now that you've started the company, your first tutoring student shows up and his name is Mike Mercer. And you're going to tutor Mike, and you're going to charge $150 and all this is going to take place on December 15th. But Mike can't afford to pay you. He's near the end of the term so he's running low on funds and he says, "Look, I'll give you $50 on December 20th, and I'll give you the rest out here on January the 8th." And you say, "Fine," and you go ahead and tutor him. And then we move out to December 20th where he's supposed to pay you the $50. Mike says, "Look, I can't afford the $50 I was going to pay you. I'm going to pay you $20 instead." So out here on December 20th he pays you $20 cash. And he said, "But I'll pay you $130 instead of $100 that I was going to originally pay you out here on January 8th, and I'm pretty good for that." Now, he's just told you he's having financial difficulties on December 20th, but he's promising to pay you by January 8th. And you're not quite as certain about this receivable anymore but you decide you won't impair it. You think he'll still make the payment. And then on December 25th you decided, "Hey, this is going pretty well. I think I'll advertise." So you run an advertisement in the college newspaper and you're invoiced for $60 so you run it on account. Now, consistent with IFRS and US GAAP, you expense the advertisement, but you haven t paid anything. And then you're going to pay off $15 of the $60 you owe for the advertisement. Those are all the events, and now what we want to do is analyze them. Balance Sheet Equation (BSE) matrix with operating, investing, and financing classifications I want to first indicate some changes in the BSE matrix. You might recall in earlier chapters what we did is we would start and just run the events down E1, E2, E3, E4, all the way down 2

3 the page. And here instead we've classified them as operating and financing. Now, actually the BSE matrix will be classifying them as operating, financing and investing just as you learned in the What Do I See section of the chapter. There are three sections in cash flow statement, and we want to keep our entries straight. And we've also added some subtotals. So here's net from operations and net cash from financing, and you just have to envision there would be a comparable section for investing but we don t have any investments here. We're not buying property, plant and equipment. We're just trying to do a little tutoring, make some money while we're in college. So here it goes. Let's look at the events. So the first event is issue stock, and we said what happened is you contributed a business plan, you contributed cash, but only the cash is reliably measurable so cash goes up by a dollar and it's positively signed. And we could go through the formalities of the entry but I think you get it. And under permanent owners' equity we're going to record the dollars worth of common stock, and then we can look at the other entries. What happened for E2? Well, remember that's where Mike Mercer shows up and you tutor him. He owes you $150 and you're fairly confident you're going to collect that. So you go ahead and record it. Should you recognize revenue? Well, accounts receivable went up, and the big question now is do you have any remaining obligations? Well no, you just tutored him. So an asset went up, no assets went down, no liabilities were affected so you have a change in owners' equity because you have an increase in net assets. It's not permanent. It's not a transaction with owner so you have revenue, and that's a very important judgment that we just made. The receivables are good, and we have no remaining obligations. We'll come back to that later. And then you collect $20 on December 20th. Cash goes up, and accounts receivable goes down. Then we take on an advertising expense on the 25th. We go to the college newspaper, and we run an ad that costs $60. But we're not going to pay for the ad at that time, but we ran it. And because we ran it under GAAP, we have to take an expense. So over here we have advertising expense negatively signed, and over here we have accounts payable. Accounts payable goes up. Advertising expense goes up. And then we make an advertising payment, and the liability goes down and cash goes out. So that s it. You know all these entries. There's nothing new, and that's really important because we just want to focus on how do these entries affect the statements here? So we want to pick entries you're familiar with. So let's move on and see how the statements are affected. Statement of Cash Flow (SCF) effects- Entry by entry: Issue stock We begin with the easy event, E1, issue stock for cash. What would EasyLearn report on its income statement? What would EasyLearn report on the direct cash flow statement? What about the indirect statement? So those are the three questions we're interested in. First, does this affect income? Well, no, this entry doesn't affect income. It does affect owners' equity, we just saw that, but it's a transaction with owners. Remember, anything that affects owners' equity is either a transaction with owners or it affects other items and generally comprehensive income then down to net income, et cetera. 3

4 Well, this is simply a transaction with owners, so it does not affect income. It does affect the direct cash flow statement whenever you record something to cash, and only when you record something to cash as we've done here, you are going to affect the direct cash flow statement. That's precisely what we mean by direct cash flows. And the only time you get on this statement is if you record something to cash. And if you record something to cash, it goes on the statement. And so all you have to do is classify it. Well, it's a financing activity, sale of common stock. It's the only dollar that came in so that's our net from financing. And if this was the only event we recorded, which is a fiction we re going to be playing in this entryby-entry approach, then the change in cash will be $1. So we're ignoring all other events here. One of the lessons we learned from the What Do I See section of this chapter is for the operating section of direct and indirect cash flow statements we have significant differences, but for the Investing and Financing section they're exactly the same. So we know on the indirect statement we're going to have exactly the same effects as over here. Sale on account Now we move on to E2, sale on account. So this is where we recognized $150 of revenue when we delivered tutoring services to Mike Mercer, and we charged those to accounts receivable. Now, what about the effect on the financial statements? Well, let's start with the income statement. Since we recognized revenue, we re going to have $150 worth of revenue here. We're not going to recognize any advertising expense. Remember, this is one entry at a time so we're going to maintain the fiction that this is the only entry that happened during the period, and this is a really healthy fiction to maintain because as we work our way through Navigating Accounting we want to focus just on one entry at a time. When we can figure out how that affects the financial statements, well you're going to get a much deeper understanding, we can always combine the effects later. Moving on, we see that we have $150 of revenues. We have no advertising expense so our net income is $150. Now, what about the direct cash flow statement? Direct cash flow statement? No, no effect. Remember, because we didn t record anything to cash, there can be no effect on the direct cash flow statement because the only way that we affect the direct cash flow statement is when we record something in cash. Now, how about the indirect statement? When we move the indirect statement, if we were recording something to financing or investing we d have the same answer because the investing and financing are the same for the direct and the indirect, we wouldn't record anything. But we're looking at an indirect statement and remember the objective of an indirect statement is reconciliation. We're trying to reconcile net income to net cash from operations, but we know we have $150 of net income. So we'll go over here, and we'll start with $150 of net income. Now, how much net cash from operations? Well, the answer has to be zero, and the answer is zero because we couldn't put zero over here on net cash from operations on our direct statement and put some non-zero number over here. Those would be inconsistent. Remember, we didn't record anything to cash so we can't have cash from operations. That means we have to reconcile net income to cash because the effects are different. We have to explain that to our shareholders. 4

5 Well, it turns out we have a little table down here that's going to help us tremendously with that. And we'll be doing this as we go through entries. So this table, let's try to understand it. Over here we have what will eventually be shown by EasyLearn to its shareholders. So this combines all the events. This is what's going to be reported. This is what we're trying to understand. And we're going to have a net income of $90. We're going to have a receivables adjustment of -$130; accounts payable, a $45 adjustment; and net cash from operations, $5, just by adding these together mathematically. Now, that's what we'll see as outsiders, and then we're trying to gain insights about that. And we're going to go behind the numbers one entry at a time and build this table. And as we put all the effects in here moving across the table, we'll then combine them and that will explain what we're seeing on the financial statements. So here is the event E2, the sale on account, and we know net income went up by $150 right here. We also know that's in our reconciliation right here, so that's part of the $90. And we know net cash from operations because of E2 the effect was zero. So we know mathematically we have to subtract $150. Otherwise, we can't get from $150 to zero here in our reconciliation. And we also know that this is a transaction with customers so it's going to deal with the receivables versus payables. So we take away $150. Now, it turns out there's another way to tell, which line item do we focus our adjustment on? If we go back to our entry and we say, "Okay, what accounts have we referred to so far in our analysis?" Well, we mentioned revenues. There's the revenues right there and right there. And we said there's no cash effect. So the account we haven't used yet which will be the non-cash, non-income account always, that's where you're getting your adjustments. So this is an accounts receivable adjustment. So look for the account. It's not an income account, not a cash account, and that will tell you where the adjustment is coming from. Now, that's quite mechanical at this point. We haven't really explained why that's true, but when we get to the Record Keeping & Reporting Map later we will explain exactly why it is that we can look at the accounts we haven't used yet to get the adjustments. For now it's the logical choice here, and we see mathematically that if we take $150 and subtract $150, we get zero. Now, understanding something from a mathematical perspective is good, but that's not enough. We need to get a deeper understanding of this because we're not going to be talking to mathematicians. We're going to be talking to business people trying to explain to them why is it that income differs from cash, and giving them the math is not going to be enough. So let's move on and try to get a little more intuition. What we want to do now is try to get a deeper understanding of what that means in terms of what s going on in the business. We're going to go real slow through this first one. Assume E2 was the only event during the period. Here is how you could explain the reconciliation to someone who is a prospective shareholder in your business. Maybe you decide to expand. And this is a really good mindset to get into to show that you're understanding something. Just pick anyone and try to explain it to them as if they are relatively smart but don't understand accounting. Imagine you're working in a summer job and something happens and you're trying to explain how does that event affect the cash flow statement to a colleague? And they understand the 5

6 business because they're working in the business, but they really don t understand accounting. And yet they've seen the consequences on the financial statements, and they are trying to interpret them. That is the mindset one should have. And when you can do that, your understanding of the concepts is going to be meaningful to you because you can explain it to others. You might begin by saying, "Look, the purpose of the reconciliation is to explain why income differs from cash." And during this period, we recognize $150 of net income and no cash from operations. Remember, this is the only event we're assuming that happened. If you want to understand the difference between the income effect and the cash effect, you ve got to understand income. This income arose from a sale on account for which we had no remaining obligations to our customers. So we recognized $150 increase in accounts receivable because we are confident we will collect in the future, but we didn't recognize the liability because we met all of our obligations to the costumer. So our assets went up, our liabilities were unaffected, therefore our net assets went up, and therefore owners' equity increased by $150. Now, if your owners' equity goes up, well, that's performing for the owners. We're recognizing an increase in the value of their claims. That s what it means to perform for your owners. We ve been through this on the Income Statement chapter but remind yourself of it because you see if you're going to explain why income differs from cash, you need to understand in the deepest sense what went into creating income because cash is easy, cash is cash, but income is complex. It s very complex. And so when you understand the complexities that went into income, you can quickly say why it differs from cash. That s the reason net income is $150 more than cash from operations, accounts receivable rather than cash increased by $150. Accounts receivable went up by $150 but not cash. If this had been a cash sale, income and cash would have been the same because cash would have gone up, revenues would have gone up, and they'd be exactly the same and there would be no reason to explain their difference. Stated alternatively, the $150 increase in receivables is the reason net income exceeded net cash from operations. Think about it, you re trying to reconcile to explain why they differ. Well, they differ because receivables went up instead of cash. Accordingly, to reconcile the $150 income effect of the sale to the zero cash effect, a reconciliation adjustment subtracts $150 increase in receivables for which the cash has not been collected. Now, we took a long time ago through that and the reason is when we start doing this quickly later, we want you to realize there's an awful lot going on in the background. And if you were talking to someone who didn t understand accounting but understood business, you d have to take them through each one of those steps. Now, we want talk about the judgments that went on. The quality of the $150 of net income, the quality, that is the likelihood that we realize this cash is the same as the quality of the receivable and we are reasonably confident that this receivable will be collected. Well, the amount of judgment that goes into determining whether we are reasonably confident that we re going to collect in the future, that can vary across different business contexts. And sometimes, unfortunately, people can be quite dishonest about that. There's a very famous case called ZZ Best. ZZ Best was a janitorial service. They had a really good idea. They said, We re going to consolidate the janitorial business-cleaning buildings. And they were doing quite well, and they went public. That means their shares 6

7 were traded on markets and their stock price was going up and everybody was happy and rich. And then they said, You know, this has gone real well and we could go better. So they took a very simple equation, asset equals liabilities plus owners' equity, and they said, Look, the market, Wall Street, they really like when earnings are high. Well, why don't we just make them high? We'll go over here." Here s accounts receivable over here is revenue positively signed, positively signed. "All we ve got to do is pretend to clean buildings, not really clean them, just pretend to clean them." And so they started to put a whole bunch of receivables over here and a whole bunch of revenue over here. They made a judgment that eventually took them to jail, by the way. But the point I want to make is- receivables went up, revenues went up, what didn t go up? Cash. So income looked great. The stock price went up. They were doing great for a while, worked really well, and therefore the management was getting rich off the value of their stock options, but in the end they we re discovered. One of the things that we want you to walk away with is when accounts receivable are going up that's going to show up in the reconciliation as a negative adjustment especially when there s no cash going with it. Here, we just have the revenues. Here we re going to be including the cash. But if all you re doing is recognizing a lot of revenue on sales on account and you re not collecting cash which we're going to look at next, well you re going to get a big negative adjustment to receivables. And that should be a red flag, and that doesn t mean you should be cynical but you should be skeptical. You should look deeply then at that judgment as an outsider. So when we think about understanding these adjustments, we can do it at several levels, and it s very important to realize one of the key benefits of the reconciliation adjustments is they give us pretty deep insights about these judgments. Receivable collection What happens when they collect the $20? Remember the entry- cash goes up and accounts receivable goes down. What is the effect on the financial statements? No effect on the income statement whatsoever because all the action is on the assets side. One asset went up; one asset went down. We recognize an asset; we derecognize an asset. No effect on liabilities. Overall, no effect on net assets; no effect on owners' equity; you got the picture. What about on the direct cash flow statement? Yes, because we recorded something to cash. What did we record? Customer collections, $20, net cash from operations $20. Now, what happens over on the reconciliation? Well, we know there s no income effect, and we know there s a $20 effect on cash from operations. Again, that has to come over here. We need a reconciliation adjustment and so we go down here and we say, well, the income effect is zero. The cash effect to this entry is $20. We need an adjustment. Again, the account we haven t used yet is accounts receivable. There s no income effect. We haven t used this. That s where the adjustment is coming from. We ll show you that when we go to the R&R Map later. And so what do we have? We ve got a receivables adjustment, and it s going to be +$20. Just again mathematically, zero plus 20 is 20. But that doesn t give you much insight once again. So let s see if we can go get some. We ll skip a few of the steps here. You ought to explain what the statement is all about. We just did that. So here s the thing you say to your prospective business colleague or to an 7

8 investor. During the current period we recognized $20 of net cash from operations and no income. And of course, we re going to try to explain to you why we ve got no income. We're assuming this is the only event that happened. No income but $20 of net cash. So we had already recognized the income associated with the $20 collection when the sale occurred. Well, the reason we didn t recognize income now is we don t want to go to jail. If we recognized income before and we turn around and do it again, then we ll show an increase in owners' equity before and an increase in owners' equity now. And that will get you in trouble. Moreover, we only recognize income when owners' equity and thus net assets increase, which didn t happen when we collected the $20. We recognized a $20 increase in cash, a $20 decrease in accounts receivable, and no change in liabilities. So there was no change in net assets, no change in owners' equity, no change in income. If this had been a $20 cash sale rather than a collection on a prior sale on account, we would have recognized a $20 increase in revenue. Cash goes up by $20; revenue goes up by $20 rather than receivables going down by $20. Thus, the $20 decrease, decrease in receivables, is the reason net cash from operation exceeds net income by $20. Accordingly, to reconcile zero, the income affect of the entry, to the $20 cash effect a reconciliation adjustment subtracts the $20 decrease, subtracts the $20 decrease in accounts receivable, so it's subtracting a negative, or equivalently adds $20 since this is a double negative. And that s what s going on. We re subtracting the decrease in receivables, but a negative and a negative is a plus. Advertise on account Now, we move on to the advertising expense, which you might recall we incurred on December 25th. So what was the entry? Well, we didn t pay for it. We just ran the ad and under GAAP we have to take the expense. So there s our expense. There s our accounts payable. Does this entry affect the income statement? Well, yes. We took an expense. So the expense is $60. We'll sign it negatively, and we d have a loss of $60. Now, again, we re assuming this is the only event that happened during the period, and that s the effect on income if that was all we had. Our income statement would be not $60 in net income but a $60 loss. What about the effect on the direct cash flow statement? We didn t record any cash. If you don t record cash there s no effect. What about on the indirect statement? Well, net income was -$60 if this is the only event we recorded. Net cash from operations, no effect over here, so zero and we need to make an adjustment. So we go back down here to our little table- net income, -$60; cash, zero. We need an adjustment of +$60. That s obvious from the math and it s got to go to accounts payable. Again, we ve got the income effect here. There is no cash effect over here. The only account left is accounts payable. That s where our adjustment is coming from and so we need an adjustment of +$60. Again, mathematics, -60 plus 60 is zero. Now, we want to dig deeper once again and try to understand that. Assuming E4 was the only event during the period, here s our explanation. Once again, if we were explaining this to a prospective shareholder, business colleague, tell them what the purpose of the statement is, tell them what we re trying to reconcile during the period. We have a $60 loss -- 8

9 remember, only one event -- and zero cash from operations. This loss arose from purchasing advertising on account. So you re going to say, Look, I m about to explain to you why income differs from cash, but I need to explain to you first why it is we had a $60 loss. So we recognize the $60 increase in accounts payable because we re obligated. We have to pay the college newspaper this amount in the future. They ran the ad; we owe the money. We believe we will receive future benefits from the advertisement. But GAAP does not allow us to recognize an asset. That s a judgment, but that s not a judgment on the part of EasyLearn. That s a judgment the standard setters made. They said, Look, you just can t measure reliably these future benefits for advertising. So what we re going to do is we re going to have you expense it rather than make an asset. Notice we'd have a whole different story if they made an asset because we have accounts payable going up by $60, we have an asset going up by $60, and we wouldn't have any effect on net assets and therefore no expense. So it's important to understand that's going on in the background because if you're the business manager that's working in sales or marketing for a company, well the first thing that happens is you got to run this wonderful ad, and the accountants tell you, unfortunately, there is no future benefits that are going to be recorded for that even though we know there is probably some future benefits. So that's an important understanding when you're explaining the accounting. The reason we don't recognize the asset is we just can't measure it reliably enough to put on the balance sheet. As a result, net assets and net owners' equity decrease by $60 because liabilities increase by $60 and assets were unaffected because we didn't recognize the benefit. We recognize the $60 decrease in owners' equity as advertising expense in net income. We are confident this decrease in owners' equity will be more than offset by an increase future revenues generated by the advertising. So we have to take this hit on our income statement right now, and it looks terrible. We have a $60 loss, but we know this is going to turn into benefits later. And we're telling you, our prospective shareholders, this so you can look at our numbers and have a better understanding. Now, this happens in business a lot. If you're a company that has a good deal of marketing expense, like any pharmaceutical company can have billions of dollars of marketing expense and billions of dollars in R&D, research and development expense, those hit the income statement and the benefits are in the future, but they never get on the balance sheet. And management has to communicate to the investors that all these benefits are there, and they can't communicate it through the accounting so they have to tell stories about how the marketing programs are going, the R&D programs are going. Now, if we had paid cash for the advertisement when we purchased it, rather than purchase it on account, then net income and net cash from operations would both have decreased by $60. So cash would have gone down by $60 on the left-hand side of the balance sheet, on the assets side, and we would have taken an expense on the other side. Instead, accounts payable went up by $60, and we took the expense for $60. Thus, the $60 increase in payables is the reason no current cash outflow is associated with the $60 expense. Accounts payable went up rather than cash going down. Accordingly, if you want to reconcile the -$60 income effect to zero cash effect, we add a $60 reconciliation adjustment, and that's an accounts payable adjustment. 9

10 10 Just to summarize, you ve got to explain the purpose of the statement. You ve got to explain how much income differs from cash. You ve got to tell how income was constructed- that gives all sorts of insights as to why it differs from cash. Everyone is going to understand cash; they are not going to understand the income. So if you're trying to explain the difference, understand the income effect and right away you're going to know why income effect differs from the cash effect. It just falls out. Where students go wrong often is they overlook the income effect. They'll say income went up and it becomes mechanical, and they lose their understanding because the understanding comes from the depth of complexity and the judgments that go into income. And then cash is cash, and we can understand the adjustments much better when we can make that connection. Payable payment Now E5, the payables payment, and this is very similar to what we did before. So we're going to skip over pretty quickly here. Here is the effect on the statements, and we can go right down to the bottom here and get the interpretation. E5 was the only event during the period. Here is how we can explain the reconciliation. Remember what happened? We paid $15 in cash with no income effect. Accounts payable went down by $15. Here is the explanation. The operating section of the indirect SCF explains the reasons net income differs from cash from operations. During the current period we recognized $15, the negative, of net cash from operations and no income. This $15 cash outflow arose from a payables payment that decreased cash from operations by $15 but had no effect on income. If we want to reconcile the income effect to the cash effect, well, we're going to have to make an adjustment to the payables. I think this is quite apparent at this point so I'm going to skip ahead. Statement of Cash Flow (SCF) effects- Grouping related entries: Receivables Remember there were two steps to understanding cash flow adjustments. The first was to go entry-by-entry and figure out what the effects were. And when we say figure them out, go beyond the math, get a real clear understanding, and then combine all those effects by adding them mathematically. So if you just go across and add all these events up right here, all the effects for each line item, well you get exactly what's over here. Which entries affect the receivables adjustment? Well, it's pretty obvious, right? We have to group E2 and E3. These are the only entries that affect the adjustment, and you can see it here as a receivables adjustment. There is no effect over here. E4 and E5 had no effect. And if we add these two together mathematically, we get $130. When we say group the entries that have an effect, that's what you're trying to do. So what entries explain the adjustment? E2 and E3. What would an outsider see? Now, this is really important. When you're an outsider, this is all you're seeing, the -$130 receivables adjustment. If you want to interpret this, you have to have a pretty good idea of what's behind the numbers. Now pretend you're an insider, how could you explain the adjustment to a prospective shareholder in terms of the purpose of the reconciliation and the underlying business activities? Now by preview here, we re going to look at what an insider knows and how they could explain it to an outsider if an outsider asked and the insider was willing to give the information. Insiders don t explain every line item of their statements. So this is a bit of a fiction, but it will help you understand where we re heading because as an outsider you need to look at these line items and try to come to your own conclusions, and that's where we're heading next.

11 Here's the insiders explanation. Again, they explain what the statement tries to do just as we did before. The -$130 receivables adjustment reflects a net increase, even though it's negative, a net increase in accounts receivable due the operating entries. Now, our explanation. We recognize revenue and a receivable at the time tutoring services are rendered, and we collect the receivables at a later date. When there is a net increase in accounts receivable during the year it means we recognized more revenue than we collected because the receivable goes up when we recognized revenue, it goes down when we collect cash. So if our net went up, well we must have recognized more revenue than we collected cash. And thus, we recognized more income than cash from operations when that happens. So the fact it was $130 increase in accounts receivable means we recognized more revenue than we collected cash. And in fact, we recognized $130 more revenues than cash. Thus, the -$130 receivables reconciliation adjustment signifies that revenues included in the $90 of net income that you saw in our income statement exceeded collections in the $5 of net cash from operations. So just this one adjustment signifies that the revenues that are part of that income exceeded the collections that are part of that net cash from operations by $130. Absent an explanation from management, what would an outsider conclude? See, an outsider wouldn t have all that information. An outsider wouldn t know all of these numbers. Insiders would know the amounts recorded to receivables for E2 and E3. So they could tell the story we just told. Outsiders don t observe the numbers behind the -$130 receivables adjustment. So if an outsider assumes sales on account and customer collections are the only operating entries that affect receivables, which is true for EasyLearn but won't be true in general, they can conclude sales on account exceeded collections by $130. Why? Sales on account minus collections must be $130 because the adjustment was $130 and they're assuming the only two events that are going on are E2 and E3. So even though they don t see these numbers they know the difference between them and they can say, "Well, it must be that sales on account exceeded collections by $130." If an outsider assumes revenue is only recognized when there are sales on account, which is also true for EasyLearn but not in general, we've seen companies that defer revenue, then they can locate the $150 of revenues on the income statement. So here they have an equation, sales on accounts minus collections equals $130. But if we're willing to assume sales on account as revenues, well then we can get this number off the income statement $150. And now we got $150 minus the collections equals $130 and that means collections must be $20. So they can solve for that given all their assumptions. Remember what their assumptions were. Their first assumption was there are only two things happening in the account, sales on account and collections. And their second assumption was that the company recognizes revenue only when there's sales on account so when you substitute revenue off the income statement for sales on account. So later we will consider what outsiders can conclude when these simplified assumptions are no longer reasonable, and that will be in the next scenic route video on limitations and company disclosures. Payables What about the payable's reconciliation adjustment? Well, it's the same sort of logic. So what entries are affected? E4 and E5. What would an outsider see? They would just see the payables adjustment. They wouldn t see these two numbers over here. As an insider how could you explain it? The operating section again has to be explained. The $45 payables 11

12 adjustment that you're looking at on our indirect cash flow statement corresponds to a net increase and accounts payable, a net increase in accounts payable, due the operating entries. So these adjustments are always the net effect of operating entries, and that's really important to understand, at least in absolute value. And we'll come to that in a second. We recognize advertising expense and a payable at the time we run an advertisement and pay the payable at a later day. When there is a net increase in accounts payable it means we recognized more expense. Remember, when you recognize the expense, accounts payable goes up. And when you pay it off, it goes down. So when there's a net increase, it means you went up more than you went down, and therefore you recognized more expense then paid down the payables. And thus, we recognized a bigger decrease in net income than in cash from operations. Thus, the $45 reconciliation adjustment signifies that advertising expense included in the $90 of net income that we're showing you exceeded payments included in the $5 of cash collection that we're showing you by $45. So that's the explanation for the payables adjustment. Absent an explanation from management, what could an outsider conclude? Well, the same sort of analysis we did before, purchase on account minus payments equals $45 because they're going to assume there's two events and they can get to that point. Adjustment signs Now, let's go to something that often confuses students at first and we just want to give you a little hint of it, and then there's a scenic route later. The observations that we want you to see right away is that the receivables reconciliation adjustment has the same absolute value -- now, the absolute value of a number is always positive. It just picks up the magnitude number -- as the net effect of the operating entries recorded to receivables. Receivables went up by $150 when we made the sale on account, and it went down by $20 when we had the collections. So the net effect of the two operating entries was +$130. Now payables went up by $60 when we recognized the expense. It went down by $15 when we made the payment. And so the net effect of the changes there was $45. Now, the adjustment will always be in absolute value, the same as the net effect of the operating entries. So the absolute value of the adjustment is $130 for receivables and $45 for payables. But for an asset like accounts receivable, the reconciliation adjustment will have the opposite sign to what happened to the receivables account. So the receivables account went up by $130, but we see the adjustment is -$130. The account went up by $130. The adjustment is -$130. So whenever you have an asset adjustment, the sign is the opposite. Whenever you have a liability adjustment, the sign is the same. Payables went up by $45, and we see $45, receivables went up by $130 and we see a -$130 adjustment. Now, that's just an outcome and observation. Here's the general concept. Asset reconciliation adjustments have the same absolute value as the net effect of the operating entries recorded to them but the opposite sign. And liability and contra asset reconciliation adjustments have the same sign. Now, we're not giving you much insight as to why that's true. It just sort of fell out from the analysis we did earlier where we did give a lot of insight entry-by-entry. But this is always going to be true, and you can actually derive it from the BSE matrix. And we do that in one of scenic route videos and show you very clearly why the signs are different than the net effect of the operating entries for the asset adjustments. We 12

13 recommend you go watch it. It's a very short scenic route, and it will cement once and for all why these signs are different. Take-aways What are our takeaways? What should you know? Mastering cash flow statements is a twostep process. Entry-by-entry analysis. As you are introduced to new entries throughout Navigating Accounting, learn how they affect the cash flow statement by connecting them to the purpose statement and the underlying business activities. Then group entries in the second step that affect the line items. Identify entries you've learned that affect the line item. Include a placeholder for those you're going to learn in the future. We've only done three chapters. We haven t finished all the entries. We only looked at five entries for EasyLearn, five entries. Just to remind you, General Electric is rumored to have about $100 B, so there's a few more out there. But the process we're showing, believe it or not, is going to get you a clear foundation for understanding all those entries. We ve just got a little more work to do as we work our way into the next module. And then you want to interpret the line items by connecting the collective impact of the entries that affect them to the purpose of the statement and the underlying business activities. So combine what you learned from the entry-by-entry. Bring it down here as we did just a while ago. Tables like the one below for EasyLearn, they illustrate how each entry affects the cash flow statement, and they facilitate grouping and make it really easy. So even though an outsider only sees this, what we want you to start thinking about is what's going on behind the numbers. And you can start doing that by assuming, okay, what was the income effect? What was the cash effect? What do I need to reconcile? That's the math. Can you explain it? The depth of your understanding of cash flow statement items depends on the entries you know. The more entries you know, the more you can start thinking about what's going on behind the numbers. So as we learn entries going forward that's going to improve the depth of your understanding of the statement and your understanding of how these entries affect the cash flow statement. That was the entry-by-entry effect analysis and the extent to which companies disclose the information about these effects. Sometimes you can learn a great deal about what s behind the numbers. The more the insider tells you through their disclosures and footnotes, well the deeper your understanding and your capacity to locate and interpret these disclosures. Often companies are saying things in the footnotes, but if you don t know where to go look, well, that s not going to help you much. Where are we heading? EasyLearn s simple events explain important concepts behind actual cash flow statements, but they have limitations. The next scenic route discusses two limitations you need to understand to interpret actual statements especially for larger global companies. It also illustrates related concepts for Intel and Oracle. A subsequent scenic route will help you gain a deeper understanding of how entries effect cash flow statements by completing the R&R Map. So we ll have our final version of the Record-Keeping and Reporting Map by developing the SCF Entry Map. This is a brand new map, Statement of Cash Flow Entry Map. And when we finish this chapter, we ll have three maps. We ll have the R&R Map, the SCF Entry Map, which we'll introduce in the next module, and of course the Owners' Equity Change Map. Those three maps are going to really help you navigate what s going on, and 13

14 we re going to show you how they can all be combined to give you a much deeper understanding of the financial statements. Well, I hope you enjoyed this video. See you in the next one. 14