Chapter 3. Cash-Flow Statements

Transcription

1 Introduction to Cash-Flow Statements 1 Chapter 3 Cash-Flow Statements TABLE OF CONTENTS Introduction 3 Direct Format Operating Section 5 Indirect Format Operating Section 6 Exercise What Do I See? 8 Operating Section 10 Investing Section 13 Financing Section 14 Supplemental Disclosures of Cash Flow Information 15 What s Behind the Numbers? 16 EasyLearn Company 17 Events and Entries 17 Asset Reconciliation Adjustments 17 Liability Reconciliation Adjustments 20 Why Do Asset and Liability Adjustments Signs Differ? 23 Why Do Asset and Liability Adjustments Differ from the Balance Sheet Change? 25 Record-Keeping & Reporting (R&R) Maps 26 EasyLearn Example Summary 30 Exercise ABC Company 33 Events and Entries 33 Tracing ABC s Entries to Statements 33

2 2 Navigating Accounting Creating Financial Statements From BSE Matrix 56 Combined Effects of Entries on Reconciliation 57 When are Intuitive Explanations Appropriate? 58 Process for Interpreting Adjustments 59 Exercise How Do I Use the Numbers? 68 Analyzing Recent Cash Flows 69 Assessing the Quality of Earnings 73 Exercise Exercise Exercise Key Take-Aways 83 Figure 3.01 Intel s Statement of Cash Flows 85 Figure 3.02 Yum! Brands Balance Sheets 86 Figure 3.03 Yum! Brands Income Statements 87 Figure 3.04 Yum! Brands Statements of Cash Flows 88 Figure 3.05 Yum! Brands Supplemental Cash Flow Data Footnote 89 Figure 3.06 Yum! Brands Five-Year Summary of Select Financial Data 90 Figure 3.07 Cisco s Statements of Cash Flows 91 Figure 3.08 Starbucks Statements of Cash Flows 92 Chapter Solutions 93 Solution to Exercise Solution to Exercise Solution to Exercise Solution to Exercise Solution to Exercise Solution to Exercise

3 Introduction to Cash-Flow Statements 3 INTRODUCTION A central theme for cash-flow statements is current-period income can differ significantly from current-period cash flows and both measures have important consequences for future cash flows. To see what we mean here, consider the financial value of your human capital your future earnings power. It is by far your biggest asset even though banks and other lenders would not allow you to recognize it on your balance sheet because it can t be measured reliably. Likewise, they would not allow you to recognize the increases in the value of your human capital on your income statements; however, from an economic perspective it is probably by far the biggest source of income you earn while in college. Thus, by performing well in school this term you can earn current income by increasing your future earnings power and thus future cash flows. However, you need current cash flows for tuition, books, etc. to generate current income and thus future cash flows. Indeed, students often generate a great deal of income while in college, but continually run out of cash and confront liquidity crises. Like you, most companies have significant differences between currentperiod income and current-period cash flows. For instance, Intel reported nearly $7 billion of net income during fiscal 2007, which was significantly less than the $12 billion of cash inflows from operating activities. Net income is an important measure of Intel s performance during 2007; however, an analysis of Intel s cash flows can provide additional information needed for forecasting future performance. By the end of this chapter, you ll understand how Intel s cash-flow statements, and those of other companies, help analysts gain insights into current and future performance. You will also see that Intel s operating cash flows were much stronger than its biggest competitor during Such cash flow analyses are increasingly important during tight credit markets, as they were during the financial crisis of 2007 and 2008.

4 4 Navigating Accounting Cash-flow statements have two purposes: (1) they help users predict future cash flows by explaining the current-period change in cash in terms of operating, investing, and financing business activities, and (2) they help users reconcile differences between net income and net cash from operating activities, which helps them assess the quality of net income and predict when income will be converted to cash. Operating cash flows mostly pertain to ongoing activities that support a company s primary business purpose including events associated with research and development, purchasing, manufacturing, sales, marketing, distribution, customer collections, and support. Investing cash flows are primarily associated with buying or selling property, plant, and equipment, intangibles, and most types of investment securities. They also include cash flows associated with buying or selling complete companies. Financing cash flows primarily result from transactions with owners (e.g., dividend distributions, stock issues, and stock repurchases), issuing debt, and repaying debt principal (but not interest, which is an operating cash flow). With regards to cash-flow statements, GAAP defines operating activities as a residual concept to include all activities that do not meet the criteria to be classified as investing or financing activities. As a result, cash from operating activities also includes a few items that seem to have very little to do with operating activities such as income tax payments, interest payments, and interest and dividends received from investments. The decision to include these items in operating cash flows was extremely controversial. Those who opposed classifying them in operations argued that the classifications are inconsistent with those used on income statements: interest expense, tax expense, and interest and dividend income are not included in operating income. Do not spend time trying to understand why income tax payments, interest payments, and interest and dividends received from investments are included in cash from operations. Just note that these items are classified inconsistently on income statements and cash-flow statements.

5 Introduction to Cash-Flow Statements 5 Cash-flow statements are arranged hierarchically. At the highest level, they have a uniform format that classifies cash inflows and outflows as operating, investing, and financing activities. Cash Flow Statements Operating Investing Financing Cash change Companies generally report three cash-flow statements at once. One for the reporting period that just ended and others for the two preceding periods. These statements show how cash flows changed during these periods and thus suggest future trends. Within the operating, investing, and financing sections of the statement, companies report line items that disclose the related cash inflows and outflows. Line items in the investing and financing sections provide details about these activities that are relatively easy to interpret. By contrast, operating sections can be presented in two different formats, one of which is more challenging to interpret. Companies can use a direct or an indirect format for the operating section of their cash-flow statements. (The investing and financing sections always have the same format.) Direct Format Operating Section The direct format is very easy to understand and studying it will help you understand the cash flows that are netted together to derive net cash from operations, the bottom line of the operating section. Analysts track this number closely because ultimately companies succeed by generating cash from operations. Here is an example of a direct format operating section: Customer collections $30 Supplier payments (10) Payments for other operating costs (6) Net cash from operations $14

6 6 Navigating Accounting Indirect Format Operating Section By contrast, the second, and more challenging format, is the indirect format. It indirectly derives cash from operations by starting with net income, the top of the indirect format, and then explaining the reasons income differs from cash from operations, the same bottom line as the direct format. For example, if net income is $10, the indirect format would be: Net income $10 Adjustments to reconcile net income to cash from operation 4 Net cash from operations $14 Notice the bottom line, net cash from operations of $14, is the same on the direct and indirect format. However, unlike the direct format, the line items above net cash from operations are not cash flows. They merely explain how net income differs from net cash from operations. You already know the primary reasons why net income can differ from net cash from operations: revenues and expenses can be recognized before, after, or at the same time as the related cash flows. For example, expenses associated with a resource can be prepaid in one reporting period (which reduces cash from operations in the current period but does not affect net income) and expensed in the next period as the company receives the benefits from the resource (which increases expenses the next period and thus reduces net income, but does not affect cash from operations). Similarly, revenues can be recognized when products are sold on account in one period (which increases net income but does not affect cash from operations) and collected in the next period (which increases cash from operations but does not affect income). In the indirect format example, a single line item of $4 reconciled the $10 of net income to $14 of net cash from operations. As we shall see, companies report several reconciliation line items and these can be very useful for forecasting future income and cash flows. In the United States, companies that report a direct cash-flow statement for external reporting must also provide the indirect format in a footnote or accompanying statement. By contrast, those using the indirect format do not have to provide the direct format. As a result, most U.S. companies use the indirect format for external reporting and use the direct format for internal (managerial) purposes. This is especially true for smaller companies that are concerned about whether they will have enough cash to pay their bills on time.

7 Introduction to Cash-Flow Statements 7 Usage Icon This exercise helps you learn how accounting reports are used by investors, creditors, and other stakeholders. Exercise 3.01 Identify the following examples as operating (O), investing (I), or financing (F) activities. Solutions are at the end of the chapter. Hint: Think about the description. Does it sound like an activity that pertains to a company s primary business? Does it pertain to taxes or interest? If so, it is an operating activity. Does it sound like an activity associated with buying or selling property, plant, and equipment, investment securities and the like? If so, it is an investing activity. Does it sound like an activity that pertains owners or creditors, like issuing stock, issuing debt, or repaying debt principal (but not interest, which is an operating cash flow)? If so, it is a financing activity. Issue common stock in exchange for cash Buy a building with cash Purchase inventory on account Sell inventory on account Collect cash from customers Pay suppliers Receive interest earned Pay cash dividend to shareholders Recognize depreciation expense Purchase securities Pay employees wages Sell securities Issue long-term debt Sell building for cash Pay interest on debt loan

8 8 Navigating Accounting WHAT DO I SEE? What you see on cash-flow statements depends on how you look at them. They should be navigated hierarchically, starting with the subtotals for the operating, investing and financing sections and progressing to the individual line items within the sections. In the process, you will progressively gain a better understanding of the company s current cash flows, which will help you predict its future cash flows (the first purpose of the statement), and will help you develop a more informed assessment of the quality of its earnings (the second purpose). At the big picture level, the operating, investing and financing subtotals explain the difference between the beginning and ending cash reported on the balance sheet. Intel Consolidated Statements of Cash Flows Three Years Ended December 29, 2007 Beginning Cash (In Millions) Cash and cash equivalents, beginning of year $ 6,598 $ 7,324 $ 8,407 Cash flows provided by (used for) operating activities: Net income 6,976 5,044 8,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 4,546 4,654 4,345 Share-based compensation 952 1,375 Restructuring, asset impairment, and net loss on retirement of assets Excess of tax benefit from share-based payment arrangements (118) (123) Amortization of intangibles and other acquisition related costs (Gains) losses on equity investments, net (157) (214) 45 (Gains) on divestitures (21) (612) Deferred taxes (443) (325) (413) Tax benefit from employee equity incentive plans 351 Changes in assets and liabilities: Operating Trading assets (1,429) 324 1,606 Accounts receivable 316 1,229 (912) Inventories 700 (1,116) (500) Accounts payable Income taxes payable and receivable (248) (60) 797 Other assets and liabilities 633 (444) 241 Total adjustments 5,649 5,588 6,187 Net cash provided by operating activities 12,625 10,632 14,851 Cash flows provided by (used for) investing activities Additions to property, plant, and equipment (5,000) (5,860) (5,871) Acquisitions, net of cash acquired (76) (191) Purchases of available-for-sale investments (11,728) (5,272) (8,475) Maturities and sales of available-for-sale investments 8,011 7,147 8,433 Investing Investments in non-marketable equity instruments (1,459) (1,722) (193) Net proceeds from divestitures Other investing activities 294 (33) (118) Net cash used for investing activities (9,926) (4,988) (6,415) Cash flows provided by (used for) financing activities Increase (decrease) in short-term debt, net (39) (114) 126 Proceeds from government grants Excess tax benefit from share-based payment arrangements Additions to long-term debt 125 1,742 Repayments and retirements of long-term debt Financing (19) Repayments of notes payable (581) Proceeds from sales of shares through employee equity incentive plans 3,052 1,046 1,202 Repurchase and retirement of common stock (2,788) (4,593) (10,637) Payment of dividends to stockholders (2,618) (2,320) (1,958) Net cash used for financing activities (1,990) (6,370) (9,519) Net increase (decrease) in cash and cash equivalents 709 (726) (1,083) Cash Change Cash and cash equivalents at the end of the year $ 7,307 $ 6,598 $ 7,324 Supplemental disclosures of cash flow information: Cash paid during the year for: Ending Cash Interest, net of amounts capiatlized of $57 in 2007 and $60 in 2006 $ 15 $ 25 $ 27 Income taxes, net of refunds $ 2,762 $ 2,432 $ 3,218 See notes to Consolidated Financial Statements.

9 Introduction to Cash-Flow Statements 9 As we look at Intel s cash-flow statements, we see: The top line reports $6,598 of cash Intel recognized on its balance sheet at the end of 2006, which equals the amount recognized at the beginning of The third item from the bottom reports $7,307 of cash Intel recognized on its balance sheet at the end of The line immediately above this one reports $709 increase in cash during We can see right away how Intel s statement meets the first purpose of cash-flow statements and helps users understand the current-period change in cash in terms of operating, investing, and financing activities. The $709 cash increase equals the $12,625 net cash from operating activities less the $9,926 used for investing activities less the $1,990 used for financing activities: Cash Flow Statements Operating Investing Intel $12,625 $10,632 $14,851 (9,926) (4,988) (6,415) Financing (1,990) (6,370) (9,519) Cash change $709 ($726) ($1,083) Users assessments of Intel s future cash flows depend on many factors, including the reasons cash increased by $709. For example, users would likely be very concerned if Intel had reported a $709 increase in cash from operations and $0 cash for investing and financing activities, especially after having reported $10,632 and $14,851 net cash from operations for 2006 and 2005, respectively. So, what do we know at this point of our analysis about the factors that caused the changes in cash each year? The most important observation is that Intel s operating cash flows have not only covered its investing cash outflows each year, there has been enough left over to provide a significant return to Intel s investors (as evidenced by the financing cash outflows). We also observe a good deal of variation in all three cash flows from year to year, especially in the financing net cash outflows, which decreased by about 80% from 2005 to Why did Intel return less cash to investors in 2007? One possibility is the company wanted to increase its cash reserves to support future investments or weather downturns in

10 10 Navigating Accounting the economy. However, Intel s ending cash balances were pretty stable over the three years. A second possibility is Intel returned less money to investors because operating cash flows decreased by $2,226 and investing outflows increased by $3,511 from 2005 to What s driving the variation? When we progress to the second level of our analysis examining the individual line items within each section we will gain insights into the changes in these subtotals. Drill Deeper To learn more see the reference document: Line-by-Line Tour: Intel s Financial Statements. Operating Section Like most companies, Intel reports an indirect format so the first line item in the operating section is net income and the last line item is net cash from operations. The lines in between are the reconciliation adjustments, which explain the reasons net income differs from net cash from operations. For 2007, Intel s operating section begins with $6,976 of net income, the same as reported on the income statement, and ends with $12,625 net cash provided by operating activities. Notice other line items in this section are indented and fall below the heading Adjustments to reconcile net income to net cash provided by operating activities. The $5,649 sum of these adjustments is reported immediately above net cash provided from operating activities. Net Income Adjustments Net cash from operations Intel Consolidated Statements of Cash Flows Three Years Ended December 29, 2007 (In Millions) Cash and cash equivalents, beginning of year $ 6,598 $ 7,324 $ 8,407 Cash flows provided by (used for) operating activities: Net income 6,976 5,044 8,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 4,546 4,654 4,345 Share-based compensation 952 1,375 Restructuring, asset impairment, and net loss on retirement of assets Excess of tax benefit from share-based payment arrangements (118) (123) Amortization of intangibles and other acquisition related costs (Gains) losses on equity investments, net (157) (214) 45 (Gains) on divestitures (21) (612) Deferred taxes (443) (325) (413) Tax benefit from employee equity incentive plans 351 Changes in assets and liabilities: Trading assets (1,429) 324 1,606 Accounts receivable 316 1,229 (912) Inventories 700 (1,116) (500) Accounts payable Total adjustments Income taxes payable and receivable (248) (60) 797 Other assets and liabilities 633 (444) 241 Total adjustments 5,649 5,588 6,187 Net cash provided by operating activities 12,625 10,632 14,851

11 Introduction to Cash-Flow Statements 11 Thus, the $5,649 adjustment reconciles the $6,976 of net income to the $12,625 of cash from operations. More generally, here is the structure of Intel s operating section for : Indirect Format Operating Section Net Income 2007 $6,976 Intel 2006 $5, $8,664 Reconciliation adjustments 5,649 5,588 6,187 Net cash from operations $12,625 $10,632 $14,851 Other Adjustments There are a few other insignificant adjustment types associated with issues beyond the scope of this chapter. Drill Deeper To learn more See: Conceptual Foundation for Reconciliation Adjustments, a Chapter 3 supplement. Virtually every accounting decision that requires judgment affects one or more reconciliation adjustment. Users of financial statements need to know how to interpret these adjustments to assess the quality of the underlying judgments and thus, the quality of earnings. This is quite challenging but by the end of this chapter you will have a solid foundation for understanding the most common types of reconciliation adjustments. The first thing you need to know about the reconciliation adjustments is that they are generally not cash flows. We mention this because students often mistakenly conclude they are cash flows because they are reported on the cash-flow statement. In fact, adjustments explain differences in income and cash from operations, but generally, they are not cash flows. For an indirect cash-flow statement, the line items above net cash from operations help explain the reasons net income differs from cash from operations. Generally, they are not cash flows. By contrast, for a direct cash-flow statement, the items above net cash from operations are cash flows. Types of Adjustments Reconciliation adjustments are mostly one of three types (or a combination of these types): Adjustments associated with gains and losses. For example, Intel s 2007 reconciliation reports an adjustment related to gains associated with divestitures. Adjustments associated with assets. For example, Intel reports an accounts receivable adjustment. Adjustments associated with liabilities. For example, Intel reports an accounts payable adjustment.

12 12 Navigating Accounting Gains and losses adjustment Asset adjustment Liability adjustment Cash inflow from divestitures Intel Consolidated Statements of Cash Flows Three Years Ended December 29, 2007 (In Millions) Cash and cash equivalents, beginning of year $ 6,598 $ 7,324 $ 8,407 Cash flows provided by (used for) operating activities: Net income 6,976 5,044 8,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 4,546 4,654 4,345 Share-based compensation 952 1,375 Restructuring, asset impairment, and net loss on retirement of assets Excess of tax benefit from share-based payment arrangements (118) (123) Amortization of intangibles and other acquisition related costs (Gains) losses on equity investments, net (157) (214) 45 (Gains) on divestitures (21) (612) Deferred taxes (443) (325) (413) Tax benefit from employee equity incentive plans 351 Changes in assets and liabilities: Trading assets (1,429) 324 1,606 Accounts receivable 316 1,229 (912) Inventories 700 (1,116) (500) Accounts payable Income taxes payable and receivable (248) (60) 797 Other assets and liabilities 633 (444) 241 Total adjustments 5,649 5,588 6,187 Net cash provided by operating activities 12,625 10,632 14,851 Cash flows provided by (used for) investing activities Additions to property, plant, and equipment (5,000) (5,860) (5,871) Acquisitions, net of cash acquired (76) (191) Purchases of available-for-sale investments (11,728) (5,272) (8,475) Maturities and sales of available-for-sale investments 8,011 7,147 8,433 Investments in non-marketable equity instruments (1,459) (1,722) (193) Net proceeds from divestitures Other investing activities 294 (33) (118) Gains and Losses Reconciliation Adjustments Gains and losses reported in net income generally arise from selling assets, which are investing activities. Thus, the cash flows associated with these activities are reported in the investing section, not the operating section. However, gains and losses are included in net income at the top of the operating section. As a result, adjustments are needed to remove gains and losses included in net income (by deducting gains and adding losses) because they do not affect net cash from operations. Interpreting these adjustments in the operating section in the context of disclosures in the investing section can provide additional insights. For example, in the 2007 operating section, Intel recognized a ($21) reconciliation adjustment to reverse gains reported in income related to divestitures when it sold businesses. This adjustment removed these gains from the operating section. In the investing section, Intel reports $32 net cash proceeds received from divestitures. Thus, we can assume the historical, book value of the sold businesses was $11 (= $32 cash received - $21 gain). Asset and Liability Reconciliation Adjustments Asset and liability adjustments are usually affected by two or more entries. To interpret them, you need to understand these entries. We will explain asset and liability adjustments later in the chapter when we go behind the numbers. By contrast, as we learned above, gains and losses adjustments can be interpreted without understanding the related entries.

13 Introduction to Cash-Flow Statements 13 Investing Section Investing cash flows are direct cash inflows and outflows associated with investing activities. Generally, companies report three types of cash flows in this section: Buying and selling property, plant and equipment Buying and selling investment securities such as government bonds Buying and selling complete companies or business subunits During , Intel invested $21.3 billion dollars. Investors and other users of Intel s financial statements need to assess the expected risks and rewards associated with these investments when forecasting Intel s future performance. For example, depending on their assessment of the long-term demand for Intel s products, they would likely react quite differently to major investments in new factories versus equivalent investments in Treasury bonds. Also, they would want to know the reason why Intel spent nearly $5 billion more on investing activities in 2007 than in The line items in the investing section can help them better understand the net cash flows related to these investment activities. These items are relatively easy to identify from their descriptions. For example, Intel reports 2007 additions to property, plant and equipment of ($5,000), representing the cash Intel spent to purchase PP&E. Most companies include net at the end of the description, meaning cash outflows used to purchase PP&E net of cash inflows from selling PP&E. Similar to most companies, Intel signs cash outflows negatively. Investing Section of Intel s Cash Flow Statement Three Years Ended December 29, 2007 (In Millions) Cash flows provided by (used for) investing activities Additions to property, plant, and equipment (5,000) (5,860) (5,871) Acquisitions, net of cash acquired (76) (191) Purchases of available-for-sale investments (11,728) (5,272) (8,475) Maturities and sales of available-for-sale investments 8,011 7,147 8,433 Investments in non-marketable equity instruments (1,459) (1,722) (193) Net proceeds from divestitures Other investing activities 294 (33) (118) Net cash used for investing activities (9,926) (4,988) (6,415)

14 14 Navigating Accounting Financing Section Financing cash flows are direct cash inflows and outflows associated with financing activities. The financing section generally reports two types of cash flows: All cash transactions with owners, which include cash inflows from issuing shares, cash outflows from repurchasing shares or paying dividends and cash inflows associated with exercising stock options. All cash transactions with debt holders except interest payments. When analyzing financing cash flows, it is important to relate them to the business context and, in particular to the company s development stage and the state of the economy. For example, they will be quite different for a high tech start-up in a booming economy than for a mature airline in an economic downturn. Typically high-tech start-ups tend to use mostly equity financing, because they have very little collateral to offer to debt holders, and they generally do not pay dividends. By contrast, airlines rely heavily on debt financing and they often need to add debt during economic downturns to finance operations. Financing cash flows can usually be interpreted from their captions. For Intel, the most conspicuous observation is that all of the significant cash flows relate to owners, reflecting the fact that Intel has very little debt. Also, readily apparent is the primary reason that the net financing outflows decreased from $9,519 in 2005 to $1,990 in 2007 is that the cash outflows associated with stock repurchases decreased from $10,637 to $2,788. This decrease was partly offset by an approximately $2 billion increase in the inflows from exercising stock options. Financing Section of Intel s Cash Flow Statement Three Years Ended December 29, 2007 (In Millions) Cash flows provided by (used for) financing activities Increase (decrease) in short-term debt, net (39) (114) 126 Proceeds from government grants Excess tax benefit from share-based payment arrangements Additions to long-term debt 125 1,742 Repayments and retirements of long-term debt (19) Repayments of notes payable (581) Proceeds from sales of shares through employee equity incentive plans 3,052 1,046 1,202 Repurchase and retirement of common stock (2,788) (4,593) (10,637) Payment of dividends to stockholders (2,618) (2,320) (1,958) Net cash used for financing activities (1,990) (6,370) (9,519)

15 Introduction to Cash-Flow Statements 15 Supplemental Disclosures of Cash Flow Information Companies disclose interest and tax payments and other required supplementary information, either at the bottom of their cash-flow statements or in footnotes. Interest and tax expenses can differ from interest and tax payments so this disclosure provides valuable insights. For example, Intel recognizes $2,190 tax expense on its income statement for 2007, but the supplementary disclosure at the bottom of the cashflow statement indicates it paid $2,762 of taxes, net of refunds. Tax payments are classified as operating cash flows, thus the $12,625 of net cash from operations reported for 2007 would have been $2,762 greater if Intel had not paid taxes. Interest payments and tax payments are operating cash flows that would likely be disclosed separately on a direct cash-flow statement. However, while they are embedded in cash from operations on indirect statements, they are not disclosed separately in the operating section. Instead, the reconciliation adjustments explain the difference between interest expense and interest payments and between tax expense and tax payments.

16 16 Navigating Accounting WHAT S BEHIND THE NUMBERS? There are no new entries behind cash-flow statements relative to those needed for balance sheets and income statements. However, knowing the entries needed to create the other statements and understanding the relationships across all statements will help you interpret cash-flow statements. Interpreting investing and financing sections of cash-flow statements are relatively straight forward. It is easy to connect the line items to the related business activities and entries. This is generally not true for the operating section of indirect cash-flow statements. Thus, we will focus on interpreting the reconciliation adjustments in the operating section of indirect cash-flow statements. To lay the foundation, we use two fictitious companies to introduce related concepts: EasyLearn, a tutoring service company and ABC, a retail company. EasyLearn has one asset adjustment and one liability adjustment that fully reconciles income to cash from operations. It is particularly useful for illustrating basic concepts. ABC adds a few new twists including asset and liability adjustments that work together to reconcile a single income-statement line item (cost of sales) to a single operating cash flow (vendor payments). For both companies, we start with an entry-by-entry approach, explaining how each entry affects the income statement, direct cash-flow statement, and balance sheet. Then we explain how changes in assets and liabilities associated with each operating entry reconcile the entry s income effect to its cash from operations effect. Next, we consider the combined effects of entries by illustrating how all of the financial statements we have studied thus far can be created from the balance-sheet-equation matrix. There are two purposes here: First, we develop a framework for understanding how any entry flows into the financial statements and how this helps you interpret reported numbers, especially reconciliation adjustments. Thus, as you learn new entries, you can readily apply the framework to new accounting and business contexts. Second, you get a much clearer picture of how the statements relate to each other, which is fundamental for financial statement analysis.

17 Introduction to Cash-Flow Statements 17 EasyLearn Company Events and Entries You start a tutoring company, EasyLearn, on December, 1, 2009 and record the following entries during December: E1 December 2: You contribute $1 to the company, a business plan, and a commitment to run the business in exchange for 100% ownership. The entry is a $1 increase to cash and common stock. E2 December 15: You tutor your first and only customer for December, Mike Mercer, for $150, with $50 collectible December 22 and the remaining $100 on January 18. The December 15 entry is a $150 increase to accounts receivable and revenues. E3 December 22: Mike Mercer pays you $20 of the scheduled $50 payment due on this date and notifies you that he is having financial difficulties. He proposes to pay the $130 balance on January 18, when he expects to receive his financial aid for next term. You accept his proposal; but you are slightly concerned about whether he will meet this obligation. The entry is a $20 increase to cash and a $20 decrease to accounts receivable. E1 is a financing activity so $1 is reported in the financing section of the cash-flow statement. We included this to underscore that reconciliation adjustments are only associated with operating entries. Asset Reconciliation Adjustments First, we create financial statements for the period that starts on December 1 and ends on December 22. E2 is the only entry during this period that affects income and, in particular, there are no expenses prior to December 22. Thus, revenues and net income are both $150 for this period. E3 is the only operating entry that affects cash and thus net cash from operations is $20 for this period. The purpose of the reconciliation is to explain why net income differs from cash from operations. The explanation is straightforward for this simple example: EasyLearn recognized $150 of revenues in E2 but only collected $20 of cash in E3. Thus, $130 must be subtracted from the $150 of net income to reconcile it to the $20 of cash from operations. EASYLEARN COMPANY SCF RECONCILIATION December 1-22, 2009 Operating Activities Net Income $150 Adjustment ($130) Net cash from operations $20

18 18 Navigating Accounting The adjustment can also be explained in terms of the $130 net increase in accounts receivable during the period: receivables increased $150 when revenues were recognized in E2 and decreased $20 when cash was collected in E3. Thus, the $130 increase in receivables represents the amount by which revenues exceeded cash collections. Accordingly, the net increase in accounts receivable associated with these two operating entries is subtracted as an adjustment (not a cash flow) from the $150 of net income to reconcile it to the $20 of net cash from operations: EASYLEARN COMPANY SCF RECONCILIATION December 1-22, 2009 Operating Activities Net Income $150 Less net increase in receivables associated with operating entries ($130) Net cash from operations $20 The above reconciliation adjustment caption is considerably more descriptive than those you typically see for actual companies. They usually report something like receivables and assume you know to interpret this abbreviated caption as subtract net increase in receivables associated with operating entries: EASYLEARN COMPANY SCF RECONCILIATION December 1-22, 2009 Operating Activities Net Income $150 Receivables ($130) Net cash from operations $20 The next figure illustrates how the accounts receivable entries reconcile net income to cash from operations. An outsider would only see the reported numbers in the first column. The E2 and E3 columns show the entry-by-entry effects: EASYLEARN COMPANY SCF RECONCILIATION December 1-22, 2009 Reported Behind Reported Numbers Operating Activities E2 E3 Combined Net Income $150 $150 $0 $150 Receivables ($130) ($150) $20 ($130) Net cash from operations $20 $0 $20 $20

19 Introduction to Cash-Flow Statements 19 E2 increases revenues by $150, but it has no effect on cash from operations because accounts receivable increased rather than cash. To reconcile the entry s $150 income effect to its $0 cash effect, the adjustment subtracts the $150 increase in accounts receivable. E3 increases cash from operations by $20, but it has no effect on income because the collection relates to a prior sale. To reconcile the entry s $0 income effect to its $20 cash effect, the adjustment subtracts the $20 decrease in accounts receivable (or, equivalently, we add $20 since this is a double negative). For this simple example, we do not gain much from the expanded figure. However, generally it is not possible to explain the adjustments intuitively when more than two operating entries affect the related adjustment, which is frequently the case. For example, in later chapters you will learn that, depending on the business context, bad debts, product returns, price rebates, or sales discounts can significantly affect accounts receivable. In these situations, a figure similar to the earlier one with additional columns for the additional entries will help you interpret the reconciliation adjustments. In summary, here s the general rule for interpreting asset adjustments: Asset reconciliation adjustments are the opposite of the effect of the period s operating entries on the related assets. Thus, negative asset reconciliation adjustments are associated with net increases in the related asset and positive adjustments with net decreases. Equivalently, asset adjustments are the negative of the net effect of the period s operating entries on the related assets. This means the asset adjustment subtracts the net effect. For example, Intel reports a positive $316 receivables adjustment for This adjustment is the opposite, or negative, of the net effect of operating entries on accounts receivable. Thus, there was a $316 net decrease in receivables during 2007 because of operating entries. If Intel s entries were the same as EasyLearn s, we could assume that since the adjustment is positive and added to income to get cash from operations, the cash collected was more than the income effect. We might conclude Intel collected exactly $316 more cash from customers than it recognized as revenues in net income. However, Intel defers some revenues when it sells products on account and reports receivables net of expected bad debts (indicating entries associated with deferred revenues and bad debts that affect the receivables account and thus the receivables adjustment).

20 20 Navigating Accounting Thus, it is unlikely that Intel collected exactly $316 more cash than it recognized revenues during Still, there are situations where it is reasonable to ignore entries not recorded by EasyLearn and conclude Intel collected approximately $316 more cash than it recognized revenues. (When the other entries are relatively small.) Receivables adjustment Intel Consolidated Statements of Cash Flows Three Years Ended December 29, 2007 (In Millions) Cash and cash equivalents, beginning of year $ 6,598 $ 7,324 $ 8,407 Cash flows provided by (used for) operating activities: Net income 6,976 5,044 8,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 4,546 4,654 4,345 Share-based compensation 952 1,375 Restructuring, asset impairment, and net loss on retirement of assets Excess of tax benefit from share-based payment arrangements (118) (123) Amortization of intangibles and other acquisition related costs (Gains) losses on equity investments, net (157) (214) 45 (Gains) on divestitures (21) (612) Deferred taxes (443) (325) (413) Tax benefit from employee equity incentive plans 351 Changes in assets and liabilities: Trading assets (1,429) 324 1,606 Accounts receivable 316 1,229 (912) Inventories 700 (1,116) (500) Accounts payable Income taxes payable and receivable (248) (60) 797 Other assets and liabilities 633 (444) 241 Total adjustments 5,649 5,588 6,187 Net cash provided by operating activities 12,625 10,632 14,851 Working capital adjustments Intel reports separate adjustments for assets and liabilities. By contrast, some companies combine these adjustments into a single working capital adjustment and report the separate items in a footnote. Liability Reconciliation Adjustments Next we extend the EasyLearn example with the following entries associated with a liability adjustment. E4 December 23: You run an advertisement in the college newspaper and are invoiced $60. The entry is a $60 increase to accounts payable and advertising expense. E5 December 31: You pay $15 of the $60 you owe for the advertisement invoiced on December 23. The entry is a $15 decrease to cash and accounts payable. Combining these entries with E1-E3, we get the income statement, direct cash-flow statement, and balance sheets for December (at the top of the next page):

21 Introduction to Cash-Flow Statements 21 EASYLEARN COMPANY INCOME STATEMENT December 1 31, 2009 Revenues $150 Advertising expense (60) Net Income $90 EASYLEARN COMPANY BALANCE SHEETS Assets 31-Dec-09 1-Dec-09 Cash $6 $0 Accounts receivable Total assets $136 $0 EASYLEARN COMPANY DIRECT CASH FLOW STATEMENT December 1-31, 2009 Operating Activities Sales collections $20 Advertising payment ($15) Net cash from operations $5 Financing Activities Sale of common stock $1 Net cash from financing $1 Change in cash $6 Beginning Cash balance $0 Ending cash balance $6 Liabilities and stockholders' equity Liabilities Accounts payable 45 0 Total liabilities 45 0 Stockholders' equity Common stock 1 0 Retained earnings 90 0 Total stockholders' equity 91 Total liabilities and stockholders' equity $136 $0 The figure below explains the adjustments needed to reconcile the $90 of net income reported in the income statement to the $5 of net cash from operations reported in the direct cash-flow statement: EASYLEARN COMPANY SCF RECONCILIATION December 1-31, 2009 Reported Behind Reported Numbers Operating Activities E2 E3 E4 E5 Combined Net Income $90 $150 $0 ($60) $0 $90 Receivables ($130) ($150) $20 ($130) Accounts payable $45 $60 ($15) $45 Net cash from operations $5 $0 $20 $0 ($15) $5 E4 decreases income by $60 but it does not affect cash from operations (because the advertisement is expensed and purchased on account). As indicated, to reconcile the -$60 income effect to the $0 cash effect, we add $60 as an adjustment (not a cash flow) related to the increase in accounts payable. E5 decreases cash from operations by $15 but it does not affect income (because the related expense was already recognized in E4). As indicated, to reconcile the $0 income effect to the $15 cash outflow we add $15 decrease as an adjustment (not a cash flow) related to the decrease in accounts payable.

22 22 Navigating Accounting The combined effects of E4 and E5 decrease income by $60 and cash from operations by $15. The $45 net increase in accounts payable associated with the two operating entries reconciles income to cash from operations: $45 is the amount by which the $60 advertisement expense in net income exceeds the $15 advertisement payment in net cash from operations. In summary, here s general rule for interpreting liability adjustments: Liability reconciliation adjustments are the same as the effect of the period s operating entries on the related liabilities. Thus, positive liability reconciliation adjustments are associated with net increases in the related liability and negative adjustments with net decreases. Equivalently, liability reconciliation adjustments add the net effect of the period s operating entries on the related liabilities. As indicated, Intel recognized a positive $102 accounts payable adjustment. This represents the net effect of operating entries on accounts payable. From Intel s balance sheet we can determine accounts payable increased $105 during The adjustment tells us $102 of the $105 increase was due to operating entries. Payables adjustment Intel Consolidated Statements of Cash Flows Three Years Ended December 29, 2007 (In Millions) Cash and cash equivalents, beginning of year $ 6,598 $ 7,324 $ 8,407 Cash flows provided by (used for) operating activities: Net income 6,976 5,044 8,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 4,546 4,654 4,345 Share-based compensation 952 1,375 Restructuring, asset impairment, and net loss on retirement of assets Excess of tax benefit from share-based payment arrangements (118) (123) Amortization of intangibles and other acquisition related costs (Gains) losses on equity investments, net (157) (214) 45 (Gains) on divestitures (21) (612) Deferred taxes (443) (325) (413) Tax benefit from employee equity incentive plans 351 Changes in assets and liabilities: Trading assets (1,429) 324 1,606 Accounts receivable 316 1,229 (912) Inventories 700 (1,116) (500) Accounts payable Income taxes payable and receivable (248) (60) 797 Other assets and liabilities 633 (444) 241 Total adjustments 5,649 5,588 6,187 Net cash provided by operating activities 12,625 10,632 14,851

23 Introduction to Cash-Flow Statements 23 The Short Answer: The operating section is a vertical form of the balance-sheet equation (A=L+OE). To isolate cash in the equation, non-cash assets move to the opposite side of the equation, changing signs. So asset adjustments have the opposite sign as the BSE effect. Why Do Asset and Liability Adjustments Signs Differ? Here is a question you might be pondering: Why do asset adjustments have the opposite sign as the net effect of operating entries on assets, but liability adjustments have the same sign the net effect on liabilities? The answer can be derived from the highlighted total operations row of the BSE matrix at the bottom of the page. This matrix classifies events as operating, investing, or financing and subtotals each category. EasyLearn has four operating entries (E2-E5) and one financing entry (E1). The total operations row reports the net effect of the operating entries associated with each account. For example, the cash column reports the net effect of operating entries on cash, which is net cash from operations. EasyLearn collected $20 from customers in E3 and paid $15 for advertising in E4. Thus, net cash from operations is $5. This is the number net income must be reconciled to the bottom line of the reconciliation in the operating section of the cash-flow statement. EasyLearn reports $90 of net income: $150 of revenues (Rev) less $60 of advertising expense (AdEx) the top line of the reconciliation. EasyLearn has no gains or losses and therefore no related adjustments. These are not needed to explain the different signs for asset and liability adjustments. EasyLearn Company BSE: Subdivided into Operating and Financing Assets = Liabilities + Permanent Owners' Equity + Net income December 1, C + AR = + AP + CS + RE + Rev - AdEx + IncS + + $0 + + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 + + $0 E2 Recognize revenue = Operating E3 Customer collections = E4 Advertising expense + + = E5 Advertising payment = Total operations + + $5 + + $130 = + + $ $0 + + $0 + + $ $ $0 Financing E1 Issue stock for cash = Total financing = Trial balance Closing to and from income summary December 31, $6 + + $130 = + + $ $1 + + $0 + + $ $ $0 + + = = $6 + + $130 = + + $ $1 + + $ $0 - + $0 + + $0

24 24 Navigating Accounting Thus, we can create the equation below from the total operations row of the BSE matrix: EASYLEARN COMPANY Connecting Total Operations Row of BSE to Reconciliation Cash from operations + Net increase in accounts receivable due to operating entries = Net increase in accounts payable due to operating entries + Net income after adjusting for gains and losses + $5 + $130 + $45 + $90 To derive a version of the equation that explains the reconciliation, we rearrange it by: Isolating the +$5 of cash from operations on the left side of the equation by moving the +$130 receivables term to the right side of the equation, which changes its sign to negative. This is why the adjustment has the opposite sign. Repositioning the $90 of net income so it is immediately to the right of the equal sign. Now, cash from operations equals net income plus the liability adjustments less the asset adjustments. The rearranged equation (on the left below) is a horizontal representation of the reconciliation (on the right below). Importantly, the receivables adjustment is the negative of the net change in receivables because receivables moved from the cash-side to the income-side of the equation to create the horizontal representation. Thus, the receivables adjustment subtracts the net increase in receivables associated with operating entries. By contrast, the net increase in accounts payable was already on the income-side of the equation, so its sign remains the same, positive. The accounts payable adjustment adds the net increase in accounts payable associated with operating entries. EASYLEARN COMPANY Rearranging Total Operations Row of BSE Cash from operations = Net income after adjusting for gains and losses + Net increase in accounts payable due to operating entries - Net increase in accounts receivable due to operating entries + $5 + $90 + $45 + $130 Reconciliation bottom line Reconciliation top line Reconciliation asset and liability adjustments EASYLEARN COMPANY SCF RECONCILIATION December 1-31, 2009 Operating Activities Net Income $90 Receivables ($130) Accounts payable $45 Net cash from operations $5

25 Introduction to Cash-Flow Statements 25 Why Do Asset and Liability Adjustments Differ from the Balance Sheet Change? Asset and liability adjustments represent the net effect of the period s operating entries on the related assets and liabilities. So, why doesn t this always equal the difference between the beginning and ending balance sheets? Why can t you just determine the change from the balance sheets and report these as adjustments, after changing the sign of the asset adjustment to the opposite sign? The adjustments on the cash-flow statement represent the net effect of operating events only on the related account. The balance sheet changes include the net effect of operating and non-operating events. Non-operating events include, among other things, buying and selling complete companies or business subunits. Even without knowing the entries behind an adjustment, we can use it to determine the net effect of operating entries and separately the net effect of non-operating entries. For example, from Intel s balance sheet, net receivables decreased $133 during 2007, from $2,709 at the end of 2006 to $2,576 at the end of This is the combined net effects of the operating and nonoperating entries. However, from the cash-flow statement we know the net effect of the operating entries was -$316. This means non-operating entries must have caused an additional net increase of $183: X + - $316 = - $133 X = $183 This can be validated by using the information from Intel s 2007 balance sheet and its statement of cash flows: $2,709 beginning accounts receivable, net balance for net effect of operating events from cash-flow statement net effect of non-operating events (derived) = $2,576 ending receivables balance for 2007 So, why is it useful to know the change in the balance sheet associated with non-operating events? Non-operating events typically do not happen every period and thus are not predictive of future performance. Analysts consider adjusting for such unusual events when forecasting.

26 26 Navigating Accounting Figure Colors Use the PDF to see the color-coded figures. Record-Keeping & Reporting (R&R) Maps Creating Financial Statements from the BSE Matrix The record-keeping and reporting map (R&R Map) below illustrates how EasyLearn s financial statements can be created from the balancesheet-equation matrix. This reviews the map discussed in prior chapters. Balance Sheet (brown and green) Balance sheet beginning and ending balances come from the top and bottom rows of the BSE matrix, respectively. Only entries in the permanent accounts are included, starting with cash and ending with retained earnings. The map connects the balance sheet to the statement of owners equity: The beginning and ending balance-sheet balances for common stock and retained earnings trace to the top and bottom rows of the statement of owners equity, respectively. It also connects the balance sheet to the direct and indirect cash-flow statements: The beginning and ending balances trace to beginning and ending cash balances reported at the R&R Map: Creating Financial Statements from BSE Matrix Assets = Liabilities + Permanent Owners' Equity + Net income + C + AR = + AP + CS + RE + Rev - AdEx + IncS December 1, $0 + + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 + + $0 E2 Recognize revenue = Operating Financing E3 Customer collections = E4 Advertising expense + + = E5 Advertising payment = Total operations + + $5 + + $130 = + + $ $0 + + $0 + + $ $ $0 E1 Issue stock for cash = Total financing = Trial balance + + $6 + + $130 = + + $ $1 + + $0 + + $ $ $0 + + = Closing to and from income summary + + = December 31, $6 + + $130 = + + $ $1 + + $ $0 - + $0 + + $0 EASYLEARN COMPANY BALANCE SHEETS Assets 12/31/09 12/1/09 Cash $6 $0 Accounts receivable Total assets $136 $0 Liabili es & owners' equity Liabili es Accounts payable 45 0 Total liabilities 45 0 Stockholders' equity Common stock 1 0 Retained earnings 90 0 Total stockholders' equity 91 0 Total liabili es & owners' equity $136 $0 EASYLEARN COMPANY DIRECT CASH FLOW STATEMENT December 1-31, 2009 Operating Activities Sales collections $20 Advertising payment (15) Net cash from operations 5 Financing Activities Sale of common stock 1 Net cash from financing 1 Change in cash 6 Beginning Cash balance 0 Ending cash balance $6 EASYLEARN COMPANY INDIRECT CASH FLOW STATEMENT December 1-31, 2009 Operating Activities Net Income $90 Receivables ($130) Accounts payable $45 Net cash from operations $5 Financing Activities Sale of common stock $1 Net cash from financing $1 Change in cash $6 Beginning Cash balance $0 Ending cash balance $6 EASYLEARN COMPANY INCOME STATEMENT December 1-31, 2009 Revenues $150 Adver sing expense (60) Net Income $90 EASYLEARN COMPANY STATEMENT OF OWNERS' EQUITY Retained Earnings Common Stock Total December 1, 2009 $0 $0 $0 Net income Common stock sale 1 1 December 31, 2009 $90 $1 $91

27 Introduction to Cash-Flow Statements 27 bottom of the cash-flow statements, respectively. This signifies one of the objectives of cash-flow statements: to explain the balance sheet change in cash during the reporting period. Income Statement (blue) Income statement numbers come from the trial balance row of the BSE matrix. Only entries in income accounts (revenues and advertising expense) are included. The map also connects the income statement to the indirect cash-flow statement and statement of owners equity: Net income, the bottom line of the income statement, is reported on the top line of the reconciliation on the indirect cash-flow statement and the net income row of the statement of owners equity. Statement of Owners Equity (brown, pink, blue, and green) Statement of owners equity numbers come from the permanent owners equity columns of the BSE matrix. The beginning and ending balances for common stock and retained earnings reported on the top and bottom rows of the statement of owners equity, respectively, come from the top and bottom rows of the BSE matrix (brown and green). The other rows of the statement of owners equity report events that occurred during the period. They are pink to signify they come from the corresponding rows of the BSE matrix. Net income is blue to signify it comes from the income statement and that income is closed into retained earnings. Direct Cash-Flow Statement (purple, green, and brown) Direct cash-flow statement numbers come from the cash column of the BSE matrix. The purple region explains the changes in cash recorded during the reporting period. The map also illustrates that cash from operations and all investing and financing cash flows are the same for the direct and indirect statements. Only the operating sections differ. Indirect Cash-Flow Statement (blue, orange, purple, green, and brown) The map illustrates that the operating section of the indirect cash-flow statement reconciles net income (from the income statement) to cash from operations (from the direct cash-flow statement). The reconciliation adjustment numbers (orange) come from the total operations row of the BSE matrix. The negative $130 receivables adjustment has the opposite sign to the + $130 reported in the total from operations row of the receivables column of the BSE matrix, signifying that asset adjustments are the opposite or negative of the net effect of the operating entries on the corresponding asset. By contrast, the $45 accounts payable adjustment has the same sign as the + $45 reported in the total from operations row of the BSE matrix, signifying that liability adjustments are the net effect of operating entries on the corresponding liability.

28 28 Navigating Accounting Mapping BSE Template to Intel The map below demonstrates how the R&R map generalizes to Intel s statement of cash flows: Assets = Liabilities + Owners' Equities Permanent + Comprehensive Income Beginning balances Cash + + Other Assets = + + Net Income + + OCI Operating events Cash from operations + Change in other assets related to operations = Change in liabilities related to operations + Change in paid in capital related to operations + Net income excluding gains & losses + OCI related to operations Cash from Non-operating investing and events financing + activities = + + Gains & losses + Transfer comprehensive income to permanent owners equity Ending balances + = Intel Consolidated Statements of Cash Flows Three Years Ended December 29, 2007 (In Millions) Cash and cash equivalents, beginning of year $ 6,598 $ 7,324 $ 8,407 Cash flows provided by (used for) operating activities: Net income 6,976 5,044 8,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 4,546 4,654 4,345 Share-based compensation 952 1,375 Restructuring, asset impairment, and net loss on retirement of assets Excess of tax benefit from share-based payment arrangements (118) (123) Amortization of intangibles and other acquisition related costs (Gains) losses on equity investments, net (157) (214) 45 (Gains) on divestitures (21) (612) Deferred taxes (443) (325) (413) Tax benefit from employee equity incentive plans 351 Changes in assets and liabilities: Trading assets (1,429) 324 1,606 Accounts receivable 316 1,229 (912) Inventories 700 (1,116) (500) Accounts payable Income taxes payable and receivable (248) (60) 797 Other assets and liabilities 633 (444) 241 Total adjustments 5,649 5,588 6,187 Net cash provided by operating activities 12,625 10,632 14,851 Cash flows provided by (used for) investing activities Additions to property, plant, and equipment (5,000) (5,860) (5,871) Acquisitions, net of cash acquired (76) (191) Purchases of available-for-sale investments (11,728) (5,272) (8,475) Maturities and sales of available-for-sale investments 8,011 7,147 8,433 Investments in non-marketable equity instruments (1,459) (1,722) (193) Net proceeds from divestitures Other investing activities 294 (33) (118) Net cash used for investing activities (9,926) (4,988) (6,415) Cash flows provided by (used for) financing activities Increase (decrease) in short-term debt, net (39) (114) 126 Proceeds from government grants Excess tax benefit from share-based payment arrangements Additions to long-term debt 125 1,742 Repayments and retirements of long-term debt (19) Repayments of notes payable (581) Proceeds from sales of shares through employee equity incentive plans 3,052 1,046 1,202 Repurchase and retirement of common stock (2,788) (4,593) (10,637) Payment of dividends to stockholders (2,618) (2,320) (1,958) Net cash used for financing activities (1,990) (6,370) (9,519) Net increase (decrease) in cash and cash equivalents 709 (726) (1,083) Cash and cash equivalents at the end of the year $ 7,307 $ 6,598 $ 7,324

29 Introduction to Cash-Flow Statements 29 Determining Entries Financial Statement Effects from the BSE Matrix The record-keeping and reporting map below illustrates the financial statement effects of entries from the balance-sheet-equation matrix using entry E2 as an example, recognizing $150 revenue on a sale on account. The map generalizes to any entry for any company. Tracing the $150 Increase in Accounts Receivable Operating entries, other than cash and income accounts, are coded orange, signifying they affect the reconciliation adjustments. The orange arrow from the $150 recorded to receivables to the $130 total from operations signifies that E2 affects the -$130 reconciliation adjustment (which has the opposite sign to the net effect of the operating entries because it is an asset adjustment). R&R Map: Determining Entries Financial Statement Effects from BSE Matrix Assets = Liabilities + Permanent Owners' Equity + Net income + C + AR = + AP + CS + RE + Rev - AdEx + IncS December 1, $0 + + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 + + $0 Financing Operating E2 Recognize revenue = E3 Customer collections = E4 Advertising expense + + = E5 Advertising payment = Total operations + + $5 + + $130 = + + $ $0 + + $0 + + $ $ $0 E1 Issue stock for cash = Total financing = Trial balance + + $6 + + $130 = + + $ $1 + + $0 + + $ $ $0 + + = Closing to and from income summary + + = December 31, $6 + + $130 = + + $ $1 + + $ $0 - + $0 + + $0 EASYLEARN COMPANY BALANCE SHEETS Assets 12/31/09 12/1/09 Cash $6 $0 Accounts receivable Total assets $136 $0 Liabili es & owners' equity Liabili es Accounts payable 45 0 T otal liabilities 45 0 Stockholders' equity Common stock 1 0 Retained earnings 90 0 Total stockholders' equity 91 0 Total liabili es & owners' equity $136 $0 EASYLEARN COMPANY DIRECT CASH FLOW STATEMENT December 1-31, 2009 Operating Activities Sales collections $20 Advertising payment (15) Net cash from operations 5 Financing Activities Sale of common stock 1 Net cash from financing 1 Change in cash 6 Beginning Cash balance 0 Ending cash balance $6 EASYLEARN COMPANY INDIRECT CASH FLOW STATEMENT December 1-31, 2009 Operating Activities Net Income $90 Receivables ($130) Accounts payable $45 Net cash from operations $5 Financing Activities Sale of common stock $1 Net cash from financing $1 Change in cash $6 Beginning Cash balance $0 Ending cash balance $6 EASYLEARN COMPANY INCOME STATEMENT December 1-31, 2009 Revenues $150 Adver sing expense (60) Net Income $90 EASYLEARN COMPANY STATEMENT OF OWNERS' EQUITY Retained Earnings Common Stock Total December 1, 2009 $0 $0 $0 Net income Common stock sale 1 1 December 31, 2009 $90 $1 $91

30 30 Navigating Accounting The green arrow from the $130 total from operations row to the $130 December 31 balance signifies that E2 affects the ending balance for accounts receivable on the balance sheet. In contrast to Intel, EasyLearn s receivables are not affected by non-operating entries. Thus, the $130 total from operations is identical to the balance sheet change. Tracing the $150 Increase in Revenues Numbers recorded to income accounts are coded blue. Following the blue path, we see that the recorded revenues flow to the trial balance row of the BSE matrix and from there directly to the revenues line on the income statement and to net income. This means it affects the $90 of net income reported on the income statement, indirect cash-flow statement (top line of reconciliation) and statement of owners equity. EasyLearn Example Summary Here are some key takeaways: The purpose of the reconciliation in the operating section of indirect cash-flow statements is to explain why income differs from cash from operations. The reconciliation has three elements: income, reconciliation adjustments, and net cash from operations. With a few rare exceptions, there are three types of adjustments: gains and losses adjustments, asset adjustments, and liability adjustments. Gains and losses adjustments remove gains and losses from net income because these items are not associated with operations: gain adjustments are subtracted and loss adjustments added in the reconciliation. Asset adjustments are the opposite of the net effects of operating entries on the related assets or, equivalently, are the negative of the net effects. Liability adjustments are the same as the net effects of operating entries that affect the related liabilities. The net effects of the non-operating entries can be determined using numbers reported in reconciliations and balance sheets. Balance sheets report the total change of operating and non-operating events, where cash-flow statement adjustments report only the operating effects of events. R&R maps illustrate how financial statements are created from the BSE matrix and can help you understand where reported numbers come from and how the financial

31 Introduction to Cash-Flow Statements 31 statements are related. In particular, they illustrate how asset and liability reconciliation adjustments are related to the total operations row of the BSE matrix. R&R maps also illustrate how entries affect financial statements and can be created for all entries recorded by actual companies. We will discuss these maps further in the ABC Company example and use them repeatedly throughout Navigating Accounting to demonstrate how new entries flow into the financial statements and how to envision the structure of the entries behind reported numbers even when you are an outsider who does not know the numbers recorded in the entries.

32 32 Navigating Accounting Usage Icon This exercise helps you learn how accounting reports are used by investors, creditors, and other stakeholders. Exercise 3.02 Procter and Gamble s (P&G) portfolios of brands, including Pampers, Tide, Ariel, Always, Pantene, Bounty, Folgers, Pringles, Charmin, Downy, Iams, Crest, Actonel and Olay. Use the following excerpts to interpret its statements. Solutions are at the end of the chapter. (a) True or False: Based on the excerpt from the cash-flow statement, P&G s inventories increased $383 in 2006 due to operating entries. Search Icon This exercise helps you search for information Amounts in millions CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 6,389 4,232 OPERATING ACTIVITIES Net earnings 8,684 6,923 Depreciation and amortization 2,627 1,884 Share-based compensation expense Deferred income taxes (112) 564 Change in accounts receivable (524) (86) Change in inventories 383 (644) Change in accounts payable, accrued and other liabilities 230 (101) Change in other operating assets and liabilities (508) (498) Other TOTAL OPERATING ACTIVITIES 11,375 8,679 Page 45, P&G s 2006 Annual Report (b) True or False: Based on the excerpt of the cash-flow statement, it is reasonable to assume that inventories changed by $383 from 2005 to 2006 on P&G s balance sheets. (c) Based on the excerpt of P&G s balance sheet below, estimate the net effect of non-operating entries on total inventories. Amounts in millions Inventories Materials and supplies 1,537 1,424 Work in process Finished goods 4,131 3,232 Total inventories 6,291 5,006 Page 42, P&G s 2006 Annual Report

33 Introduction to Cash-Flow Statements 33 ABC Company Events and Entries We will be using the same events as in earlier chapters, where all amounts are in thousands of dollars: E1: ABC s shareholders contribute $1,000 of cash to ABC in exchange for 1 million shares of ABC s non-par common stock. E2: ABC purchases a building from Kaplan Properties for $200 cash. The building will be used as a store. E3: ABC purchases $100 of merchandise from Healy Inc. on account and it plans to sell to customers for a profit. E4: ABC sells merchandise that cost $20 for $60. The customers who purchase the merchandise promise to pay the $60 in the future. ABC recognizes revenue when goods are sold to customers. E5: ABC collects $40 of the $60 that customers promised to pay (in event E4). E6: ABC pays $60 of its outstanding obligation to Healy Inc. E7: ABC receives $10 of cash from customers who owe this much in interest because they did not pay their bills on time. E8: ABC declares and pays a $20 dividend on the last day of the year. E9: ABC records depreciation of $10 related to the building purchased from Kaplan Properties. Tracing ABC s Entries to Statements In this section we provide an analysis of each of ABC s entries s effects to the financial statements to build a framework for interpreting real companies reports. How will this help you? (1) As an insider working in a company, knowing how to address these questions will help you understand and anticipate how business activities affect financial statements. (2) As an outsider analyzing a company, knowing how to address these will help you understand what s behind the financial statement numbers and the relationships of the numbers across the statements. For example, as you read about business activities of a company, such as in press releases, you can anticipate the ripple effects throughout the financial statements.

34 34 Navigating Accounting Importantly, most companies only disclose the indirect format of the cash-flow statement so the following discussion aims to help you envision the direct cash-flow effect on cash from operations and the indirect effect to the reconciliation. (3) The concepts you learn in this section generalize to all entries and companies. The primary differences between ABC and large global companies with billions of transactions each year is the size of the BSE matrix and the diversity of entries. The way entries flow from the matrix to the financial statements and the relationships across the statements are the same. Event E1 Issuing Common Stock The entry to record issuing $1,000 of common stock in exchange for cash is highlighted in the BSE matrix in the R&R map: cash and common stock both increase by $1,000. How does the event affect the balance sheet? The map illustrates the entry has two balance sheet effects: the $1,000 recorded to cash in the BSE matrix traces to cash on the balance sheet and the $1,000 recorded to common stock traces to common stock. How does the event affect the income statement? It does not affect the income statement (on the lower right) because it does not affect revenues, expenses, gains or losses. How does the event affect the direct cash-flow statement? The cash received from issuing common stock is a financing inflow. The map illustrates how the cash recorded in the BSE matrix traces to the direct and indirect cash-flow statements (on the lower left and center). How does the event affect the indirect cash-flow statement? Financing and investing cash flows are the same on direct and indirect statements. Only the operating sections differ. This is illustrated in the map (on the lower left and center). How does the event affect the statement of owners equity? Issuing common stock increases owners equity. This is illustrated in the map (on the lower right). What would an outsider see? Assuming ABC reported an indirect cash-flow statement, which is what most companies do, an outsider would only see the numbers reported in the balance sheet, statement of owners equity, and indirect cash-flow statement.

35 Introduction to Cash-Flow Statements 35 Event E1 Issuing $1,000 of common stock for cash = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = E7 Interest income and = collection + 10 Operating Entries Non-operating Entries E9 Depreciation expense = Total operations $10 = $ $10 + $20 + $80 + $0 + $40 + $0 + $0 + $60 + $20 + $10 + $ = E2 Purchase building with cash Total investing = , = + + 1, E1 Issue stock for cash + E8 Dividend declared and = paid - 20 Total financing = , Trial balance + + $ $ $ $ $10 = + + $ $1, $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend declared (20) 0 (20) Ending balances $1,000 $60 $0 $1,060 Get a Closer Look of the Maps in Color The R&R maps are color coded with lots of great details. To view them in color and zoom in and out use the PDF. Generally, even though the entry affects the balance sheet, an outsider would not see the effect because it would be aggregated with the effects of other entries (from the current or past periods). For example, ABC s $770 ending cash balance is the net effect of six entries that affected cash. An outsider would see the $1,000 effect of the entry on paid-in capital. This would not be true if ABC had issued common stock in prior years or if other entries affected paid-in capital during the current year. An outsider can generally find the total cash inflow from common stock issuances that occurred during the reporting period in the financing section of the cash-flow statement, especially when they have a significant financial impact. This inflow can also be found in the statement of shareholders equity (as shown in the map).

36 36 Navigating Accounting E2 Purchasing a Building The entry to record purchasing a building for $200 cash is highlighted in the R&R map: cash decreases by $200 and property, plant, and equipment at historical cost (GPPE) increases by $200. How does the event affect the balance sheet? The map illustrates two balance sheet effects: the $200 cash outflow traces to cash on the balance sheet and the $200 increase in other assets traces to property, plant, and equipment. How does the event affect the income statement? It does not affect the income statement because it does not affect revenues, expenses, gains or losses. How does the event affect the direct cash-flow statement? The cash used to purchase property, plant, and equipment is an investing cash flow. The map illustrates how the cash outflow recorded in the BSE matrix traces to the direct and indirect cash-flow statements. How does the event affect the indirect cash-flow statement? Same as direct cash-flow statement. How does the event affect the statement of owners equity? It does not affect the statement because it does not affect any of the owners equity accounts. What would an outsider see? Generally, even though the entry affects the balance sheet, an outsider would not see the effect because it would be aggregated with the effects of other entries (from the current or past periods). An outsider would see the $200 impact of the entry on ABC s balance sheet because this is ABC s first year of operations and E2 is the only entry that affected gross property and equipment. An outsider can generally find the net cash outflows from purchasing and selling property, plant and equipment in the investing section of the cash-flow statement, meaning cash outflows used to purchase PP&E net of cash inflows from selling PP&E. This item does not include PP&E acquired when the reporting company acquires other companies. Nor does it include PP&E purchased using debt financing when the debt is directly related to the purchase. It only includes related cash transactions.

37 Introduction to Cash-Flow Statements 37 Event E2 Purchasing a building for $200 cash = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = E7 Interest income and = collection + 10 Operating Entries Non-operating Entries E9 Depreciation expense = Total operations $10 = $ $10 + $20 + $80 + $0 + $40 + $0 + $0 + $60 + $20 + $10 + $ = E2 Purchase building with cash Total investing = , = + + 1, E1 Issue stock for cash + E8 Dividend declared and = paid - 20 Total financing = , Trial balance + + $ $ $ $ $10 = + + $ $1, $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend declared (20) 0 (20) Ending balances $1,000 $60 $0 $1,060 Take-aways As an outsider, you can find a good deal of useful information about financing and investing transactions in cash-flow statements that you can not find on balance sheets, even though these events affect balance sheets. The financing and investing sections of direct and indirect cash-flow statements are identical.

38 38 Navigating Accounting E3 Purchasing Inventory on Account The entry to record purchasing $100 of inventory on account is highlighted in the R&R map: inventory and accounts payable both increase by $100. How does the event affect the balance sheet? There are two balance sheet effects: the $100 recorded to inventories traces to inventories on the balance sheet and the $100 recorded to accounts payable traces to accounts payable. How does the event affect the income statement? It does not affect revenues, expenses, gains or losses and thus, income. How does the event affect the direct cash-flow statement? Cash and thus the direct cash-flow statement is not affected by the entry. How does the event affect the indirect cash-flow statement? The $100 recorded to inventories has a -$100 effect on the inventories adjustment. That is, this adjustment would have been ($100) if E3 had been the only operating entry that affected inventories. The $100 recorded to accounts payable has a +$100 effect on the accounts payable adjustment. If E3 had been the only operating entry that affected payables, the adjustment would have been $100. Here is a summary of how this entry affects the reconciliation: Net income $0 Inventories -$100 Accounts payable +$100 Net cash from operations $0 This entry has a $0 effect on net income and a $0 effect on cash from operations. Thus, strictly speaking no adjustment is needed to reconcile income to cash from operations. However, by historical convention, GAAP permits companies to include the effects of all operating events in reconciliation adjustments and virtually every company follows this convention. Two offsetting adjustments are needed to meet the convention when entries do not affect income or cash. How does the event affect the statement of owners equity? No effect, because it does not affect any of the owners equity accounts.

39 Introduction to Cash-Flow Statements 39 Event E3 Purchasing $100 of merchandise on account = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = E7 Interest income and = collection + 10 Operating Entries Non-operating Entries E9 Depreciation expense = Total operations $10 = $ $10 + $20 + $80 + $0 + $40 + $0 + $0 + $60 + $20 + $10 + $ = E2 Purchase building with cash Total investing = , = + + 1, E1 Issue stock for cash + E8 Dividend declared and = paid - 20 Total financing = , Trial balance + + $ $ $ $ $10 = + + $ $1, $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories ntories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ntories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend declared (20) 0 (20) Ending balances $1,000 $60 $0 $1,060 What would an outsider see? Nothing, the entry s effects are behind the numbers reported on the balance sheet and cash-flow statement. However, after we have analyzed the other entries associated with inventories and payables, we will see that an outsider can draw related inferences in some business contexts.

40 40 Navigating Accounting E4a Recognizing Sale on Account The entry to recognize revenue at point of sale on a $60 sale on account is highlighted in the R&R map: accounts receivable and revenues both increase by $60. How does the event affect the balance sheet? Accounts receivable and retained earnings both increase by $60. Recall, revenues are included in income, which is closed into retained earnings (as shown in the map near the bottom of the BSE matrix). How does the event affect the income statement? Revenues increases by $60 and thus income increases by $60. How does the event affect the direct cash-flow statement? Cash and thus the direct cash-flow statement is not affected by the entry. How does the event affect the indirect cash-flow statement? The $60 recorded to receivables has a -$60 effect on the receivables reconciliation adjustment. That is, this adjustment would have been ($60) if E4a had been the only operating entry that affected receivables. The $60 of revenues are included in the $40 of net income reported at the top of the reconciliation. Here is a summary of how this entry affects the reconciliation: Net income $60 Receivables -$60 Net cash from operations $0 How does the event affect the statement of owners equity? Retained earnings increases because the entry affected income. What would an outsider see? The $60 of revenues are disclosed on the income statement. The effects of this entry are aggregated with other information on the balance sheet and cash-flow statement.

41 Introduction to Cash-Flow Statements 41 Event E4a Recognizing $60 revenue for sale on account = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = E7 Interest income and = collection + 10 Operating Entries Non-operating Entries E9 Depreciation expense = Total operations $ $10 = $ $10 + $80 + $0 + $40 + $0 + $0 + $60 + $20 + $10 + $ = E2 Purchase building with cash Total investing = , = + + 1, E1 Issue stock for cash + E8 Dividend declared and = paid - 20 Total financing = , Trial balance + + $ $ $ $ $10 = + + $ $1, $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend declared (20) 0 (20) Ending balances $1,000 $60 $0 $1,060 Take-aways Under GAAP, ABC must be reasonably assured it will collect the $60 if it recognizes revenues. To the extent this is true, the revenues, and thus income, reflect performance accurately and are deemed to have high quality. By contrast, if collection is doubtful but ABC recognizes revenue anyway to give the appearance of performing well, the $60 reconciliation adjustment reflects opportunistic manipulation. We will discuss how reconciliation adjustments can be used to assess earnings quality in more detail after we have examined all of ABC s entries.

42 42 Navigating Accounting E4b Recognizing Cost of Sales The entry to recognize $20 of cost of sales is highlighted in the R&R map: inventories decreases $20 and cost of sales increases $20. How does the event affect the balance sheet? Inventories and retained earnings both decrease $20. How does the event affect the income statement? Cost of sales increases $20 and thus income decreases $20. How does the event affect the direct cash-flow statement? Cash and thus the direct cash-flow statement is not affected by the entry. How does the event affect the indirect cash-flow statement? The -$20 recorded to inventories has a +$20 effect on the inventories reconciliation adjustment. That is, this adjustment would have been $20 if E4b had been the only operating entry that affected inventories. The $20 of cost of sales are included in net income reported at the top of the reconciliation. Here is a summary of how this entry affects the reconciliation: Net income -$20 Inventories +$20 Net cash from operations $0 How does the event affect the statement of owners equity? Retained earnings decreases because the entry affected income. What would an outsider see? The $20 of cost of sales is disclosed on the income statement. The effects of this entry are aggregated with other information on the balance sheet and cash-flow statement. Next we are going to summarize the effects of purchasing inventories and selling them on a combined figure. This will set the stage for an analysis that will allow you to estimate the purchases and qualitatively gauge the accuracy of this estimation when analyzing real companies.

43 Introduction to Cash-Flow Statements 43 Event E4b Recognizing $20 of cost of sales = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = E7 Interest income and = collection + 10 Operating Entries Non-operating Entries E9 Depreciation expense = Total operations $ $10 = $ $10 + $20 + $0 + $40 + $0 + $0 + $60 + $20 + $10 + $ = E2 Purchase building with cash Total investing = , = + + 1, E1 Issue stock for cash + E8 Dividend declared and = paid - 20 Total financing = , Trial balance + + $ $ $ $ $10 = + + $ $1, $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories ntories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ntories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend declared (20) 0 (20) Ending balances $1,000 $60 $0 $1,060

44 44 Navigating Accounting Net Effects of Operating Entries on Inventories The R&R map combines the maps for E3 (purchasing $100 of inventories on account) and E4b (recognizing $20 of cost of sales). What is the combined effect on the indirect cash-flow statement? Here are the separate and combined effects of these entries: E3 E4b Combined Net income $0 -$20 -$20 Inventories -$100 +$20 -$80 Accounts payable +$100 $0 +$100 Net cash from operations $0 $0 $0 The most important observation here is that the two operating entries completely explain the ($80) inventories adjustment: it is the negative of the net effect of the two entries on inventories in the BSE matrix. What would outsiders see for ABC Company? Outsiders would see the $20 of cost of sales, the $80 change in inventories and the ($80) adjustment on the cash-flow statement. Could outsiders reliably estimate the inventories purchased? Yes, providing they assume: (1) Purchases and cost of sales were the only operating entries recorded to inventories during the year. (2) Cost of sales is only affected by costs previously recognized in inventories. Given these assumptions and knowing that asset adjustments are the negative of the net effect of operating entries on the related assets, outsiders can solve the following equation for the $100 of purchases: ($80) = -[net effect of operating entries on inventories] = -[purchases - inventoried costs of sold goods + net effect of other operating entries on inventories] = -[purchases - $20 + $0] = - purchases + $20 When does this approach produce good estimates of the purchases? Whenever the two assumptions above are reasonably close to reality this approach provides a good estimate of purchases. This is never true for manufacturing companies and seldom true for retail stores, but is generally close to true for other companies. The reason the approach is inappropriate for manufacturing companies is the first assumption is far from true. As you will learn in a later chapter, many other entries significantly affect inventories and it is impossible for outsiders to reliably estimate their effects on inventories.

45 Introduction to Cash-Flow Statements 45 Combining E3 and E4b to Assess Net Effects on Inventories = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = E7 Interest income and = collection + 10 Operating Entries Non-operating Entries E9 Depreciation expense = Total operations $10 = $ $10 + $20 + $80 + $0 + $40 + $0 + $0 + $60 + $20 + $10 + $ = E2 Purchase building with cash Total investing = , = + + 1, E1 Issue stock for cash + E8 Dividend declared and = paid - 20 Total financing = , Trial balance + + $ $ $ $ $10 = + + $ $1, $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories ntories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ntories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend declared (20) 0 (20) Ending balances $1,000 $60 $0 $1,060 The reason the approach seldom works for retailers is they often report a single income statement line item that combines cost of sales and occupancy costs and do not provide adequate footnote information to isolate cost of sales. This would not be a problem if occupancy costs were relatively small. However, occupancy costs include the costs to rent and operate retail stores, which tend to be quite significant. The approach probably produces reasonable estimates for retailers and other non-manufacturing companies that report cost of sales separately on their income statements. Other entries generally affect inventories and cost of sales (such as shipping and handling costs) but these are relatively inconsequential. Take-aways The combined map for E3 and E4a illustrates that ABC s inventories adjustment is the opposite, or negative, of the net effect of the two operating entries that affected inventories during the year. This continues to be true if more than two operating entries affect inventories, which is the case for manufacturing companies.

46 46 Navigating Accounting However, for manufacturing companies it is not reasonable to assume away the net effect of other operating entries on inventories, as we did in the analysis of E3 and E4b for ABC company. More generally, most reconciliation adjustments are affected by more than two entries, or by significant entries you may not be aware of yet. The earlier discussion underscores that your proficiency at analyzing cash-flow statements will improve steadily as you learn more entries, understand how they affect financial statements, and can gauge their relative importance from the business context. ABC s inventories were not affected by non-operating entries such as acquiring inventories as part of acquiring another company. E5 Customer Collections The entry to recognize $40 of customer collections on accounts receivable is highlighted in the R&R map: cash increases by $40 and accounts receivable decreases by $40. How does the event affect the balance sheet? Cash increases $40 and accounts receivable decreases $40. How does the event affect the income statement? It does not affect revenues, expenses, gains or losses and thus, income. How does the event affect the direct cash-flow statement? Sales collections increases $40, which increases cash from operations $40 on the direct and indirect cash-flow statements. How does the event affect the indirect cash-flow statement? Here is a summary of how this entry affects the reconciliation: Net income $0 Receivables +$40 Net cash from operations +$40 How does the event affect the statement of owners equity? No effect, because it does not affect any of the owners equity accounts. What would an outsider see? Nothing, the entry s effects are behind the numbers reported on the balance sheet and cash-flow statement. However, outsiders can often get reasonable estimates of customer collections following an approach

47 Introduction to Cash-Flow Statements 47 Event E5 Collecting $40 from customers = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = E7 Interest income and = collection + 10 Operating Entries Non-operating Entries E9 Depreciation expense = Total operations $ $10 = $ $10 + $80 + $0 + $40 + $0 + $0 + $60 + $20 + $10 + $ = E2 Purchase building with cash Total investing = , = + + 1, E1 Issue stock for cash + E8 Dividend declared and = paid - 20 Total financing = , Trial balance + + $ $ $ $ $10 = + + $ $1, $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend declared (20) 0 (20) Ending balances $1,000 $60 $0 $1,060 similar to the one we just completed for inventories. Moreover, the accuracy of these estimates can sometimes be improved by incorporating disclosed information about related entries introduced in later chapters. Take-aways Collecting cash from customers enhances ABC s liquidity and confirms the quality of previously recognized revenues. The map illustrates that operating cash flows reported on the direct cashflow statement flow through to net cash from operations, which is the same for the direct and indirect statements. As an outsider, you will generally not observe these operating cash flows. Still, knowing about them helps you get a better understanding of the cash inflows and outflows included in net cash from operations. You do not get this understanding from the reconciliation because it only explains the difference between net income and net cash from operations.

48 48 Navigating Accounting E6 Supplier Payments The entry to recognize $60 of supplier payments is highlighted in the R&R map: cash and accounts payable decrease $60. We will assume from here on that you can understand how entries affect financial statements other than the indirect cash-flow statement from the R&R maps. Combined effect of E3, E4b, and E6 on the indirect statement The separate and combined effects of E6 and the earlier entries are summarized in the table: E3 E4b E6 Combined Net income $0 -$20 $0 -$20 Inventories -$100 +$20 $0 -$80 Accounts payable +$100 $0 -$60 +$40 Net cash from operations $0 $0 -$60 -$60 These entries only affect one line item on the income statement (cost of sales) and one on the direct cash-flow statement (vendor payments) so we can replace net income with cost of sales and net cash from operations with vendor payments. Making these substitutions, we can use the combined effects to derive the vendor payments from items outsiders observe in the financial statements: Cost of sales -$20 Inventories -$80 Accounts payable +$40 Vendor payments -$60

49 Introduction to Cash-Flow Statements 49 Event E6 Paying suppliers $60 = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = E7 Interest income and = collection + 10 Operating Entries Non-operating Entries E9 Depreciation expense = Total operations + - $ $ $ $0 - + $10 = + + $ $0 + + $0 + + $ $ $ $ $ = E2 Purchase building with cash Total investing = , = + + 1, E1 Issue stock for cash + E8 Dividend declared and = paid - 20 Total financing = , Trial balance + + $ $ $ $ $10 = + + $ $1, $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend declared (20) 0 (20) Ending balances $1,000 $60 $0 $1,060 Take-aways This analysis is only applicable to the extent the ABC assumptions are valid. These include assumptions for inventories and cost of sales which are not valid in many contexts such as manufacturing companies. Additionally, the earlier discussion assumes inventories are the only resources purchased on account included in accounts payable. Some companies follow this practice. However, similar to EasyLearn other companies record all resources purchased on account to accounts payable (once invoices are received from resource providers). For example, they include purchasing advertising and utilities in accounts payable. Both approaches are consistent with U.S. GAAP and companies do not have to disclose which one they use. Thus, it is generally not possible to determine how reliable the estimates of vendor payments are using the earlier approach. Still, we have included it so you will know to be skeptical if you see it advocated elsewhere.

50 50 Navigating Accounting E7 Recognizing interest income received As illustrated in the R&R map, E7 recognizes $10 of interest income that was received during the year: cash and interest income both increase $10. How does the event affect the indirect cash-flow statement? Here is a summary of how this entry affects the reconciliation: Net income +$10 Adjustments +$0 Net cash from operations +$10 No adjustment is needed because the recognized interest income is the same as the cash received. In practice, interest income is often recognized before the related cash is received. This occurs when the company has earned the income and is reasonably assured it will receive it in the future. In these situations, an adjustment is needed to reconcile the income recognized to the cash collected. What would an outsider see? ABC reports the interest income on its income statement. Most companies do not disclose a separate line item for interest income on their income statements. However, when interest income is significant, it is sometimes disclosed on the income statement or in a footnote.

51 Introduction to Cash-Flow Statements 51 Event E7 Recognizing $10 of interest income received = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = Operating Entries Non-operating Entries E7 Interest income and collection = E9 Depreciation expense = Total operations $10 = $ $10 + $20 + $80 + $0 + $40 + $0 + $0 + $60 + $20 + $10 + $ = E2 Purchase building with cash Total investing = , = + + 1, E1 Issue stock for cash + E8 Dividend declared and = paid - 20 Total financing = , Trial balance + + $ $ $ $ $10 = + + $ $1, $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend declared (20) 0 (20) Ending balances $1,000 $60 $0 $1,060 Key Take Aways Interest income is classified as an operating cash flow under U.S. GAAP, even though some believe it should be a financing cash flow. All of ABC s operating entries have affected two line items in the operating section of the indirect cash-flow statement and thus the reconciliation. This lesson generalizes: every operating entry has at least two effects on the reconciliation (although in later chapters we will see that sometimes two of these effects offset each other in a single line item or are reported as separate line items in the reconciliation). None of ABC s investing and financing entries have affected the reconciliation. The only investing and financing entries that affect the reconciliation are those associated with gains and losses.

52 52 Navigating Accounting E8 Declare and Pay Dividends As illustrated in the R&R map, this entry recognizes $20 of dividends declared and paid, which decreases cash and retained earnings. How does the event affect the indirect cash-flow statement? Declaring and paying dividends are both considered financing activities and thus the reporting is the same for the direct and indirect cash-flow statements. However, dividends are often declared before they are paid by decreasing retained earnings and increasing a dividends payable liability. Later, when declared dividends are paid, cash and dividends payable decrease. This entry affects the financing sections of the direct and indirect cash-flow statements. What would an outsider see? For ABC company, an outsider would see the $20 dividend that was declared and paid in the financing section of the statement of cash flows and in retained earnings column of the statement of shareholders equity (as shown in the map). More generally, a separate line item is usually provided in the statement of shareholders equity for dividends declared during the reporting period and a separate line item in the financing section of the cash-flow statement for dividends paid during the period.

53 Introduction to Cash-Flow Statements 53 Event E8 Declare and pay dividend of $20 = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = E7 Interest income and = collection + 10 Operating Entries Non-operating Entries E9 Depreciation expense = Total operations $10 = $ $10 + $20 + $80 + $0 + $40 + $0 + $0 + $60 + $20 + $10 + $ = E2 Purchase building with cash Total investing = , = + + 1, E1 Issue stock for cash + E8 Dividend declared and = paid - 20 Total financing = , Trial balance + + $ $ $ $ $10 = + + $ $1, $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends vdends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends vdends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend vdend declared (20) 0 (20) Ending balances $1,000 $60 $0 $1,060

54 54 Navigating Accounting E9 Recognizing Depreciation As indicated in the R&R map, this entry increases accumulated depreciation (a contra asset that has a negative sign in the BSE equation) by $10 and increases depreciation expense $10. How does the event affect the indirect cash-flow statement? Here is a summary of how this entry affects the reconciliation: Net income -$10 Depreciation +$10 Net cash from operations +$0 Notice the sign of the adjustment for accumulated depreciation, a contra asset, is the same as the effect on the accumulated depreciation account: An increase in a contra asset results in a positive reconciliation adjustment. Likewise, a decrease in a contra asset results in a negative adjustment. For E9, the $10 increase in accumulated depreciation leads to a +$10 depreciation reconciliation adjustment. Why do increases in contra assets lead to positive adjustments? Contra assets, such as accumulated depreciation, have a negative sign in the balance sheet equation. By contrast, other assets have positive signs in the equation. Contra asset adjustments, like all asset adjustments, have the opposite of the effect of the period s operating entries on assets. Since contra assets are negative accounts, increases to contra assets decrease total assets and result in a positive adjustment (the opposite to the effect on total assets). What would an outsider see? For ABC company, an outsider would find the $10 of depreciation reported as an expense on the income statement, as an adjustment in the reconciliation on the indirect cash-flow statement, and as the ending balance in accumulated depreciation on the balance sheet (because this is the first year of operations). Most companies do not report separate line items for depreciation on their income statements. Rather, they include depreciation expense in a line item such as sales and general administrative expenses. Could outsiders reliably estimate depreciation expense? Yes, providing the depreciation estimate is for a company that does not manufacturer or produce many of the products it sells. For these nonmanufacturing companies, the depreciation adjustment will be the same as, or close to, the depreciation expense recognized in net income. And in these situations, it is correct to say that depreciation adjustment only reverses a non-cash expense included in net income.

55 Introduction to Cash-Flow Statements 55 Event E9 Recognize $10 of depreciation = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = E7 Interest income and = collection + 10 Operating Entries Non-operating Entries E9 Depreciation expense = Total operations + - $ $ $ $0 - + $10 = + + $ $0 + + $0 + + $ $ $ $ $ = E2 Purchase building with cash Total investing = , = + + 1, E1 Issue stock for cash + E8 Dividend declared and = paid - 20 Total financing = , Trial balance + + $ $ $ $ $10 = + + $ $1, $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend declared (20) 0 (20) Ending balances $1,000 $60 $0 $1,060 However, this is generally a bad assumption for manufacturing companies for reasons that will become apparent when we study manufacturing companies in a later chapter. Key Take Aways An increase in a contra asset is associated with a positive reconciliation adjustment. As we shall see in a later chapter, for manufacturing companies the depreciation reconciliation adjustment does more than reverse the depreciation expense in net income.

56 56 Navigating Accounting Creating Financial Statements From the BSE Matrix = + Assets Liabilities Owners' Equity Current Net + = + + Current Noncurrent Permanent income + AR GPPE - AcDep AP CS + RE - DepEx + + C + Inven + = Rev - Cgs Intinc + IncS Beginning balances + + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $ = E3 Purchase inventory on account E4a Recognize revenue = E4b Recognize cost of sales = E5 Customer collections = E6 Supplier payments = E7 Interest income and = collection + 10 Operating Entries Non-operating Entries E9 Depreciation expense = Total operations + - $ $ $ $0 - + $10 = + + $ $0 + + $0 + + $ $ $ $ $ = E2 Purchase building with cash Total investing = ,000 E1 Issue stock for cash = , E8 Dividend declared and paid = Total financing = , Trial balance + + $ $1, $ $ $ $ $10 = + + $ $ $ $ $ $ = Closing to and from income summary = Ending balances + + $ $ $ $ $10 = + + $ $1, $ $0 - + $0 - + $0 + + $0 + + $0 ABC Company Balance Sheet Assets End Bal Beg Bal Current Cash $770 $0 Accounts receivable 20 0 Inventories 80 0 Total current assets Non-current assets Property, plant, and equipment, net Historical cost of PP&E Less accumulated depreciation (10) 0 Property, plant and equipment, net Total non-current assets Total assets $1,060 $0 Liabilities and Stockholders' Equity Liabilities Current Accounts payable 40 0 Total current liabilities 40 0 Non-current 0 0 Total liabilities 40 0 Stockholders' equity Common stock 1,000 0 Retained earnings 20 0 Total stockholders' equity 1,020 0 Total liabilities and stockholders' equity $1,060 $0 ABC Company Direct Cash Flow Statement Operating Activities Sales collections $40 Vendor payments ($60) Interest received $10 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Company Indirect Cash Flow Statement Operating Activities Net profit $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40 Net cash from operations ($10) Investing Activities Purchase of building ($200) Net cash (used) for investing ($200) Financing Activities Sale of common stock $1,000 Cash dividends ($20) Net cash from financing $980 Change in cash $770 Beginning Cash balance $0 Ending cash balance $770 ABC Statement of Comprehensive Income Operating profit Revenues $60 Cost of sales (20) Depreciation (10) Operating profit 30 Non-operating profit Interest income 10 Net profit 40 Other comprehensive income 0 Comprehensive income $40 ABC Company Statement of Changes in Equity Common Stock Retained Earnings Reserves Total Beginning balances $0 $0 $0 $0 Comprehensive income Net profit Other comprehensive income 0 0 Total Common stock issued 1,000 1,000 Dividend vdend declared d (20) 0 (20) Ending balances $1,000 $60 $0 $1,060 Creating Financial Statements From BSE Matrix The R&R map illustrates how ABC s financial statements can be created from the BSE Matrix. It is structurally identical to the one we discussed earlier for EasyLearn. The differences center on scale: ABC has more entries and accounts than EasyLearn, so the BSE matrix is larger and its financial statements have more line items. Key Take Aways The EasyLearn and ABC maps capture all of the concepts you need to know to create financial statements for any company. As we introduce new entries in later chapters, the only thing that will change is we will add rows and columns to the BSE matrix and add line items to the financial statements. Similarly, we have now introduced all of the concepts you need to know to trace entries to the financial statements.

57 Introduction to Cash-Flow Statements 57 Combined Effects of Entries on Reconciliation In this section, we combine the entry-by-entry effects reported in the R&R map and interpret them in terms of the underlying events. This will set the stage for the next section where we explain when it is reasonable to generalize the ABC interpretations to actual companies. Depreciation Adjustment: $10 The first adjustment on ABC s cash-flow statement is deprecation. E9 is the only operating entry associated with depreciation. E9 decreases net income but it does not affect cash. Thus, $10 of depreciation expense must be reversed from income to get to cash from operations. Depreciation has a negative effect on assets. Thus, consistent with rule for asset reconciliation adjustments, the adjustment is the opposite of the effect on assets, or positive $10. Receivables Adjustment: ($20) As seen in the map, two operating entries result in a $20 net increase in receivables: E4a records a $60 sale on account, which increases revenues and receivables by $60, and E5 records a $40 collection on a prior sale on account, which decreases receivables and increases cash. The net effect of these entries is that income increases by $60 and cash from operations increases by $40. The difference between the income and cash effects is explained by the $20 increase in accounts receivable. Thus, consistent with the rule for asset adjustments, the receivables adjustment is opposite, or the negative of the net effect of the two operating entries on accounts receivable, ($20). Intuitively, the revenues included in net income exceed the collections included in cash from operations. Thus, the amount by which revenues exceeds collections, which is the increase in accounts receivable, must be subtracted from net income to reconcile it to net cash from operations. Inventories Adjustment: ($80) As indicated in the map, two operating entries result in a $80 net increase in inventories: E3 records a $100 purchase of inventories on account, which increases inventories and accounts payable, and E4b records the sale of merchandise that cost $20, which decreases inventories by $20 and increases cost of sales by $20. Consistent with the asset adjustment rule, the inventories adjustment is the negative of the net effect of the operating entries on inventories, or ($80). This ($80) inventories adjustment must be analyzed in combination with the payables adjustment. We discuss the intuition

58 58 Navigating Accounting behind the combined effects of the inventories and payables adjustments when we discuss the payables adjustment next. Accounts payable Adjustment: $40 Two operating entries result in a $40 net increase in accounts payable: E3 records a $100 purchase on account, which increases inventories and accounts payable by $100, and E6 reports a $60 supplier payment, which decreases accounts payable and cash by $60. Consistent with the rule for liability reconciliation adjustments, the accounts payable adjustment is the same as the net effect of the operating entries that affect accounts payable, or $40. The combined effect of the ($80) inventories adjustment and $40 payables adjustment is ($40). This reconciles the $20 decrease in net income associated with the cost of sales recorded in E4b to the $60 decrease in net cash from operations associated with the supplier payment recorded in E6. The reason the inventories and payables adjustment must be analyzed in combination is the $100 purchase in E3 affects both adjustments: it increases inventories by $100, which has a negative $100 effect on the inventories adjustment, and increases accounts payable by $100, which has a positive $100 effect on the payables adjustment. Thus, E3 has no net effect on the reconciliation. When are Intuitive Explanations Appropriate? There is an intuitive explanation for all of ABC s reconciliation adjustments: the depreciation adjustment reverses an expense that does not affect cash; the receivables adjustment reverses the amount by which the revenues included in net income exceed the collections included in cash from operations; and the combined effect of the inventories and payables adjustment is the amount cost of sales recognized in net income exceeds supplier payments recognized in cash from operations. It is important to recognize that these explanations are appropriate for companies with relatively simple transactions, but they can be quite misleading in contexts where other operating entries besides ABC s entries are prominent. For example, ABC assumes: (1) Revenue is recognized at the point of sale (2) All sales are on account (3) Sales on account and customer collections are the only entries that affect accounts receivable (4) Customers are billed when revenue is recognized

59 Introduction to Cash-Flow Statements 59 The explanation that the receivables adjustment reverses the amount revenues exceeds customer collections is misleading for companies with: Significant deferred revenues, which is inconsistent with assumption (1) that revenue is recognized at the point of sale. Significant anticipated uncollectible accounts associated with bad debts or product returns, which is inconsistent with assumption (3) because entries associated with bad debts and product returns affect receivables. Drill Deeper Here is a three-step process to help you gain a deeper understanding of reconciliation adjustments. Significant differences between the timing of billings and revenue recognition, which is inconsistent with assumption (4) and common practice for companies that enter contracts to construct bridges or other projects that can take several years to complete. Still, there are many contexts where the deviations from the four assumptions are relatively inconsequential and thus where the intuitive argument captures the primary effects of the receivables adjustment. For example, many companies deferred revenues, bad debts, and product returns are relatively insignificant compared to customer collections. Moreover, even when they are significant you can sometimes adjust your analysis for deviations from the basic assumptions. Your challenges as a user of financial statements are to learn the intuitive explanations, know when it is reasonable to apply them, and know how to interpret adjustments when it is not reasonable to apply intuition. Process for Interpreting Adjustments We close our study of ABC with a three-step process that will help you increasingly gain a deeper understanding of reconciliation adjustments as you learn new entries in future chapters: Step 1 Determine whether the adjustment is associated with an asset or liability and interpret it qualitatively in terms of the rules given earlier. For example, ABC s ($20) receivables adjustment is associated with an asset, so we interpret it as follows: ($20) = the negative of the net effect of the operating entries that affected accounts receivable during the reporting period = -[net effect of operating entries on receivables]

60 60 Navigating Accounting Step 2 Based on your understanding of the accounting entries that affect the adjustment and the company s accounting policies, replace the expression inside the bracket with these entries effects. Consider the most common entries that have the biggest impact on increasing and decreasing the account. Add a place holder for the net effect of other operating entries. Here is how this step applies to the example: ($20) = -[net effect of operating entries on receivables] = -[sales on account - collections + net effect of other operating entries on receivables] As you learn more entries, you will increasingly replace net effect of other operating entries with the effects of new entries and gain a deeper interpretation. Step 3: Based on your understanding of the business context, determine whether it is reasonable to assume any of the terms are relatively inconsequential and can be ignored. If there are only one or two terms remaining, you can usually apply an intuitive explanation. For our example, we have assumed ABC has a simple business context and, in particular, that only two operating events affect receivables. Thus, we can ignore the net effect of other operating entries. The right side of the earlier expression simplifies to the following. ($20) = - [sales on account - collections] Because there are only two terms remaining, we can explain the ($20) receivables adjustment intuitively: it reverses the amount by which the revenues included in net income exceed the collections included in cash from operations. As you learn more about business contexts, you will increasingly become more adept at deciding when it is reasonable to ignore entries effects on adjustments and thus when intuitive explanations are valid.

61 Cash change Assets cash +other assets = liabilities + permanent OE+ temporary OE Zero Owners' Equity Operating Cash Zero Gains & Losses Introduction to Cash-Flow Statements 61 R EP O RT I N G Liabilities Owners' Equities i s Tr Bal Cls IS Cls RE End Bal Direct Cash Flows Balance Sheets Income Statements Operating Assets Revenue Investing Liabilities Expenses R E C = + O RD Beg Bal E nt r e K E E P I N G Financing Reconciliations Net Income Adjustments Net Income Record Keeping and Reporting Icon This exercise helps you meet the insider record keeping and reporting challenge. Exercise 3.03 This exercise extends the CreativeABC exercise in an earlier chapter. Here the focus changes from the company s first month of operations to the second month, January. Here are the entries for the month of January: E1 E2 E3 E4 E5 CreativeABCs declares and pays a $100 dividend. CreativeABCs sells debt securities for $1,500 cash. CreativeABCs buys inventories on account from TrustySupplier for $5,000. CreativeABCs sells inventories that cost $2,000 for $5,000 on account. The company recognizes revenues when sells occur. CreativeABCs pays Nick, its only employee, $1,100. $500 is for services rendered in December and $600 for services rendered from January 1-January 15th. E6 CreativeABCs pays TrustySupplier $6,250. E7 E8 E9 CreativeABCs pays its landlord $800 for store space rented during January. CreativeABCs collects $4,930 from customers for previously recognized revenues associated with sales on account. CreativeABCs receives $25 cash for interest earned during January on the debt securities purchased on December 2. E10 At the end of the month, Nick determines that CreativeABCs owes him $600 for services rendered from January 16th through January 31st. E11 At the end of the month, Nick learns the fair values of the debt securities are the same as they were on the dates they were purchased. He also expects that all outstanding receivables will be collected. E12 At the end of the month, CreativeABC owes the government income taxes for January, which will be determined by multiplying its income before taxes for January by 40%. By the end of January, CreativeABC had still not paid the taxes for December. CreativeABC s balance sheet at the start of January and its chart of accounts are provided on the next page. Exercise questions, parts (a)-(e), are on the following pages. Solutions are at the end of the chapter.

62 62 Navigating Accounting CreativeABC COMPANY BALANCE SHEETS (In Thousands) Assets 31-Dec-10 Current Cash $2,430 Accounts receivable 2,300 Short-term investments 5,500 Inventories 3,000 Total current assets 13,230 Noncurrent 0 Total assets $13,230 Liabilities and Stockholders' Equity Liabilities Current Accounts payable $2,500 Accrued compensation and benefits 500 Income taxes payable 92 Total current liabilities 3,092 Non-current 0 Total liabilities 3,092 Stockholders' equity Common stock 10,000 Retained earnings 138 Total stockholders' equity 10,138 Total liabilities and stockholders' equity $13,230 ASSETS Current AR C Inven StInv LIABILITIES CreativeABC Company Chart of Accounts Accounts receivable Cash Inventory Short-term investments Current AP Accounts payable AcCB Accrued compensation & benefits TaxP Taxes payable OWNERS' EQUITY Permanent CS Common stock (non-par) RE Retained earnings Net income Cgs Cost of goods sold MG&A Marketing, general & administrative expense IncS Income summary Intinc Interest income Rev Revenues, net TxExp Tax expense

63 Introduction to Cash-Flow Statements 63 Part (a) Record all entries for the month of January and determine all balances in the BSE matrix: CreativeABC Company BSE for Entries E1-E12 and Closing for January 1-31, 2011 Owners' Equity Assets = Liabilities + Permanent + Net income + C + AR + StInv + Inven = + AP + AcCB + TaxP + CS + RE + Rev - Cgs - MG&A + Intinc - TxExp + IncS December 31, = E3 Purchase inventory on account = E4a Recognize revenue = E4b Recognize cost of sales = E5 Pay wages for Dec 16- Jan = E6 Supplier payments = E7 Pay landlord for January rent = E8 Customer collections = E9 Interest earned = E10 Unpaid wages for Jan 15- Jan = E12 Recognize tax expense = = E2 Sell debt securities = Total investing = E1 Declare and pay dividend = Total financing = Financing Operating Total operations Investing Trial balance = Closing to and from income summary = = January 31, =

64 64 Navigating Accounting Part (b) Record all journal entries for the month of January, including the closing entries: CreativeABC Company: Recording Journal Entries for January, 2011 E1 Declare and pay dividend E2 Sell debt securities Debit Credit Debit Credit E3 Purchase inventory on account E4a Recognize revenue Debit Credit Debit Credit E4b Recognize cost of sales E5 Pay wages for Dec 16- Jan15 Debit Credit Debit Credit E6 Supplier payments E7 Pay landlord for January rent Debit Credit Debit Credit E8 Customer collections E9 Interest earned Debit Credit Debit Credit E10 Unpaid wages for Jan 15- Jan 31 E12 Recognize tax expense Debit Credit Debit Credit C1: Income summary C2: Close income to retained earnings Debit Credit Debit Credit

65 Introduction to Cash-Flow Statements 65 Part (c) Complete the T-accounts for January, including beginning and ending balances: CreativeABC Company: Recording T-accounts for January, 2011 C AR StInv Inven AP AcCB TaxP CS RE Rev Cgs MG&A Intinc TxExp IncS

66 66 Navigating Accounting Part (d) Complete the balance sheets, income statement, and statement of owners equity: CreativeABC Company Balance Sheets Assets 31-Jan Dec-10 Current Cash Accounts receivable Short-term investments Inventories Total current assets Non-current Total assets Liabilities and Stockholders' Equity Liabilities Current Accounts payable Accrued compensation and benefits Income taxes payable Total current liabilities Non-current Total liabilities Stockholders' equity Common stock Retained earnings Total stockholders' equity Total liabilities and stockholders' equity CreativeABC Company Income Statement January 1 - January 31, 2011 Operating profit Revenues Cost of sales Marketing general and administrative Income from operations Non-operating profit Interest income Profit before taxes Income tax expense Net profit Other comprehensive income 0 Comprehensive income CreativeABC Company Statement of Changes in Owners' Equity (In Thousands) December 31, 2010 Comprehensive income Net profit Other comprehensive income Total Common stock issued January 31, 2011 Common stock Retained earnings Reserves Total

67 Introduction to Cash-Flow Statements 67 Part (e) Complete the direct and indirect cash-flow statements: CreativeABC Company Direct Cash Flow Statement January 1 - January 31, 2011 Operating Activities Sales collections Supplier payments Compensation payments Rent payments Interest received Net cash from operations Investing Activities Sell debt securities Net cash (used) for investing Financing Activities Declare and pay dividends Net cash from financing Change in cash Beginning cash balance Ending cash balance CreativeABC Company Indirect Cash Flow Statement January 1 - January 31, 2011 Operating Activities Net profit Receivables Inventories Accounts payable Accrued compensation & benefits Taxes payable Net cash from operations Investing Activities Sell debt securities Net cash (used) for investing Financing Activities Declare and pay dividends Net cash from financing Change in cash Beginning cash balance Ending cash balance

68 68 Navigating Accounting HOW DO I USE THE NUMBERS? At the start of the chapter we indicated that the indirect cash flow statement can be a valuable resource for assessing the quality of a company s income how useful it is for predicting future performance. Understanding the reconciliation adjustments in terms of the underlying business and accounting issues is the key to these analyses. In concept, if income is measured reliably it should be a better predictor of future performance than current cash flows because it reflects the expected impact of current events and circumstances on future cash flows. For example, income often reflects sales on account that have yet to be collected at year-end but are reasonably assured of being collected in the future. Of course, the key assumption here is that the receivables will be collected in the future. When this is not true, the quality of the revenues and receivables is poor. This can occur if a company starts extending credit to risky customers to ensure it meets its performance targets, or worse yet begins to fabricate sales on account to make-believe customers. When these situations are extreme, there is a red flag (warning) in the reconciliation adjustments. The receivables adjustment becomes much more negative than in the past (because receivables are increasing). However, an increase in receivables can be beneficial if a company fully expects to collect on the sales. Red flags, such as increases in receivables, are signals to dig deeper into the numbers. To determine whether they are good or bad news, you need to understand the underlying events and circumstances and the accounting decisions that determined how they were measured and reported. The better you understand the entries behind reconciliation adjustments, the more prepared you will be for these analyses. Almost every accounting decision requiring judgment affects one or more reconciliation adjustments. This includes many decisions associated with revenue recognition, expense recognition, and gains and losses recognition. However, remember, these judgments are a two-edged sword: they allow honest and competent managers an opportunity to convey useful information through accounting decisions, and dishonest managers an opportunity to commit fraud. Most managers fall somewhere between these extremes and your task as an informed outsider is to identify red flags, generate as many hypotheses as possible about what is behind them, and use logic and facts to validate or refute these hypotheses.

69 Introduction to Cash-Flow Statements 69 Analyzing Recent Cash Flows Over the long run, companies perform for shareholders to the extent net cash from operations exceeds the cash outflows required to maintain and grow the business and to meet debt obligations. To assess recent progress towards this end, users often rearrange items reported on cash-flow statements, as indicated on the next page for Intel and AMD, or create other tables along similar lines to assist in their analysis. The modified cash-flow statements illustrate that Intel s operating cash flows have been much stronger over the past three years than those of its biggest competitor, AMD and that Intel s cash reserves are much larger. Net cash from operations The first row in the modified statements reveals net cash from operations is positive all three years for Intel but negative for AMD in Operating cash flow deficits (e.g., negative net cash from operations) are often red flags for investors, meaning situations where healthy skepticism and further inquiry is warranted. Operating deficits must be covered by cash reserves, selling assets, or by issuing debt or common stock. Successful companies often have operating deficits when they are growing quickly, especially during their early years. Operating deficits are also common when there are downturns in the economy. However, operating deficits can also signal problems: sooner or later companies have to generate positive operating cash flows to stay in business and return cash to their investors. Net cash provided from operations before interest and taxes Investors often assess performance before interest and taxes. Adjusting for interest allows investors to compare operating performance across companies with different levels of debt financing. Adjusting for taxes allows them to focus on management s performance in running the company independent from their tax strategies, over which they have limited control. You may have heard of a similar adjustment on income statements called EBIT earnings before interest and taxes, or of a related measure called EBITDA earnings before interest, taxes, depreciation, and amortization, which we will discuss later. Intel s tax payments were significantly larger than AMD s over the three years, reflecting its larger size and superior profitability. (For reasons that are well beyond the scope of this chapter, Intel also has an adjustment for excess tax credits associated with share-based compensation.)thus, the tax adjustments are more significant for Intel. By contrast, notwithstanding its smaller size, AMD paid more interest each year, especially in As we shall see shortly, AMD increased its debt significantly over this period.

70 70 Navigating Accounting Intel Cash Flow Analysis Three Years Ended December 29, 2007 (In Millions) Net cash from operations 12,625 10,632 14,851 + Interest payments Income tax payments 2,762 2,432 3,218 + Excess tax benefit from share-based payment arrangements Net cash from operations before interest and taxes 15,520 13,212 18,096 - CAPX and intangibles needed to maintain current capacity (estimated as depreciation and amortization) (4,798) (4,912) (4,595) Cash surplus (shortfall) after maintaining current capacity, pretax and prefinancing 10,722 8,300 13,501 - Interest payments (15) (25) (27) - Income tax payments (2,762) (2,432) (3,218) - Principal payments on long-term debt and notes payable (581) (19) - Short-term debt payments in excess of short-term borrowings (39) (114) 0 Cash surplus (shortfall) after maintaining current capacity and paying debt and taxes 7,906 5,148 10,237 - Cash purchases of PP&E to both maintain and expand capacity, net of disposals (5,000) (5,860) (5,871) - Net cash purchases of other long term assets to both expand and maintain capacity (estimated by net of all other investing cash flows except those related to securities) (309) + Cash outflows to maintain capacity ( as reported above) 4,798 4,912 4,595 Cash surplus (shortfall) after maintaining and expanding capacity and paying debt and taxes 7,954 4,919 8,652 - Share repurchases (2,788) (4,593) (10,637) - Cash dividends (2,618) (2,320) (1,958) Cash surplus (shortfall) before new financing and securities transactions 2,548 (1,994) (3,943) New financing + Proceeds from issuing capital shares 3,052 1,046 1,202 + Proceeds from issuing long term debt 125 1,742 + Short-term borrowings in excess of short-term debt payments Securities transactions + Proceeds from selling investment securities and maturities 8,011 7,147 8,433 - Purchases of investment securities (13,187) (6,994) (8,668) Other cash flows Net increase (decrease) in cash 709 (726) (1,083) AMD Cash Flow Analysis Three Years Ended December 29, 2007 (In Millions) Net cash from operations (310) 1,287 1,483 + Interest payments Income tax payments Net cash from operations before interest and taxes 30 1,383 1,662 - CAPX needed to maintain current capacity (estimated as depreciation and amortization) (1,305) (837) (1,219) Cash surplus (shortfall) after maintaining current capacity, pretax and prefinancing (1,275) Interest paid (314) (79) (139) - Income taxes paid (26) (17) (40) - Principal payments on long-term debt and capital lease obligations (2,291) (539) (316) - Purchase of capped call (182) - Other financing (2) (7) Cash surplus (shortfall) after maintaining current capacity and paying debt and taxes (4,090) (89) (59) - Cash purchases of PP&E to both maintain and expand capacity, net of disposals (1,612) (1,834) (1,503) - Net cash purchases of other long term assets to both expand and maintain capacity 175 (3,416) (41) (estimated by all other investing cash flows except those related to marketable securities) + Cash outflows to maintain capacity ( as reported above) 1, ,219 Cash surplus (shortfall) after maintaining and expanding capacity and paying debt and taxes (4,222) (4,502) (384) - Repayment of silent partner contributions (46) 0 0 Net cash inflows (outflows) before new financing (4,268) (4,502) (384) New financing + Proceeds from issuance of common stock Proceeds from sales of shares through employee equity incentive plans Short-term borrowings in excess of short-term debt payments Additions to long-term debt and notes payable to bank 3,649 3, Proceeds from limited partners and sale leaseback Proceeds from government grants and subsidies Marketable securities transactions Purchases of available-for-sale investments (545) (2,119) (1,562) Maturities and sales of available-for-sale investments 307 3, Other cash flows 7 Net increase (decrease) in cash (286) Sources: Intel s K and AMD s K

71 Introduction to Cash-Flow Statements 71 Cash surplus (shortfall) after maintaining current capacity, pretax and prefinancing This measure assesses the extent to which operating cash flows are adequate enough to maintain the current operating capacity. Ideally, it is the amount spent on PP&E and other long-term assets during the current year to maintain the current level of sales and profitability. This measure allows investors to isolate the effects of growth. For example, they can split the current cash outflows for PP&E additions into two components: the cash needed to maintain capacity and the cash needed to expand capacity (included below). Outsiders do not observe this measure so they must estimate it from reported information. One approach, which we have followed, is to use the current year s depreciation and amortization as a proxy for the expenditure needed to maintain capacity. The rationale for this proxy is that depreciation and amortization measure current period usage of longterm assets and this usage must be replaced to maintain capacity levels. Intel s pretax-prefinancing operating cash flows are significantly more than is needed to cover depreciation and amortization for the three years. AMD s operating cash flows covered capacity maintenance for but fell short by $1,275 in Cash surplus (shortfall) after maintaining current capacity and paying debt, and taxes If companies can not maintain their current operating capacity and can not meet their current obligations to debt holders and tax authorities, investors are likely to be skeptical about making contributions to finance growth. This skepticism can be overcome if investors believe there are great products in the pipeline or other reasons to believe the company will generate more cash in the future than it has in the past. For Intel s operating cash flows easily covered its expenditures to maintain current capacity, pay taxes, and meet debt obligations. By contrast, AMD has a $4,090 deficit after these cash outflows in Cash surplus (shortfall) after maintaining and expanding current capacity and paying debt, and taxes When this measure is positive, as it is for Intel in all three years, it means the company is financing its growth internally from operating cash flows. Any remaining cash flows can be returned to owners or invested in securities that can be liquidated in the future to cover growth or weather downturns. For the three years , Intel generated a total of $21,525 for these purposes. By contrast, AMD had a total deficit of $9,108 during these three years that had to be covered by new financing.

72 72 Navigating Accounting Cash surplus (shortfall) before new financing and securities transactions This is the current-year cash flow after distributions to owners but before new financing. When it is positive, as it was for Intel in 2007, it means the company has held back cash flows that otherwise could have been distributed to owners. When this measure is negative, it means the company had to cover the total net outflows for the current year, including returns to owners, by a combination of liquidating securities purchased in prior years, using cash balances carried over from prior years, or securing external financing. For Intel, the measure was negative in 2005 and 2006 because Intel returned over $19.5 billion to owners through dividends or stock repurchases. For AMD, the measure was negative for all three years because of cash outflows discussed earlier. In fact, aside from a relatively insignificant return of $46 million to a silent partner, AMD did not return any cash to its owners during the three years. Net increase (decrease) in cash Intel s employees provided a total of $5,300 of new financing during the three years by exercising stock options or otherwise exchanging cash for shares. Intel also issued $1,742 of long-term debt in 2005 but only issued a total of $125 during 2006 and By contrast, during 2006 and 2007 AMD issued $7,015 of long-term debt and $1,103 of common stock, and received an additional $309 from employees related to sharebased incentive programs. Thus, AMD is increasingly relying on debt financing. When net cash flows after new financing is positive, it is used to build cash reserves or increase investments in securities. By contrast, when it is negative, cash reserves or investment balances must be used to cover the shortfall. Cash Flow Analysis and Company Life Cycles We have seen that Intel s operating cash flows were much stronger than AMD s during , which probably more than anything else reflects the fact that Intel significantly outperformed AMD in the battle for market share in microprocessor chips. The consequences for AMD show up throughout its financial statements, but as we have seen they are particularly evident on the cash-flow statement. Cash flow analyses like the one we conducted become increasingly important to investors when companies perform poorly over prolonged periods and respond by increasing debt, as AMD did. This is particularly true when credit markets are tight, as they were during late 2007 and 2008.

73 Introduction to Cash-Flow Statements 73 The closer companies get to bankruptcy or liquidation, the more investors tend to focus on cash flows and product pipelines. In fact, the focus on cash flows tends to be most pronounced at the two extremes of companies life cycles. Venture capitalists and entrepreneurs focus almost exclusively on cash flows during the early years of a new venture and, in particular, on the rate at which cash is used the burn rate. The critical concern is whether the company will run out of cash before it has time to launch products and win over customers. Intel s investors do not have this concern because Intel s operating cash flows far exceed its cash needs. More generally, as companies progress through their life cycles, their operating cash flows tend to cover more of the costs we discussed earlier: Early on cash from operations is negative. The company succeeds by first generating positive operating cash flows, then positive cash flows that cover capacity maintenance costs, and so on. If the company starts performing poorly, this process can begin to reverse itself and the lack of cash can ultimately lead to liquidation. Assessing the Quality of Earnings The indirect cash-flow statement can be a valuable resource for assessing the quality of a company s income how useful it is for predicting future performance. Understanding the reconciliation adjustments in terms of the underlying business and accounting issues is the key to these analyses. In concept, if income is measured reliably it should be a better predictor of future performance than current cash flows because it reflects the expected impact of current events and circumstances on future cash flows. For example, income often reflects sales on account that have yet to be collected at year-end but are reasonably assured of being collected in the future. Of course, the key assumption here is that the receivables will be collected in the future. When this is not true, the quality of the revenues and receivables is poor. This can occur if a company starts extending credit to risky customers to ensure it meets its performance targets, or worse yet begins to fabricate sales on account to make-believe customers. When these situations are extreme, there is a red flag (warning) in the reconciliation adjustments. The receivables adjustment becomes much more negative than in the past (because receivables are increasing). However, an increase in receivables can be beneficial if a company fully expects to collect on the sales. Red flags, such as increases in receivables, are signals to dig deeper into the numbers. To determine whether they are good or bad news, you

74 74 Navigating Accounting need to understand the underlying events and circumstances and the accounting decisions that determined how they were measured and reported. The better you understand the entries behind reconciliation adjustments, the more prepared you will be for these analyses. Almost every accounting decision requiring judgment affects one or more reconciliation adjustment. This includes many decisions associated with revenue recognition, expense recognition, and gains and losses recognition. As you learn new entries in later chapters, you will become increasingly adept at interpreting the reconciliation adjustments, and thus at assessing the quality of earnings. For now, we are going to focus mainly on ABC company, where you understand the entries. Still, seeing how to interpret ABC s reconciliation adjustments will help you begin to learn how to interpret real companies adjustments. In fact, when appropriate, we will explain how the ABC analysis applies to Intel and other companies. ABC Company Indirect Statement of Cash Flows Operating Activities Net Income $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40 Net cash from operations ($10) Outsiders analyzing ABC s financial statements would want to determine how concerned they should be about the $10 first year operating cash deficit. To the extent they conclude the $40 of net income the first year s performance measure signals solid future performance and positive future operating cash flows, they will be less concerned about the operating deficit. To this end, they will want to assess the quality of the current year s income, meaning how well it measures what it is intended to measure (performance), and they are going to want to assess the extent to which the first year s income is a good predictor of future income and cash flows. To understand how ABC s four adjustments affect the reconciliation, outsiders need to know the operating events that affect them and how these events affect net income and cash from operations. That is, as an outsider, you need to understand the earlier discussion.

75 Introduction to Cash-Flow Statements 75 You also need to know how to assess the combined or net effect of all entries associated with each reconciliation adjustment, and how to interpret this net effect in terms of the underlying events and circumstances. Depreciation adjustments Depreciation is a common reconciliation adjustment on cash-flow statements. For companies such as ABC that do not manufacture the products they sell, the depreciation adjustment simply reverses depreciation expense recognized in net income that does not affect net cash from operations. Regarding the quality of earnings, a dishonest manager who wishes to manipulate income can do so by reducing depreciation expense, providing he can deceive auditors, the SEC, and users. But, doing so will decrease the depreciation adjustment and a skeptical user of the company s financial statements will view a large decrease in this adjustment from one year to the next as a signal for further investigation. This does not mean managers are necessarily manipulating income every time they reduce depreciation expense. There are very valid reasons for doing so. For example, if a company believes an asset will last longer than originally expected, it can reduce its annual depreciation. Because of the potential for manipulation and honest errors estimating usage, auditors, investors, regulators and other outsiders generally get very skeptical when depreciation numbers deviate much from industry norms. This is good and bad news. The good news is manipulation and honest errors associated with depreciation are mitigated. The bad news is companies that use their assets differently than others in the industry and would report this usage accurately feel compelled to conform to the industry norms. In the limit, if all companies in the industry report the same depreciation, this measure is not longer useful for comparing companies within the industry. Ultimately, a user must assess the extent to which reported depreciation is a good (bad) measure of usage and this assessment will affect his overall assessment of the quality of the company s earnings and his prediction of its future cash flows. For example, if a company decreases its depreciation and the user concludes that depreciation is an excellent measure of usage, he can reasonably infer that either: (1) the cash outflows to replace the related PP&E will be deferred because the PP&E will last longer; or (2) if the PP&E will be replaced at the same time as originally planned, less cash will be needed because the trade-in value will be larger.

76 76 Navigating Accounting This discussion relates to a widely used performance measure mentioned earlier: EBITDA, or earnings before interest, taxes, depreciation, and amortization. This measure removes depreciation and amortization from income. Investors who use this measure rather than earnings are indicating, perhaps implicitly, that depreciation and amortization diminish the quality of earnings. Receivables adjustments Net income differs from cash from operations when revenues, recognized in net income, differ from cash collections, recognized in net cash from operations. We have seen that this difference explains the receivables adjustment for companies like ABC that recognize revenue when customers are billed. Again, regarding the quality of earnings, a dishonest manager can manipulate income by billing customers and recognizing revenues before goods are delivered to customers or otherwise meet customer specifications. Worse yet, in a few notorious cases managers have fraudulently recognized revenues by billing customers who did not exist and shipping merchandise to secret locations. In these examples of deceit, revenues are much larger than cash collections and large negative receivables adjustments are needed to reconcile net income to cash from operations. A healthy skeptic will view a large negative receivables adjustment (relative to past years or competitors adjustments) as a signal for further investigation. Again, keep in mind that there can be perfectly valid reasons for unusually large increases in accounts receivable so this does not necessarily signal manipulation. For example, an honest and competent manager facing an abrupt downturn in the economy and increased credit risk can end up with a comparable adjustment. After a careful investigation, to the extent that the skeptic concludes that the increase in receivables will (not) be collected in a timely basis, she will infer that the company s revenues are of high (low) quality. This assessment will affect her overall assessment of the quality of the company s earnings and her prediction of future cash flows. Inventories and accounts payable adjustments It is easier to interpret the combined effect of the inventories and payables adjustments before interpreting them separately. Recall, ABC recognized $20 cost of sales, which had a ($20) effect on income, but it paid its vendors $60, which had a ($60) effect on net cash from operations. A ($40) adjustment is needed to reconcile the ($20) income effect of cost of sales to the ($60) cash from operations effect of the

77 Introduction to Cash-Flow Statements 77 vendor payments. This combined ($40) adjustment indicates that ABC paid $40 more for inventories than it expensed as cost of good sold. Similar to receivables, unusually large increases in inventories signal a need for a thorough investigation of related business and accounting issues. For example, if inventories start increasing because sales fall off, a company may need to decrease the sales prices below cost to unload the inventory. When companies anticipate this, GAAP requires that they write down the value of the inventory on their balance sheet at year end. The entry decreases inventories and increases cost of sales, indicating the future benefits associated with the inventories have decreased. Determining whether inventories should be written down takes considerable judgment, leaving room for honest errors and manipulation. When companies fail to write down inventories, the result is higher inventories than are appropriate and thus a more negative inventories reconciliation adjustment than is appropriate. As a result, investors should exhibit a healthy degree of skepticism about inventories adjustments during periods when demand for a company s products are declining. To summarize, collectively ABC s four reconciliation adjustments meet the second purpose of cash-flow statements they help users reconcile differences between net income and cash from operations, which helps them assess the quality of net income and predict when income will be converted to cash.

78 78 Navigating Accounting Usage Icon This exercise helps you learn how accounting reports are used by investors, creditors, and other stakeholders. Search Icon This exercise helps you search for information Exercise 3.04 Figure are balance sheets, income statements, and cash-flow statements for Yum! Brands, which owns several prominent restaurant brands including Kentucky Fried Chicken, Taco Bell, Pizza Hut, A&W, and Long John Silvers. Figure 3.05 is the Supplemental Cash Flow Data footnote from its 2001 Annual Report. The company changed its name from Tricon Global Restaurants to Yum! Brands on May 16, Solutions are at the end of the chapter. (a) True or False: The balance sheet change in Cash and cash equivalents during 2001 is reported on the 2001 cash-flow statement. (b) True or False: The net income recognized on the income statement is the same as the top line in the operating section of the cash-flow statement. (c) True or False: Income tax expense was $241 for (d) True or False: As indicated on the balance sheet, income tax payments were $114 for (e) True or False: As indicated on the income statement, the Company likely collected $6,953 from its customers during (f) True or False: As indicated on the balance sheet, the Company purchased $237 of PP&E during 2001 ($2,777 - $2,540). (g) True or False: As indicated on the income statement, the Company likely paid $1,908 for food and paper during (h) True or False: As indicated on the cash-flow statement, the Company received $116 in cash during 2001 from accounts and notes receivable collections. (i) True or False: The Company received $111 cash during 2001 by selling restaurants to franchisees. (j) True or False: The Company received $842 of cash when it issued senior unsecured notes during (k) True or False: Shareholders sold some of their shares to the Company during 2001 for $100. (l) True or False: The Company spent $3 during 2001 on prepaid expenses and other current assets. (m) True or False: The deferred provision of the 2001 tax expense was ($72).

79 Introduction to Cash-Flow Statements 79 Usage Icon This exercise helps you learn how accounting reports are used by investors, creditors, and other stakeholders. Search Icon This exercise helps you search for information Exercise 3.05 Figures are balance sheets, income statements, and cash-flow statements for Yum! Brands, which owns several prominent restaurant brands. Figure 3.05 is the Supplemental Cash Flow Data footnote from the 2001 Annual Report. Figure 3.06 is a five-year summary of select financial data. The company changed its name from Tricon Global Restaurants to Yum! Brands on May 16, Tricon was formed in 1997 when Pepsico established a new company comprised of Kentucky Fried Chicken, Taco Bell, and Pizza Hut. At this time, Tricon paid $4.5 billion to Pepsico as repayment of certain amounts due to Pepsico and as a dividend. Tricon borrowed extensively to raise the cash to make this payment to Pepsico and, as a result, was highly leveraged at the end of 1997 (in millions): Assets $5,114 Liabilities $6,734 Owners equities ($1,620) Refranchising restaurants became an important element of Tricon s strategy to reduce its debt and increase its profitability. Refranchising involves selling restaurants and establishing franchise agreements with the new owners. Tricon s strategy was to sell the restaurants and use the proceeds to help pay down its debt and to put the restaurants in the hands of local owners who could run them more efficiently in some locals. Among other things, franchise agreements specify the royalties that franchisees must pay to Tricon in exchange for the right to use Tricon s brands, operating procedures, and other expertise. An example will help you understand how refranchising affects income statements. Assume that prior to refranchising, Tricon earns $4 of operating income on a $10 sale: Revenue $10 Cost of food ($4) Other costs ($2) If Tricon receives a 5% royalty after refranchising, it will earn $0.50 of operating income each time a franchisee has a $10 sale and will not bear any of the cost. While operating income will decrease, Tricon reduces its investment in restaurants and other assets considerably by refranchising. As a result, it is possible that refranchising could increase Tricon s return on invested capital. The second panel from the bottom of Figure 3.06 on page 90 indicates that the number of franchised restaurants increased from 15,097 at

80 80 Navigating Accounting the end of 1997 to 19,263 at the end of 2001, and that the number of restaurants owned by Tricon (Company stores) decreased from 10,117 to 6,435 during this period. The other panels in this figure provide other information you will need to address the following questions. The questions center on the financial-statement consequences of Tricon s strategy to sell stores to franchisees to generate cash to reduce its debt. Solutions are at the end of the chapter. (a) Identify balance-sheet information in the five-year summary that reflects the execution of this strategy. Note that Tricon defines operating working capital deficit to be current assets excluding cash and cash equivalents and short-term investments, less current liabilities excluding short-term borrowings. (b) Identify income-statement information in the five-year summary that reflects the execution of this strategy. (c) Identify cash-flow-statement information in the five-year summary, Tricon s cash-flow statements, and the Supplemental Cash Flow Data footnote that reflects the execution of this strategy. (d) Facility actions net loss (gain) consists primarily of gains and losses from selling restaurants to franchisees. Estimate the pretax net increase in Tricon s assets during 1999 from selling restaurants to franchisees. Estimate the amount that was recognized on Tricon s balance sheet for the assets coming in and the assets going out. (e) Which line items in the statement of cash flows in Figure 3.04 were directly affected by recognizing the sale of a restaurant? (f) Estimate the combined sales for the franchisees and licensees during (g) Estimate the average royalty rate that the franchisees and licensees were charged by Tricon during (h) Complete the three tables at the top of the next page for Start with the bottom table since you will need it for the computations in the other tables. The top table is the Dupont model. The second table is return on assets, ROA, defined as net income divided by average assets.

81 Introduction to Cash-Flow Statements 81 Profit margin Turnover Financial Leverage (1-tax rate) ROE Yum! Brands (Tricon) ROA Net revenues Income before taxes Tax expense Net Income Beginning total assets $6,520 Ending total assets Average total assets Beginning owners' equity ($322) ($560) ($1,163) ($1,620) $4,239 Ending owners' equity Average owners' equity (i) Why is the Dupont model inappropriate for analyzing Tricon s performance during ? (j) Similar to the Dupont model, ROA can be factored into profit margin times turnover times the tax factor. Thus, ROA does not depend on financial leverage. Did ROA improve each year as a result of the strategy? Did profit margins improve each year? Did turnover improve? (k) Tricon s profit margin s were affected by gains and losses on facility actions during Complete the following table to adjust profit margins for these gains and losses. What do the adjusted profit margins tell you about the success of the strategy? Yum! Brands (Tricon) Profit margin 10.54% 9.64% Adjusted profit margin 10.56% 7.16% Net revenues $6,953 $7,093 Income before taxes $733 $684 Facility actions (loss) gain ($1) $176 Adjusted pretax income $734 $508

82 82 Navigating Accounting Usage Icon This exercise helps you learn how accounting reports are used by investors, creditors, and other stakeholders. Search Icon This exercise helps you search for information Computation Icon This exercise helps you learn how to compute numbers for your analyses using formulas and financial statement information. Exercise 3.06 This exercise pertains to the cash-flow statements for Cisco and Starbucks in Figures on pages 91 and 92, respectively. It also pertains to their income statements which are in Figures 2.02 and 2.04 in Chapter 2. Solutions are at the end of the chapter. (a) True or False: Cisco disclosed a $149 provision for inventories on its statement of cash flows that is an expense that is not disclosed on the income statement. Hint: The provision is associated with recognizing an inventories impairment. (b) True or False: The government allowed Cisco to take a $61 deduction on its income tax form because employees exercised stock options during 2002? (c) Estimate the cash that Cisco spent on in-process research and development during (d) Estimate the amount of Cisco 2002 tax expense that is due to income recognition timing differences between financial and tax reporting. (e) In total, how much did Cisco save during fiscal years because the government permits companies to deduct stock options as compensation? (f) Assuming a 35% tax rate, what would Cisco have reported as pretax income for fiscal 2000 if GAAP required companies to expense the same amount of compensation related to stock options as they deduct for tax reporting. (g) Estimate the combined depreciation and amortization that Starbucks charged to production during (h) True or False: Starbucks paid $41,379 for inventories during (i) True or False: Starbucks disclosed a $26,852 Provision for impairment and asset disposals on its statement of cash flows that is a loss that is recognized but not disclosed on the income statement. (j) How does Starbucks $2,940 adjustment in 2001 for Internetrelated investment losses help reconcile net income to net cash from operations? (k) How much cash did Starbucks employees give to the Company when they exercised stock options during fiscal 2002.