Cash Flow Statements » What’s Behind the Numbers? » Cash Flow Basics » Express Video
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Express Video Transcript
Cash Flow Statements: Basics
Topics

New Balance Sheet Equation (BSE) matrix with operating, investing, and financing
classifications

Statement of Cash Flow (SCF) effects:

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Entry by entry
-
Grouping related entries
Reconciliation equation:
-
Connection to BSE matrix
-
Adjustment signs

New Record-Keeping and Reporting (R&R) Map

Limitations & possible violations of simplified assumptions of EasyLearn Company for
real companies

Take-aways
Transcript
Introduction
Welcome to the basics express route for what’s behind the numbers. This video will help you
understand how items reported in cash flow statements connect to the purpose of the
statement, the underlying business activities in accounting judgments, and to numbers
reported in other financial statements. We will develop most of the concepts you need to
interpret cash flow statement numbers using a tutoring company, EasyLearn, that has only
five entries, all of which you’ve learned in earlier chapters.
Here’s our agenda and we’re going to move quickly through this video. If you want some of
these concepts explained more slowly, watch the scenic routes discussed near the end of the
video.
We’re going to begin by showing some modifications to the BSE matrix, then we’ll discuss a
two-step process for figuring out how entries affect statements of cash flow, and we’re going
to look at the reconciliation equation, which is going to give us insights about the
reconciliation adjustments on the indirect cash flow statement. Then, we’ll show how our
R&R map has been modified by the addition of the direct and indirect cash flow
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statements. And then we’re going to look at some limitations to the simplified assumptions in
EasyLearn, and some possible violations in practice, and then finally some takeaways. So
let’s get started.
New Balance Sheet Equation (BSE) matrix with operating, investing, and financing
classifications
We made a few modifications to the BSE matrix. First and foremost, entries are now
classified as operating, investing, or financing. This is EasyLearn’s matrix. EasyLearn doesn’t
have any investing activities. We’ve also added subtotals, net from operating entries, so that
nets all the entries up here that are operating entries, for example, $5 net effect of the cash.
And then we get net from financing activities. So that’s the key thing we want you to
understand about the new BSE matrix.
Statement of Cash Flow (SCF) effects
Now, let’s look at one of EasyLearn’s entries, E2. We’re going to assume E2 was the only
event that happened during the period, and this is a fiction that we’ll maintain throughout
Navigating Accounting. That’s exactly what we mean by the entry-by-entry approach. Take
each entry and figure out how it affects the various financial statements, and then combine all
of those effects later. Here’s the entry, recognize revenue, and this was a sale on account of
a tutoring service. So revenues went up by $150 and accounts receivable went up by a $150.
Nothing new there, you’ve seen that before.
Now, we’re going to ask a series of questions that are going to help us get insights about the
various financial statements. What would EasyLearn report on its income statement if this
was the only entry it recorded? Well, first of all, it would have $150 of revenues. It wouldn’t
have any advertising expense, that’s going to be another entry. And it would have net income
therefore of $150. What would it report on its direct cash flow statement? Well, net cash from
operations would be zero, and the reason it would be zero is we didn’t record anything to
cash up here. The only way an entry affects the direct cash flow statement is if you record
something into cash. And if you record something into cash, it will definitely affect the direct
cash flow statement.
What about the indirect cash flow statement? Well, remember the difference between the
indirect and the direct deals with the reconciliation. We have to explain why net income
differs from net cash from operations. Well, the income effect of this entry was $150. That's
what we got on the income statement. And the cash effect is zero. That's what we got for net
cash from operations on the direct statement. Remember, the direct statement has exactly
the same line items, starting with net cash from operations all the way through the investing
and financing activities. So if we got zero over here because we didn’t record anything to
cash, then the effect on net cash from operations is going to be zero on the indirect
statement.
Now, mathematically, we see the adjustment we need. We need to get from +$150 income
effect to zero cash from operations. Well, in order to explain that mathematically we have to
subtract $150. Now, the question is, how do we know that entry affects the receivables
adjustment rather than, say, the payables adjustment? Well, it’s easy. When you look at the
entry that you recorded it will have an income effect, or not; it will have a cash effect, or not.
Any other account, that is any account that is in the entry other than cash or other than an
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income account, well, that’s where you’re going to get your reconciliation adjustments. And
we’ll explain that in more detail later when we examine the R&R map.
Now, we want to show you a table that we’re going to use to put together all these effects,
what’s called the SCF Reconciliation Table. Here are the numbers that are reported. So this
is what an outsider would see on the statement of cash flow, and that would be you if you’re
looking at a real company. And you see the net income reported for the period, and that’s for
all entries, is $90, receivables adjustment is -$130, payables adjustment $45, net cash from
operations $5. Now, if you’re looking at that as an outsider, you’re trying to understand, well,
what’s going on behind the numbers? And this table, it keeps track of all the things going on
behind the numbers. So for example, for E2 we know net income increased by $150, we
know net cash from operations had zero effect, and we know we had a receivables
adjustment of -$150. That’s what we have up here.
Now, we’re going to do the same thing for all of the other entries, and we can combine the
effects, and that combined effect will explain the reported numbers over here. So now, what
we want to do before we show all those effects is take this one adjustment that we did for the
sale on account and go beyond the mathematics of why the adjustment works and get into
an explanation in terms of what’s going on in the business.
So imagine yourself trying to explain this adjustment to someone who is fairly knowledgeable
about business issues but didn’t understand accounting. Well, the first thing you should
explain to that person is the purpose of the reconciliation, and what it is that income
measures, because when you really understand what you’re trying to measure in income,
well then you’ll know exactly why income differs from cash, keeping in mind that a savvy
business person knows what cash is but they may not realize the complexities that are
behind income.
After you do that, then you’d want to explain the reason income differs from cash. Accounts
receivable, rather than cash, increased by $150 when we recorded this entry. If this had been
a cash sale, income and cash would have been the same. Stated alternatively, the $150
increase in receivables is the reason net income exceeded net cash from operations by
$150. Accordingly, if we want to explain the $150 income effect and why it differs from the
zero cash effect, well then we need to make a reconciliation adjustment that subtracts the
$150 in accounts receivable. And the reason we subtract $150 in accounts receivable is
because we have yet to collect the cash associated with that receivable.
So that’s an explanation that connects what we’re doing up here mathematically back into the
business. You might want to look at the big picture scenic route to try to get a deeper
understanding of what we mean by explaining the purpose of the statement and explain what
income measures because that will really help you get a deeper understanding of what’s
going on in these adjustments.
Entry-by-Entry
Now, we can do the same thing for all the other entries, and that’s what we’ve done here. By
example, when we look at E3 it's customer collections. So accounts receivable goes down by
$20, cash goes up by $20. That event didn’t affect income. So there’s no income effect for
E3. Cash went up by $20 so mathematically, we need an adjustment of $20, and that again
is related to the receivables account. That’s the account that we’ve recorded something into
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in this entry that is not an income account, not a cash account. So that’s how we identify our
adjustment. And again, that’s mechanical. We’ll make more sense of that as we proceed
through the video.
And we can do that for all the other entries. These two entries here deal with the payable and
the fact that we recognize the expense before we paid for it. So we charged it to accounts
payable. That’s event E4. Income effect was -$60. Cash effect was zero. We have to add
$60, but that’s a payable’s adjustment. And then similarly, we pay off $15 of the $60 payable.
And when we do that cash goes down, but there’s no effect over here on income. So in that
case no income effect. Cash goes down by $15. We needed -$15 adjustment to get from
zero down to a -$15.
Now, we can combine all of those effects simply by adding them across. And if we do that,
for example, for receivables we get -$150 plus $150 equals -$130 and that explains the
adjustment. And again, we go through this much slower for the big picture scenic route video.
Grouping Related Entries
Now, what we want to do is go to the second step of determining the SCF entry effects,
grouping. After you figured out each of the individual entry effects, then you combine them,
and the way we do that is you ask yourself what entries explain the adjustment? So for
looking at the receivables adjustment, the two entries are E2 and E3. What would an outsider
see? The outsider will see the -$130. As an insider how could you explain that adjustment?
Well, you’ve got to combine what you learn from these two entries.
Again, if you were to explain this to someone who is a savvy businessperson, you’d first want
to explain the purpose of the reconciliation. You want to tell them what income measures and
how you go about measuring income in your company. And here’s how you then follow up.
You’d begin by explaining EasyLearn's revenue recognition policy and its implications for the
receivables reconciliation adjustments. So you’re going to tie the accounting and what
happened in the business into that reconciliation adjustment. Here it is. We recognize
revenue and a receivable at the time tutoring services are rendered and collect the
receivable at a later date.
So that’s our policy. We’ve seen those before. During their current reporting period, the net
effect of these operating entries on receivables was $130 increase. And the reason why
there was a $130 increase is accounts receivable, if we look at, went up by $150 on sales on
account, went down by $20 for collections, so the net effect was $130. When there’s a net
increase in accounts receivable like $130, it means we recognize more revenue, $150, then
we collected, and thus that we recognized more income than cash from operations.
Well, that’s the explanation. You’re trying to explain why income differs from cash, its
because you recognized more revenues than cash collected and that’s reflected in your
accounts receivable increase. Accordingly, the $130 net increase in accounts receivable
related to operating entries must be subtracted from the $150 revenue recognized in net
income to reconcile that $150 to the $20 customer collections reflected in net cash from
operations.
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So here’s your business explanation for the mathematics that’s going on in the table up here.
And again, this is really important and this will be explained more slowly in the big picture
scenic route video along with all these other adjustments.
Now, we want to tie the table that we’ve created to the BSE matrix. We start with the
accounts payable adjustment. If you look at the accounts payable adjustment, the numbers in
the BSE matrix exactly match the numbers up here in the table. For example, when we
recognized expense of $60 over here, advertising expense, we increased accounts payable
by $60 and the adjustment for payables was exactly $60, so they match. And when we paid
off the payables, accounts payable went down by $50, and then the adjustment was -$15. So
there’s a one-to-one correspondence between the numbers in the accounts payable
adjustment and the numbers in the BSE matrix for accounts payable, including the net effect
of the operating entries. So if we look at the net effect of the operating entries, it was $45
here and $45 here, so one-to-one correspondence for accounts payable.
Now, there’s a correspondence for the receivables, but all the signs are different. So
accounts receivable for E2 went up by $150 in the BSE matrix, but the adjustment was -$150
for the reasons we explained earlier. And then when we collected the cash in the BSE matrix,
accounts receivable went down by $20 because cash went up by $20, and the adjustment
was +$20. So the numbers are the same in absolute value in this table up here that explains
the reconciliation adjustments, that is the effect on the reconciliation adjustments of the same
and absolute value, but different in sign than in the BSE matrix. And when we get over to the
combined effect we see that overall there’s a combined adjustment of -$130 that has to do
with receivables on the reconciliation, and yet the net effect was +$130 on receivables,
again, because we made sales on account of $150 and we only collected $20. So that’s what
remains to be collected at the end of the year.
So we see that there’s a difference between the sign effects on the receivables from the
accounts payable. And students always say, “Well, why is that?” That’s what we turn to next.
Reconciliation Equation
To get a handle on that we go back to the reconciliation, and we observe there’s an equation
here. If you look right here there’s going to be a vertical equation. We’re going to have net
income plus the reconciliation adjustments, right here, equals, that’s what this line means,
net cash from operations. So we’ve got a vertical equation here, and the reconciliation
equation is simply a horizontal representation of that. Net cash from operations equals net
income plus the reconciliation adjustments.
Now, what we want to figure out is why is the reconciliation adjustment the opposite to the
change in accounts receivable on the BSE matrix, but the same for the change in payables
on the BSE matrix? And we’re going to do that right now.
Connection to BSE Matrix
To do that, we first connect the reconciliation to the BSE matrix. It’s easy to see the $5 net
cash from operations, we just go down to the net from operations row, and the $5 is exactly
the same. So there’s a one-to-one correspondence there. And next we look at the
reconciliation adjustments. As we’ve mentioned earlier, the $45 is here and the $45 is down
here for the payables, so they’re exactly the same, one-to-one correspondence, but there’s
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not a one-to-one correspondence for the receivables adjustment. Up here it's -$130; down
here it's +$130 in the BSE matrix.
Income is $90. Now, you might recall income comes from the trial balance row, and so the
net income statement. That closes in the income summary so there’s our $90. For the
simplified EasyLearn assumptions where we only have five entries, the numbers on the trial
balance row for income are exactly the same as the net from operations row, and that's going
to be really important in our analysis. The reason for that is we have no entries going into
investing or financing that are affecting income. And you might be saying, “Well, does that
ever happen?” Yes, we can have gains or losses. So if we sell property, plant, and
equipment for a gain, that’ll show up down here because it’s an investing activity, selling
PP&E, and the gain goes on the income statement.
So we’ll have to incorporate gains and losses in a later module, and we do that. For now, we
can look at this one row right here on the BSE matrix, and that is the row that deals with net
from operations and we can form an equation because we have an equal sign right here. So
let’s see how that works.
Adjustment Signs
Here’s our equation from the net cash from operations row on the BSE matrix. Net cash from
operations of $5, there it is right there, plus the net increase in accounts receivable due to
operating entries, the $130, it’s the net effect of the operating entries on the account, equals,
because there’s our equal sign right there, the net increase in accounts payable due to
operating entry is $45 plus the net income after adjusting for gains and losses. We're putting
on a little placeholder here to remind ourselves that later we have to adjust for gains or
losses, but right now we don’t have any so that’s going to be the same as, in this case, net
income.
So we have this equation and we’re getting that from the BSE matrix. And what we want to
do is take this equation that we got from the BSE matrix and rewrite it so that its in the form
of the reconciliation equation. Here’s our reconciliation, remember the equation runs vertical.
Here’s the reconciliation equation. So we want to rewrite this equation up here so that it
matches the form of this down here. Well, the first thing you observe is the equal sign comes
after net cash from operations. So we have to get net cash from operations isolated by itself
up here. How are we going to do that? Well, we've got to take the accounts receivable net
effect and move it across the equation.
And when we do that, its sign changes and that’s the key. Any account that’s on the same
side of the Balance Sheet Equation as cash, it has to be moved across to the other side to
isolate cash in the reconciliation equation. And then we’re going to move net income from
way over here on the end over to here, and then we’ll have all the reconciliation adjustments
on this side of the equation. Now, that tells us why the liability adjustments are the same as,
in sign, what's going on in the Balance Sheet Equation matrix because they were on the right
side of the equation, same side of the equation as income. We don’t have to separate them
from cash. Whereas anything that's on the asset side has to be brought across and its sign
will be the opposite. And in particular, if we run across the accumulated depreciation, which
is a contra asset, well then they'll go from negative to positive.
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So all the signs are changed in the BSE matrix versus the effect on the reconciliation
equation when we move assets across the Balance Sheet Equation. And that you now
understand is why the assets signs are different than the liability signs in terms of the logic
and connecting back to the BSE matrix.
New Record-Keeping and Reporting (R&R) Map
Now, here we have our new R&R map, and we just want to point out a few features here.
There’s a scenic route in the R&R and we recommend it strongly. If you’re having difficulty
with all the complexity on the map, and most students do when they first see it, what that
scenic route does is break down the complexity, takes one color at a time, maps it into the
statements, whereas here you see everything at once. So that’ll break down the complexity
for you. All we want to do now is show you a few things.
First, the cash account is used to make the direct cash flow statement. That’s all you need to
make the direct cash flow statement. Everything from cash from operations going down is the
same on the indirect statement. What’s different? Well, we get income from over here on the
income statement, or from up here on the income summary, and then we get the
adjustments. And now we know exactly where we get the adjustments because we just went
over that. And we know that any asset-related adjustment coming from accounts receivable
or, say, inventory or prepaid expenses, any of those, whatever is going on in the matrix up
here in terms of the net effect of the operating entries, well, the adjustment is going to be the
opposite of the net effect to the operating entries for assets and the same for liabilities. You
can learn so much more about the new expanded map by watching that scenic route video I
mentioned earlier.
Limitations & possible violations of simplified assumptions of EasyLearn Company for
real companies
Now, we want to look at some limitations to the simplified assumptions we have for
EasyLearn and possible violations, and we’re going to move pretty quickly through here, but
again, there’s a scenic route video called Limitations and Company Disclosures. I highly
recommend that if you’re trying to bridge the gap between EasyLearn and real companies.
First of all, only operating entries affect the working capital accounts. So when we looked at
EasyLearn, for example accounts receivable, we saw it went up by $150 because of the
sales on accounts. It went down by $20, then we had a $130 change, and that was due to
operating entries but there were no other entries. For example, there were no financing or
investing activities that affected accounts receivable, and so the balance sheet also changed
by $130.
Now, contrast that with Bischoff. Bischoff has sales on account, and Bischoff has customer
collections just like EasyLearn but Bischoff has other operating entries. And so when you put
all those together, well the net effect of those is zero. So the adjustment on the cash flow
statement is going to be zero, but that’s not going to be the overall change on the balance
sheet. The overall change on the balance sheet is going to be $66 as the beginning balance,
$84 as the ending balance, so it change by $18.
Now, why did it change by $18? Well, because there are non-operating events that are
affecting accounts receivable. That happens very frequently for large global companies
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because what happens is whenever a company acquires another company, which is an
investing activity, it’ll add receivables that it brings on board from the other company and
that’s what’s happening, by the way, in Bischoff. They go out and buy another company. And
then there are also foreign currency translation adjustments, which show up down here
towards the bottom. And so when you add all that up, there’s things going on down here that
are significant.
If you go to the Internet and you look for “How do I interpret reconciliation adjustments on a
cash flow statement,” they’re often described as the change on the balance sheet. And that
would be equivalent to saying here that it was $18. But it’s not $18; it’s zero. Remember the
adjustments on the cash flow statement are always a net effect of the operating entries,
adjusted for the sign as we mentioned earlier. Often though, these non-operating effects
down here are very small.
So I’m making that simplified assumption that the balance sheet change is the same as the
net effect of the operating entries. Well, that’s not going to get you in very much trouble. It’s
generally not true, by the way, but it can be very close. However, there are situations, and a
scenic route video describes one, where the non-operating effects can be very, very
significant. For example, in 2010 Oracle acquired Sun Microsystems and the non-operating
effects on accounts receivable were four times as large as the operating effects. You can
watch the scenic route video to get more insights about it.
A second limitation of the EasyLearn approach is we only had two operating entries affecting
the adjustments. And we just showed you that that’s not true. In general, almost every
company will have more than two types of events affecting receivables or, for that matter,
any account. And in particular we saw that there were other operating entries for Bischoff.
What are the implications of that? Well, when we were studying EasyLearn we were able to
draw nice conclusions because we had $150 increase, we had a $20 decrease; this had to
do on sales on account, this was collections. So when we found there was $130 net increase
and the adjustment was $130 negative, we can interpret the adjustment in terms of the
relative effects of sales on account and collections because there was only two things
happening. And sometimes when we’re looking at actual cash flow statements, even though
there’s lots of other entries going on, we can ignore them because the effect of sales on
account and collections is just so large relative to these other things going on. But unless you
know what these other entries are, you don’t know when you can ignore them. And as we
progress through Navigating Accounting, we’ll be teaching you how to incorporate these
other entries into your analysis and how to calibrate whether you can ignore them or not
ignore them.
Take-aways
Where are we heading? Most of the big concepts associated with cash flow statements can
be explained using EasyLearn’s five entries. And again, the scenic routes will give you more
details on that if you need it. The entry-by-entry analyses for EasyLearn’s entries apply to
many entries. So we picked these entries strategically for EasyLearn so you get a pretty
good representation, meaning the interpretations of the SCF entry effects generalize. But, the
EasyLearn interpretations don’t apply to quite a few other entries.
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In the SCF Entry Map module, you will learn how to determine how any entry affects the
statement of cash flows and how to interpret these effects in terms of the underlying business
and accounting issues. So we’re going to put in place the last piece of the puzzle you need
by studying the SCF Entry Map. It’s a powerful map, and it will help you out tremendously.
So now it’s game time. We think we taught you enough to tackle the exercises. It’s been
pretty fast, but try the exercise. Check your solutions. You may find there are a few things
you still don’t know because this is a very challenging concept. If so, take corrective actions.
And what we recommend you to do is come back to the scenic route videos or come back to
this video and they will help you. But don’t watch the entire video. Look at particular menu
items you need. There’s a big picture scenic route video- covers most of the concepts we’ve
discussed, goes in more detail, and goes much slower. And then we have the limitations and
disclosure video I mentioned earlier. The thing you really want to see there is the company
disclosures. They’re quite interesting.
Scenic route 4 is the reconciliation adjustment signs. You probably won’t have to see that
video if you follow the discussion earlier on why the signs are different for asset and
liabilities. One you might really want to spend some time on is the Record-Keeping and
Reporting map scenic route video because it goes very slowly and explains this powerful tool
that you can use in the future.
I hope you’ve enjoyed this video. See you in the next one.