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 3.01
7
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 3.02 32
ABC Company 33
Events and Entries
33
Tracing ABC’s Entries to Statements 33
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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 3.03
61
How Do I Use the Numbers? 68
Analyzing Recent Cash Flows
69
Assessing the Quality of Earnings
73
Exercise 3.04
78
Exercise 3.05
79
Exercise 3.06
82
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
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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 20052007. Such cash flow analyses are increasingly important during tight
credit markets, as they were during the financial crisis of 2007 and 2008.
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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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
Net cash from operations
(6)
$14
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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
Net cash from operations
4
$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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements
7
Exercise 3.01
Identify the following examples as operating (O), investing (I), or
financing (F) activities.
Usage Icon
This exercise helps you
learn how accounting
reports are used by
investors, creditors, and
other stakeholders.
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
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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
(In Millions)
Beginning Cash
Cash and cash equivalents, beginning of year
Cash flows provided by (used for) operating activities:
Net income
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation
Share-based compensation
Restructuring, asset impairment, and net loss on retirement of assets
Excess of tax benefit from share-based payment arrangements
Amortization of intangibles and other acquisition related costs
(Gains) losses on equity investments, net
(Gains) on divestitures
Deferred taxes
Tax benefit from employee equity incentive plans
Changes in assets and liabilities:
Trading assets
Accounts receivable
Inventories
Accounts payable
Income taxes payable and receivable
Other assets and liabilities
Total adjustments
Net cash provided by operating activities
Cash flows provided by (used for) investing activities
Additions to property, plant, and equipment
Acquisitions, net of cash acquired
Purchases of available-for-sale investments
Maturities and sales of available-for-sale investments
Investments in non-marketable equity instruments
Net proceeds from divestitures
Other investing activities
Net cash used for investing activities
Cash flows provided by (used for) financing activities
Increase (decrease) in short-term debt, net
Proceeds from government grants
Excess tax benefit from share-based payment arrangements
Additions to long-term debt
Repayments and retirements of long-term debt
Repayments of notes payable
Proceeds from sales of shares through employee equity incentive plans
Repurchase and retirement of common stock
Payment of dividends to stockholders
Net cash used for financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents at the end of the year
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest, net of amounts capiatlized of $57 in 2007 and $60 in 2006
Income taxes, net of refunds
$
$
2005
8,407
8,664
4,546
952
564
(118)
252
(157)
(21)
(443)
──
4,654
1,375
635
(123)
258
(214)
(612)
(325)
──
4,345
──
74
──
250
45
──
(413)
351
(1,429)
316
700
102
(248)
633
5,649
12,625
324
1,229
(1,116)
7
(60)
(444)
5,588
10,632
1,606
(912)
(500)
303
797
241
6,187
14,851
(5,000)
(76)
(11,728)
8,011
(1,459)
32
294
(9,926)
(5,860)
──
(5,272)
7,147
(1,722)
752
(33)
(4,988)
(5,871)
(191)
(8,475)
8,433
(193)
──
(118)
(6,415)
$
(39)
160
118
125
──
──
3,052
(2,788)
(2,618)
(1,990)
709
7,307
$
(114)
69
123
──
──
(581)
1,046
(4,593)
(2,320)
(6,370)
(726)
6,598
$
126
25
──
1,742
(19)
──
1,202
(10,637)
(1,958)
(9,519)
(1,083)
7,324
$
$
15
2,762
$
$
25
2,432
$
$
27
3,218
Financing
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
2006
7,324
5,044
Investing
See notes to Consolidated Financial Statements.
$
6,976
Operating
Cash Change
Ending Cash
2007
6,598
Introduction to Cash-Flow Statements
9
As we look at Intel’s 2005-2007 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 2007.
• The third item from the bottom reports $7,307 of cash Intel
recognized on its balance sheet at the end of 2007.
• The line immediately above this one reports $709 increase in cash
during 2007.
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
Intel
2007
2006
2005
$12,625 $10,632 $14,851
Investing
(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 2007. 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
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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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 2007.
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.
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.
Intel Consolidated Statements of Cash Flows
Three Years Ended December 29, 2007
(In Millions)
Net Income
Adjustments
Cash and cash equivalents, beginning of year
Cash flows provided by (used for) operating activities:
Net income
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation
Share-based compensation
Restructuring, asset impairment, and net loss on retirement of assets
Excess of tax benefit from share-based payment arrangements
Amortization of intangibles and other acquisition related costs
(Gains) losses on equity investments, net
(Gains) on divestitures
Deferred taxes
Tax benefit from employee equity incentive plans
Changes in assets and liabilities:
Trading assets
Accounts receivable
Inventories
Accounts payable
Income taxes payable and receivable
Other assets and liabilities
Total adjustments
Net cash provided by operating activities
Cash flows provided by (used for) investing activities
Additions to property, plant, and equipment
Acquisitions, net of cash acquired
Purchases of available-for-sale investments
Maturities and sales of available-for-sale investments
Investments in non-marketable equity instruments
Net proceeds from divestitures
Other investing activities
Net cash used for investing activities
Cash flows provided by (used for) financing activities
Increase (decrease) in short-term debt, net
Proceeds from government grants
Excess tax benefit from share-based payment arrangements
Additions to long-term debt
Repayments and retirements of long-term debt
Repayments of notes payable
Proceeds from sales of shares through employee equity incentive plans
RepurchaseR.
andWilson
retirement of common stock
& Carolyn
Payment of dividends to stockholders
Net cash used for financing activities
Total adjustments
Net cash from
operations
© 1991–2010 NavAcc LLC, G. Peter
$
2007
6,598
$
2006
7,324
$
2005
8,407
6,976
5,044
8,664
4,546
952
564
(118)
252
(157)
(21)
(443)
──
4,654
1,375
635
(123)
258
(214)
(612)
(325)
──
4,345
──
74
──
250
45
──
(413)
351
(1,429)
316
700
102
(248)
633
5,649
12,625
324
1,229
(1,116)
7
(60)
(444)
5,588
10,632
1,606
(912)
(500)
303
797
241
6,187
14,851
(5,000)
(76)
(11,728)
8,011
(1,459)
32
294
(9,926)
(5,860)
──
(5,272)
7,147
(1,722)
752
(33)
(4,988)
(5,871)
(191)
(8,475)
8,433
(193)
──
(118)
(6,415)
(39)
160
118
125
──
──
3,052
(2,788)
(2,618)
(1,990)
(114)
69
123
──
──
(581)
1,046
(4,593)
(2,320)
(6,370)
126
25
──
1,742
(19)
──
1,202
(10,637)
(1,958)
(9,519)
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 2005-2007:
Indirect Format Operating Section
Net Income
Reconciliation adjustments
Net cash from operations
Intel
2007
2006
2005
$6,976
$5,044
$8,664
5,649
5,588
6,187
$12,625 $10,632 $14,851
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.
Other Adjustments
There are a few other
insignificant adjustment
types associated with
issues beyond the
scope of this chapter.
Types of Adjustments
© NavAcc
LLC, G. Peter & Carolyn
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.
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12
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®
Intel Consolidated Statements of Cash Flows
Three Years Ended December 29, 2007
(In Millions)
Gains and losses
adjustment
Asset adjustment
Liability adjustment
Cash inflow from
divestitures
Cash and cash equivalents, beginning of year
Cash flows provided by (used for) operating activities:
Net income
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation
Share-based compensation
Restructuring, asset impairment, and net loss on retirement of assets
Excess of tax benefit from share-based payment arrangements
Amortization of intangibles and other acquisition related costs
(Gains) losses on equity investments, net
(Gains) on divestitures
Deferred taxes
Tax benefit from employee equity incentive plans
Changes in assets and liabilities:
Trading assets
Accounts receivable
Inventories
Accounts payable
Income taxes payable and receivable
Other assets and liabilities
Total adjustments
Net cash provided by operating activities
Cash flows provided by (used for) investing activities
Additions to property, plant, and equipment
Acquisitions, net of cash acquired
Purchases of available-for-sale investments
Maturities and sales of available-for-sale investments
Investments in non-marketable equity instruments
Net proceeds from divestitures
Other investing activities
Net cash used for investing activities
Cash flows provided by (used for) financing activities
Increase (decrease) in short-term debt, net
Proceeds from government grants
Excess tax benefit from share-based payment arrangements
Additions to long-term debt
Repayments and retirements of long-term debt
Repayments of notes payable
Proceeds from sales of shares through employee equity incentive plans
Repurchase and retirement of common stock
Payment of dividends to stockholders
Net cash used for financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents at the end of the year
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest, net of amounts capiatlized of $57 in 2007 and $60 in 2006
Income taxes, net of refunds
$
2007
6,598
$
2006
7,324
$
2005
8,407
6,976
5,044
8,664
4,546
952
564
(118)
252
(157)
(21)
(443)
──
4,654
1,375
635
(123)
258
(214)
(612)
(325)
──
4,345
──
74
──
250
45
──
(413)
351
(1,429)
316
700
102
(248)
633
5,649
12,625
324
1,229
(1,116)
7
(60)
(444)
5,588
10,632
1,606
(912)
(500)
303
797
241
6,187
14,851
(5,000)
(76)
(11,728)
8,011
(1,459)
32
294
(9,926)
(5,860)
──
(5,272)
7,147
(1,722)
752
(33)
(4,988)
(5,871)
(191)
(8,475)
8,433
(193)
──
(118)
(6,415)
(39)
(114)
69
123
──
──
(581)
1,046
(4,593)
(2,320)
(6,370)
(726)
6,598
126
25
──
1,742
(19)
──
1,202
(10,637)
(1,958)
(9,519)
(1,083)
7,324
160
Gains and Losses Reconciliation Adjustments
118
125
Gains and losses reported in net income generally arise
── from selling
──
assets, which are investing activities. Thus, the cash3,052
flows
associated with
(2,788)
these activities are reported in the investing section,
not
the
operating
(2,618)
(1,990)
section. However, gains and losses are included in net
income at the top
709
$ are
7,307needed
$
$
of the operating section. As a result, adjustments
to remove
gains and losses included in net income (by deducting gains and adding
$
15
$
25
$
27
2,762
$
2,432
$
3,218
losses) because they do not affect net cash from$ operations.
See notes to Consolidated Financial Statements.
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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 2005-2007, 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
Intel Consolidated Statements
of Cash
Flowsinvestments in new factories versus equivalent
investments
in
Treasury
bonds. Also, they would want to know the reason
Three Years Ended December 29, 2007
2007
2006 in 2007
2005
(In Millions)
why Intel spent nearly $5 billion more on investing
activities
Cash and cash equivalents, beginning of year
$
6,598
$
7,324
$
8,407
than
in 2006.
The line items in the investing section can help them better
Cash flows provided by (used for)
operating
activities:
Net income
understand the net cash flows related to these6,976
investment5,044
activities. 8,664
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation
4,546
4,654
4,345
These items are relatively easy to identify from
their descriptions.
For
Share-based compensation
952
1,375
──
example,
Intel
2007
additions to property,
Restructuring, asset impairment,
and net
loss reports
on retirement
of assets
564 plant and
635 equipment
74
Excess of tax benefit fromof
share-based
payment
arrangements
($5,000),
representing
the cash Intel spent (118)
to purchase(123)
PP&E. Most──
Amortization of intangibles and other acquisition related costs
252
258
250
companies
meaning
(Gains) losses on equity investments,
netinclude net at the end of the description,
(157)
(214) cash
45
(Gains) on divestitures outflows used to purchase PP&E net of cash inflows
(21)
──
from(612)
selling PP&E.
Deferred taxes
(443)
(325)
(413)
Similar to most companies, Intel signs cash outflows
negatively.
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
102
7
303
InvestingIncome
Section
of Intel’s Cash Flow Statement
taxes payable and receivable
(248)
(60)
797
Other assets and liabilities
633
(444)
241
Intel Consolidated
Statements of Cash Flows
adjustments
5,649
5,588
6,187
Three YearsTotal
Ended
December 29, 2007
NetMillions)
cash provided by operating activities
12,625
10,632
14,851
2007
2006
2005
(In
Cash flows
provided
by (used beginning
for) investing
$
6,598
$
7,324
$
8,407
Cash
and cash
equivalents,
ofactivities
year
Additions
to property,
plant,for)
and
equipment
(5,000)
(5,860)
(5,871)
Cash
flows provided
by (used
operating
activities:
Acquisitions,
(76)
──
(191)
Net
income net of cash acquired
6,976
5,044
8,664
Purchases oftoavailable-for-sale
investments
(11,728)
(5,272)
(8,475)
Adjustments
reconcile net income
to cash provided by operating activities:
Maturities
and sales of available-for-sale investments
8,011
7,147
8,433
Depreciation
4,546
4,654
4,345
Investments
in non-marketable
(1,459)
(1,722)
(193)
Share-based
compensation equity instruments
952
1,375
──
NetRestructuring,
proceeds from
divestitures
32
752
──
asset
impairment, and net loss on retirement of assets
564
635
74
Other
investing
294
(33)
(118)
Excess
of taxactivities
benefit from share-based payment arrangements
(118)
(123)
──
Net cash
used for investing
activities
(9,926)
(4,988)
(6,415)
Amortization
of intangibles
and other acquisition related costs
252
258
250
Cash flows
provided
financing activities
(Gains)
losses by
on(used
equityfor)
investments,
net
(157)
(214)
45
Increase
in short-term debt, net
(39)
(114)
126
(Gains)(decrease)
on divestitures
(21)
(612)
──
Proceeds
from
government grants
160
69
25
Deferred
taxes
(443)
(325)
(413)
Excess
tax benefit
share-based
payment plans
arrangements
118
123
──
Tax benefit
fromfrom
employee
equity incentive
──
──
351
Additions
to in
long-term
debtliabilities:
125
──
1,742
Changes
assets and
Repayments
retirements of long-term debt
──
──
(19)
Trading and
assets
(1,429)
324
1,606
Repayments
ofreceivable
notes payable
──
(581)
──
Accounts
316
1,229
(912)
Proceeds
from sales of shares through employee equity incentive plans
3,052
1,046
1,202
Inventories
700
(1,116)
(500)
Repurchase
and
retirement of common stock
(2,788)
(4,593)
(10,637)
Accounts
payable
102
7
303
Payment
of dividends
to stockholders
(2,618)
(2,320)
(1,958)
Income
taxes payable
and receivable
(248)
(60)
797
Net cashOther
usedassets
for financing
activities
(1,990)
(6,370)
(9,519)
and liabilities
633
(444)
241
Net increase
(decrease)
in cash and cash equivalents
709
(726)
(1,083)
Total
adjustments
5,649
5,588
6,187
Cash
andprovided
cash equivalents
at the
end of the year
$ 12,625
7,307
$ 10,632
6,598
$
7,324
Net cash
by operating
activities
© 1991–2010
NavAcc LLC,
G. Peter &14,851
Carolyn R. Wilson
Supplemental
disclosures
of cash
flow information:
Cash flows provided
by (used
for) investing
activities
Cash
paidtoduring
the year
Additions
property,
plant,for:
and equipment
(5,000)
(5,860)
(5,871)
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.
Intel Consolidated Statements
of Cash
Flows cash flows, it is important to relate them to the
When analyzing
financing
Three Years Ended December 29, 2007
(In Millions)
business context and, in particular to the company’s development stage
2007
2006
2005
Cash and cash equivalents, beginning
year of the economy. For example,
$ they
6,598will$ be quite
7,324 different
$
8,407
and theofstate
for
Cash flows provided by (used for) operating activities:
a high tech start-up in a booming economy than
for a mature
airline8,664
in
Net income
6,976
5,044
economic
downturn.
Typically
high-tech start-ups tend to use mostly
Adjustments to reconcile netan
income
to cash provided
by operating
activities:
Depreciation
4,654
4,345
equity
financing,
because
they
have
very little4,546
collateral
to
offer to debt
Share-based compensation
952
1,375
──
holders,
they
generallyof do
not pay dividends.
Restructuring, asset impairment,
andand
net loss
on retirement
assets
564 By contrast,
635 airlines 74
Excess of tax benefit fromrely
share-based
arrangements
(118) to add(123)
heavilypayment
on debt
financing and they often need
debt during ──
Amortization of intangibles and other acquisition related costs
252
258
250
economicnet
downturns to finance operations. (157)
(Gains) losses on equity investments,
(214)
45
(Gains) on divestitures
(21)
(612)
──
Financing cash flows can usually be interpreted
from their(325)
captions. (413)
Deferred taxes
(443)
Tax benefit from employee
equity
incentive
── all of the
──significant
351
For
Intel,
the plans
most conspicuous observation is that
Changes in assets and liabilities:
cash flows relate to owners, reflecting the fact(1,429)
that Intel has
Trading assets
324very little
1,606
Accounts receivable debt. Also, readily apparent is the primary reason
316 that the
1,229
(912)
net financing
Inventories
700
(1,116)
(500)
outflows decreased from $9,519 in 2005 to $1,990
in 20077is that the303
Accounts payable
102
Income taxes payable and
(248)
(60) $10,637
797
cashreceivable
outflows associated with stock repurchases
decreased from
Other assets and liabilities
633
(444)
241
an approximately
Total adjustments to $2,788. This decrease was partly offset by 5,649
5,588 $2 billion
6,187
Net cash provided by operating
activitiesin the inflows from exercising stock12,625
14,851
increase
options. 10,632
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
Financing
Section
of Intel’sequity
Cashinstruments
Flow Statement
Investments
in non-marketable
(1,459)
(1,722)
(193)
Intel
Statements of Cash Flows
Net Consolidated
proceeds from divestitures
32
752
──
Three
Years
Ended December
Other
investing
activities 29, 2007
294
(33)
(118)
NetMillions)
cash used for investing activities
(9,926)
(4,988)
(6,415)
2007
2006
2005
(In
Cash
provided
by (used for)
financing
$
6,598
$
7,324
$
8,407
Cash flows
and cash
equivalents,
beginning
of activities
year
Increase
(decrease)
in short-term
debt, net
(39)
(114)
126
Cash
flows provided
by (used
for) operating
activities:
Proceeds
from government grants
160
69
25
Net
income
6,976
5,044
8,664
Excess tax benefit
from share-based
payment
arrangements
118
123
──
Adjustments
to reconcile
net income to
cash provided
by operating activities:
Additions
to long-term debt
125
──
1,742
Depreciation
4,546
4,654
4,345
Repayments
andcompensation
retirements of long-term debt
──
──
(19)
Share-based
952
1,375
──
Repayments
of notes
──
(581)
──
Restructuring,
assetpayable
impairment, and net loss on retirement of assets
564
635
74
Proceeds
of shares
through employee
equity
incentive plans
3,052
1,046
1,202
Excess from
of taxsales
benefit
from share-based
payment
arrangements
(118)
(123)
──
Repurchase
andofretirement
ofand
common
(2,788)
(4,593)
(10,637)
Amortization
intangibles
other stock
acquisition related costs
252
258
250
Payment
dividends
to stockholders
(2,618)
(2,320)
(1,958)
(Gains)oflosses
on equity
investments, net
(157)
(214)
45
Net cash
usedonfor
financing activities
(1,990)
(6,370)
(9,519)
(Gains)
divestitures
(21)
(612)
──
Net increase
(decrease)
in cash and cash equivalents
709
(726)
(1,083)
Deferred
taxes
(443)
(325)
(413)
Cash and
at the
end incentive
of the year
$
7,307
6,598
7,324
Tax cash
benefitequivalents
from employee
equity
plans
── $
── $
351
Changesdisclosures
in assets and
liabilities:
Supplemental
of cash
flow information:
assets
(1,429)
324
1,606
CashTrading
paid during
the year for:
Accounts
receivablecapiatlized of $57 in 2007 and $60 in 2006
316
1,229
(912)
Interest,
net of amounts
$
15
$
25
$
27
Inventories
700
(1,116)
(500)
Income
taxes, net of refunds
$
2,762
$
2,432
$
3,218
Accounts
payable
102
7
303
See notes
to Consolidated
Financial Statements.
Income taxes payable and receivable
(248)
(60)
797
Other assets and liabilities
633
(444)
241
© 1991–2010 NavAcc LLC,
G. Peter & Carolyn R. Wilson
Total adjustments
5,649
5,588
6,187
Net cash provided by operating activities
12,625
10,632
14,851
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
Net cash from operations
($130)
$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
Operating Activities
Behind Reported Numbers
E2
E3
Combined
Net Income
$150
$150
$0
$150
Receivables
($130)
($150)
$20
($130)
$20
$20
Net cash from operations
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
$20
$0
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
2007. 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).
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
20
Navigating Accounting
®
Thus, it is unlikely that Intel collected exactly $316 more cash than it
recognized revenues during 2007. 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.)
Intel Consolidated Statements of Cash Flows
Three Years Ended December 29, 2007
(In Millions)
Cash and cash equivalents, beginning of year
Cash flows provided by (used for) operating activities:
Net income
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation
Share-based compensation
Restructuring, asset impairment, and net loss on retirement of assets
Excess of tax benefit from share-based payment arrangements
Amortization of intangibles and other acquisition related costs
(Gains) losses on equity investments, net
(Gains) on divestitures
Deferred taxes
Tax benefit from employee equity incentive plans
Changes in assets and liabilities:
Trading assets
Accounts receivable
Inventories
Accounts payable
Income taxes payable and receivable
Other assets and liabilities
Total adjustments
Net cash provided by operating activities
Cash flows provided by (used for) investing activities
Additions to property, plant, and equipment
Acquisitions, net of cash acquired
Purchases of available-for-sale investments
Maturities and sales of available-for-sale investments
Investments in non-marketable equity instruments
Net proceeds from divestitures
Intel reports separate
investing activities
adjustments for assets Net Other
cash used for investing activities
and liabilities. By contrast,Cash flows provided by (used for) financing activities
some companies combine Increase (decrease) in short-term debt, net
Proceeds from government grants
these adjustments into
Excess tax benefit from share-based payment arrangements
Additions to long-term debt
a single “working capital
Repayments and retirements of long-term debt
adjustment” and report
Repayments of notes payable
the separate items in a
Proceeds from sales of shares through employee equity incentive plans
Repurchase and retirement of common stock
footnote.
Payment of dividends to stockholders
Net cash used for financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents at the end of the year
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest, net of amounts capiatlized of $57 in 2007 and $60 in 2006
Income taxes, net of refunds
Receivables
adjustment
Working capital
adjustments
$
2007
6,598
$
2006
7,324
$
2005
8,407
6,976
5,044
8,664
4,546
952
564
(118)
252
(157)
(21)
(443)
──
4,654
1,375
635
(123)
258
(214)
(612)
(325)
──
4,345
──
74
──
250
45
──
(413)
351
(1,429)
316
700
102
(248)
633
5,649
12,625
324
1,229
(1,116)
7
(60)
(444)
5,588
10,632
1,606
(912)
(500)
303
797
241
6,187
14,851
(5,000)
(76)
(11,728)
8,011
(1,459)
32
294
(9,926)
(5,860)
──
(5,272)
7,147
(1,722)
752
(33)
(4,988)
(5,871)
(191)
(8,475)
8,433
(193)
──
(118)
(6,415)
Liability Reconciliation Adjustments
Next we extend the EasyLearn example with the following entries
associated with a liability adjustment.
(39)
126
E4 December 23: You run an advertisement in the160
college(114)
newspaper
69
25 and
118
123
──
are invoiced $60. The entry is a $60 increase to
accounts
payable
and
125
──
1,742
──
──
(19)
advertising expense.
──
(581)
──
3,052
1,046
1,202
(2,788)for the
(4,593)
(10,637)
E5 December 31: You pay $15 of the $60 you owe
advertisement
(2,618)
(2,320)
(1,958)
invoiced on December 23. The entry is a $15(1,990)
decrease(6,370)
to cash (9,519)
and
709
(726)
(1,083)
accounts payable.
$
7,307
$
6,598
$
7,324
Combining these entries with E1-E3, we get the
income
statement,
direct
$
15
$
25
$
27
$
2,762
$
2,432
$
3,218
cash-flow statement, and balance sheets for December (at the top of the
See notes to Consolidated Financial Statements.
next page):
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 21
EASYLEARN COMPANY
INCOME STATEMENT
EASYLEARN COMPANY
BALANCE SHEETS
December 1 ‐ 31, 2009
Revenues
Advertising expense
Net Income
Assets
Cash
Accounts receivable
Total assets
$150
(60)
$90
EASYLEARN COMPANY
DIRECT CASH FLOW STATEMENT
Beginning Cash balance
Ending cash balance
Liabilities and stockholders' equity
Liabilities
Accounts payable
Total liabilities
December 1 - 31, 2009
Operating Activities
Sales collections
Advertising payment
Net cash from operations
Financing Activities
Sale of common stock
Net cash from financing
Change in cash
31-Dec-09
$20
($15)
$5
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
1-Dec-09
$6
130
$136
$0
0
$0
45
45
0
0
1
90
91
$136
0
0
$0
$1
$1
$6
$0
$6
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
Operating Activities
Behind Reported Numbers
E2
E3
Net Income
$90
$150
$0
Receivables
($130)
($150)
$20
Accounts payable
Net cash from operations
$45
$5
$0
$20
E4
($60)
E5
$0
Combined
$90
($130)
$60
($15)
$45
$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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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 2007. The adjustment tells us $102 of the $105
increase was due to operating entries.
Intel Consolidated Statements of Cash Flows
Three Years Ended December 29, 2007
(In Millions)
Payables
adjustment
© 1991–2010 NavAcc LLC, G.
Cash and cash equivalents, beginning of year
Cash flows provided by (used for) operating activities:
Net income
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation
Share-based compensation
Restructuring, asset impairment, and net loss on retirement of assets
Excess of tax benefit from share-based payment arrangements
Amortization of intangibles and other acquisition related costs
(Gains) losses on equity investments, net
(Gains) on divestitures
Deferred taxes
Tax benefit from employee equity incentive plans
Changes in assets and liabilities:
Trading assets
Accounts receivable
Inventories
Accounts payable
Income taxes payable and receivable
Other assets and liabilities
Total adjustments
Net cash provided by operating activities
Cash flows provided by (used for) investing activities
Additions to property, plant, and equipment
Acquisitions, net of cash acquired
Purchases of available-for-sale investments
Maturities and sales of available-for-sale investments
Investments in non-marketable equity instruments
Net proceeds from divestitures
Other investing activities
Net cash used for investing activities
Cash flows provided by (used for) financing activities
Increase (decrease) in short-term debt, net
Proceeds from government grants
Excess tax benefit from share-based payment arrangements
Additions to long-term debt
Repayments and retirements of long-term debt
Repayments of notes payable
Proceeds from sales of shares through employee equity incentive plans
Repurchase and retirement of common stock
of dividends to stockholders
PeterNet&Payment
Carolyn
R. Wilson
cash used for financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents at the end of the year
$
$
2007
6,598
$
2006
7,324
$
2005
8,407
6,976
5,044
8,664
4,546
952
564
(118)
252
(157)
(21)
(443)
──
4,654
1,375
635
(123)
258
(214)
(612)
(325)
──
4,345
──
74
──
250
45
──
(413)
351
(1,429)
316
700
102
(248)
633
5,649
12,625
324
1,229
(1,116)
7
(60)
(444)
5,588
10,632
1,606
(912)
(500)
303
797
241
6,187
14,851
(5,000)
(76)
(11,728)
8,011
(1,459)
32
294
(9,926)
(5,860)
──
(5,272)
7,147
(1,722)
752
(33)
(4,988)
(5,871)
(191)
(8,475)
8,433
(193)
──
(118)
(6,415)
(39)
160
118
125
──
──
3,052
(2,788)
(2,618)
(1,990)
709
7,307
(114)
69
123
──
──
(581)
1,046
(4,593)
(2,320)
(6,370)
(726)
6,598
126
25
──
1,742
(19)
──
1,202
(10,637)
(1,958)
(9,519)
(1,083)
7,324
$
$
Introduction to Cash-Flow Statements 23
Why Do Asset and Liability Adjustments’ Signs
Differ?
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.
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
Operating
December 1, 2009
Financing
C
+
AR
=
+
AP
+
CS
+
RE
+
Rev
-
AdEx +
IncS
+
+ $0
=
+
+ $0
+
+ $0
+
+ $0
+
+ $0
-
+ $0
+ $0
+
+ 150
=
+
+
+
+
+ 150
-
+
+
- 20
+
+
+
-
+
+
+
-
+
+
-
E3
Customer collections
+
E4
Advertising expense
+
E5
Advertising payment
+
Total financing
Trial balance
Closing to and from income summary
December 31, 2009
Net income
+
+ $0
+
Issue stock for cash
Permanent
+
Recognize revenue
E1
Owners' Equity
+
E2
Total operations
= Liabilities +
+ 20
=
+
+
=
+
+ 60
+
- 15
+
=
+
- 15
+
+
+ $5
+ + $130
=
+
+ $45
+
+ $0
+
+
+1
+
=
+
+
+1
+
+
+1
+
=
+
+
+1
+
+0
+
+ $6
+
+ $1
+
+ $0
+0
+ + $150 +
+
+ + $130
=
+
+
+
=
+
+
+
+
+
=
+
+
+
+ 90
+
+
+ + $130
=
+
+
+ $90
+
+ $6
+ $45
+ $0
+ $45
+
+ $1
+0
+
+ 60
+ $60
+
+ $0
-
+
-
+
+0
+ + $150 -
+ $60
+
+ $0
- 150
- 60
+
+ 90
+
- 90
+
+ $0
+
-
+ $0
-
+ $0
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
Net increase in
accounts
accounts
+ receivable due = payable due to +
to operating
operating
entries
entries
+ $5
+ $130
Net income
after adjusting
for gains and
losses
+ $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
+ $5
Reconciliation
bottom line
=
Net income
after adjusting
for gains and
losses
+ $90
Reconciliation
top line
Net increase in
accounts
+ payable due to
operating
entries
+ $45
-
Net increase in
accounts
receivable due
to operating
entries
+ $130
Reconciliation asset
and liability adjustments
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
EASYLEARN COMPANY
SCF RECONCILIATION
December 1 - 31, 2009
Operating Activities
Net Income
$90
Receivables
($130)
Accounts payable
Net cash from operations
$45
$5
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 2007. 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 2007
- 316 net effect of operating events from cash-flow statement
+ 183 net effect of non-operating events (derived)
=
$2,576ending 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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
26
®
Navigating Accounting
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
Owners' Equity
Assets
= Liabilities +
Permanent
Operating
December 1, 2009
Financing
C
+
AR
=
+
AP
+
CS
+
RE
+
Rev
-
AdEx
+
IncS
+
+ $0
+
+ $0
=
+
+ $0
+
+ $0
+
+ $0
+
+ $0
-
+ $0
+
+ $0
+
+ 150
=
+
+
+
+
+ 150
-
+
+ 20
+
- 20
=
+
+
+
+
-
+
+
=
+
+ 60
+
+
+
-
+
-
E2
Recognize revenue
+
E3
Customer collections
+
E4
Advertising expense
+
E5
Advertising payment
+
- 15
+
=
+
- 15
+
+
+ $5
+ + $130
=
+
+ $45
+
+ $0
+
+
+1
+
=
+
+
+1
+
+
+1
+
=
+
+
+1
+
+0
+
+ $6
+ + $130
=
+
+
+ $1
+
+ $0
+
=
+
Total operations
E1
Issue stock for cash
Total financing
Trial balance
Closing to and from income summary
December 31, 2009
+
+
+ $6
+
EASYLEARN COMPANY
DIRECT CASH FLOW STATEMENT
December 1 - 31, 2009
Operating Activities
Sales collections
Advertis ing payment
Net cash from operations
Financing Activities
Sale of common stock
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Net income
+
+
+0
+
=
+
+ + $130
=
+
+ $45
+
+
+
+ $1
+ + $150 +
+
+
+ $45
+ $0
+
+0
+
+ 90
+
+
+ $90
+
- 150
-
+
+0
+ $60
+
+ $0
- 60
+
+ 90
-
+ $0
- 90
+
+ $0
Liabilies & owners' equity
Liabilies
Accounts payable
T otal liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilies & owners' equity
EASYLEARN COMPANY
INCOME STATEMENT
December 1 - 31, 2009
December 1 - 31, 2009
Net Income
$90
Receivables
($130)
Accounts payable
Net cash from operations
Revenues
Adversing expense
Net Income
$0
0
$0
45
45
0
0
1
90
91
$136
0
0
0
$0
$150
(60)
$90
$5
Financing Activities
0
Change in cash
$6
Beginning Cash balance
Ending cash balance
$0
$6
Sale of common stock
$1
Net cash from financing
$1
EASYLEARN COMPANY
STATEMENT OF OWNERS' EQUITY
December 1, 2009
Net income
Common stock sale
December 31, 2009
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
12/1/09
$6
130
$136
$45
1
1
6
$6
+
12/31/09
EASYLEARN COMPANY
INDIRECT CASH FLOW STATEMENT
Operating Activities
$20
(15)
5
+ $0
-
+ $0
+
+
+ + $150 +
Assets
Cash
Accounts receivable
Total assets
+ 60
+ $60
EASYLEARN COMPANY
BALANCE SHEETS
Retained
Earnings
Common
Stock
$0
90
$0
$90
1
$1
Total
$0
90
1
$91
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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:
A
ssets
= L
+
iabilities
O
wners'
Permanent
Cash
Beginning balances
Operating
events
Non-operating
events
+
+
Other
Assets
Change
g in
other
assets
related to
operations
+
=
=
Cash from
operations
+
C
Cash
from
investing
and
financing
g
activities
+
=
+
=
Change
g in
liabilities
related to
operations
E
quities
+ Comprehensive Income
+
Net
Income
+
+
+
Net
income
excluding
e
g
gains &
g
losses
+
+
+
Gains &
losses
+
+
+
+
Change in
paid in capital
related to
operations
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
Cash flows provided by (used for) operating activities:
Net income
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation
Share-based compensation
Restructuring, asset impairment, and net loss on retirement of assets
Excess of tax benefit from share-based payment arrangements
Amortization of intangibles and other acquisition related costs
(Gains) losses on equity investments, net
(Gains) on divestitures
Deferred taxes
Tax benefit from employee equity incentive plans
Changes in assets and liabilities:
Trading assets
Accounts receivable
Inventories
Accounts payable
Income taxes payable and receivable
Other assets and liabilities
Total adjustments
Net cash provided by operating activities
Cash flows provided by (used for) investing activities
Additions to property, plant, and equipment
Acquisitions, net of cash acquired
Purchases of available-for-sale investments
Maturities and sales of available-for-sale investments
Investments in non-marketable equity instruments
Net proceeds from divestitures
Other investing activities
Net cash used for investing activities
Cash flows provided by (used for) financing activities
Increase (decrease) in short-term debt, net
Proceeds from government grants
Excess tax benefit from share-based payment arrangements
Additions to long-term debt
Repayments and retirements of long-term debt
Repayments of notes payable
Proceeds from sales of shares through employee equity incentive plans
Repurchase and retirement of common stock
Payment of dividends to stockholders
Net cash used for financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents at the end of the year
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
$
2007
6,598
$
$
2005
8,407
6,976
5,044
8,664
4,546
952
564
(118)
252
(157)
(21)
(443)
4,654
1,375
635
(123)
258
(214)
(612)
(325)
4,345
(1,429)
316
700
102
(248)
633
5,649
12,625
324
1,229
(1,116)
7
(60)
(444)
5,588
10,632
1,606
(912)
(500)
303
797
241
6,187
14,851
(5,000)
(76)
(11,728)
8,011
(1,459)
32
294
(9,926)
(5,860)
(5,871)
(191)
(8,475)
8,433
(193)
3,052
(2,788)
(2,618)
(1,990)
709
7,307
74
250
45
(413)
351
(5,272)
7,147
(1,722)
752
(33)
(4,988)
(39)
160
118
125
$
2006
7,324
(118)
(6,415)
(114)
69
123
126
25
1,742
(19)
$
(581)
1,046
(4,593)
(2,320)
(6,370)
(726)
6,598
$
1,202
(10,637)
(1,958)
(9,519)
(1,083)
7,324
+
OCI
OCI
related to
operations
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
Owners' Equity
Assets
= Liabilities +
Permanent
Operating
December 1, 2009
Financing
C
+
AR
=
+
AP
+
CS
+
RE
+
Rev
-
AdEx
+
IncS
+
+ $0
+
+ $0
=
+
+ $0
+
+ $0
+
+ $0
+
+ $0
-
+ $0
+
+ $0
+
+ 150
=
+
+
+
+
+ 150
-
+
+
- 20
=
+
+
+
+
-
+
+
=
+
+ 60
+
+
+
-
+
-
E2
Recognize revenue
+
E3
Customer collections
+
E4
Advertising expense
+
E5
Advertising payment
+
- 15
+
=
+
- 15
+
+
+ $5
+ + $130
=
+
+ $45
+
+ $0
+
=
+
+
+1
+
=
+
+
+1
+
+0
+ + $130
=
+
+
+ $1
+
+ $0
+
=
+
Total operations
E1
Issue stock for cash
Total financing
Trial balance
Closing to and from income summary
December 31, 2009
+ 20
+
+1
+
+
+1
+
+
+ $6
+
+
+ $6
+
EASYLEARN COMPANY
DIRECT CASH FLOW STATEMENT
December 1 - 31, 2009
Operating Activities
Sales collections
Advertis ing payment
Net cash from operations
Financing Activities
Sale of common stock
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Net income
+
+
+0
+
=
+
+ + $130
=
+
+ $45
+
+
+
+ $1
+ + $150 +
+
+
+ $45
+ $0
+
+0
+
+ 90
+
+
+ $90
+
- 150
+
+
+0
+ $60
+
+ $0
- 60
+
+ 90
-
+ $0
- 90
+
+ $0
Liabilies & owners' equity
Liabilies
Accounts payable
T otal liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilies & owners' equity
EASYLEARN COMPANY
INCOME STATEMENT
December 1 - 31, 2009
December 1 - 31, 2009
Net Income
$90
Receivables
($130)
Accounts payable
Net cash from operations
Revenues
Adversing expense
Net Income
12/1/09
$6
130
$136
$0
0
$0
45
45
0
0
1
90
91
$136
0
0
0
$0
$150
(60)
$90
$45
$5
1
1
6
Financing Activities
0
Change in cash
$6
Beginning Cash balance
Ending cash balance
$0
$6
$6
+
12/31/09
EASYLEARN COMPANY
INDIRECT CASH FLOW STATEMENT
Operating Activities
$20
(15)
5
+ $0
-
+ $0
+
-
+ + $150 +
Assets
Cash
Accounts receivable
Total assets
+ 60
+ $60
EASYLEARN COMPANY
BALANCE SHEETS
Sale of common stock
$1
Net cash from financing
$1
EASYLEARN COMPANY
STATEMENT OF OWNERS' EQUITY
December 1, 2009
Net income
Common stock sale
December 31, 2009
Retained
Earnings
Common
Stock
$0
90
$0
$90
1
$1
Total
$0
90
1
$91
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
32
Navigating Accounting
®
Exercise 3.02
Usage Icon
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.
This exercise helps you
learn how accounting
reports are used by
investors, creditors, and
other stakeholders.
(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.
2006
Amounts in millions
2005
6,389
4,232
Net earnings
8,684
6,923
Depreciation and amortization
2,627
1,884
CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR
OPERATING ACTIVITIES
Search Icon
This exercise helps you
search for information
585
524
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)
(508)
(498)
10
113
11,375
8,679
Share-based compensation expense
Change in other operating assets and liabilities
Other
TOTAL OPERATING ACTIVITIES
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
2006
2005
Inventories
Materials and supplies
Work in process
Finished goods
1,537
623
4,131
1,424
350
3,232
Total inventories
6,291
5,006
Page 42, P&G’s 2006 Annual Report
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 35
Event E1 — Issuing $1,000 of common stock for cash
ABC Company Balance Sheet
First year of operations
Assets
Current
Beginning balances
Operating Entries
E3
Purchase inventory on account
C
+
+ $0
+
AR
+
+ $0
+
+
E4a Recognize revenue
+
+
E4b Recognize cost of sales
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
E2
Purchase building with cash
Total investing
E1
Issue stock for cash
E8
Dividend declared and paid
Total financing
Trial balance
Closing to and from income summary
Ending balances
+
+ 10
+
+
- $10
+
+
- 200
+
+
- 200
+
+
+ 1,000
+
+
+
GPPE
+
+ $0
+
+ $0
+
+ 100
+
-
+
-
= +
+
+ $0
+
+ $0
+
+ $0
+
+ $0
= +
+ 100
+
+
+
+
+
+
= +
= +
+
+
+
= +
+ $0
-
+ $10
= +
+
+ 200
-
+0
+
+ 200
-
+
+
+
+0
+
+0
+
+ $20
+
+
+ $80
+
+
+ $80
= +
+ $0
-
+ $0
+ $0
+
+
+
-
+
+
-
+
+
-
+ 20
+
-
-
+
+
-
-
+
+
+ $40
+
+
+
+
+
+
+0
+
+
+ 1,000
+
+ 1,000
+
+
+0
= +
= +
+0
+
= +
+ $40
+
+
-
+
-
+ + $200
-
= +
+
= +
+ $40
+
+ $1,000 +
+
+0
+
+
+
+ $1,000 +
-
-
+ $60
+
-
-
+
-
+ 10
+
+ $20
-
+ $10
+
+0
-
+0
+
-
+0
+
-
-
+
+ $0
+
+0
+
+
+0
+
- 20
+
- 20
+
+0
-
+0
-
+0
+
+0
+
+0
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
- 20
-
+
+ 40
+ $0
-
+
+ 40
+
+ $20
+
- 60
-
-
+
+
+
-
-
+ 10
+ $10
- $20
+
+
-
+
+ $0
+
+
+0
+ $10
+
+
+ $0
-
+ $0
-
+
- 10
-
+
+
- 10
+
+ $0
+
Operating Activities
Sales collections
Vendor payments
Interest received
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating Activities
Net profit
Depreciation
Receivables
Inventories
Accounts payable
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+ $0
-
-
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
+
-
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
IncS
+
-
= +
-
+
+
-
+ $10
Intinc
+
= +
-
+
- DepEx +
+
+ + $200
+0
+
Cgs
+
= +
+0
-
+
+
+
+ 60
-
- 60
= +
+ 10
+
+
+
-
+ $80
+
+ $20
= +
= +
- 20
+
Rev
-
+0
+
+
-
+
+
RE
-
+
Net income
+
+
+
+
Permanent
CS
+
+ $20
+
+
+
- 20
+ 980
+ $770
+ $0
Current
Owners' Equity
AP
+
+ $770
+
-
= +
+
+
+
- AcDep
=
+
+
+
Noncurrent
Inven
+
- 40
+
+
+
+ 60
+
E5
Total operations
Non-operating Entries
+
= Liabilities +
$40
$10
($20)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 40
+
+ $0
Assets
Current
Cash
Accounts receivable
Inventories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Cost of sales
Depreciation
Operating profit
Non-operating profit
Interest income
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
Comprehensive income
Net profit
Other comprehensive income
Total
Common stock issued
1,000
Dividend declared
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$1,060
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).
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 37
Event E2 — Purchasing a building for $200 cash
ABC Company Balance Sheet
First year of operations
Assets
Current
Beginning balances
Operating Entries
E3
Purchase inventory on account
C
+
+ $0
+
AR
+
+ $0
+
+
E4a Recognize revenue
+
+
E4b Recognize cost of sales
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
E2
Purchase building with cash
Total investing
E1
Issue stock for cash
E8
Dividend declared and paid
Total financing
Trial balance
Closing to and from income summary
Ending balances
+
+ 10
+
+
- $10
+
+
- 200
+
+
- 200
+
+
+ 1,000
+
+
+
GPPE
+
+ $0
+
+ $0
+
+ 100
+
-
+
-
= +
+
Cgs
- DepEx +
Intinc
+
IncS
= +
+ $0
+
+ $0
+
+ $0
+
+ $0
-
+ $0
-
+ $0
+ $0
+
+ $0
= +
+ 100
+
+
+
-
-
+
+
+
+
+
+ 60
-
-
+
+
-
+
+
= +
= +
+
+
+0
+
+
+0
+
+0
+
+ $20
+
+
+ $80
+ 10
= +
+ $0
-
+ $10
= +
+
+ 200
-
+
+ 200
-
+
+
+ $80
= +
-
+
+
-
+
+
+ $40
+
+0
+
+
+
+
+
+0
+
+
+ 1,000
+
+ 1,000
+
+
= +
= +
+0
+
= +
+ $40
+
+
-
+
-
+ + $200
-
= +
+
= +
+ $40
+
+ $1,000 +
+
+0
+
+
+
+ $1,000 +
-
-
+ $60
-
+0
-
+
+
-
+ 10
+
+ $20
-
+ $10
+
+0
-
+0
+
-
+
-
-
+0
+
+
+
+0
-
+0
-
+0
+
+0
+
+0
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
- 20
-
- 10
+
+
+ 40
+ $0
-
+ $0
+
+
+ 40
+
+ $20
+
- 60
-
+ $0
-
+
-
+
- 10
+
Operating Activities
Sales collections
Vendor payments
Interest received
Net cash from operations
Investing
g Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating Activities
Net profit
Depreciation
Receivables
Inventories
Accounts payable
Net cash from operations
Investing
g Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 20
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
+
- 20
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
+
+0
+
-
+
+
+
-
-
+ 10
+ $10
- $20
+
+
-
+
+ $0
+
+
+0
+ $10
+
+
+ $0
-
= +
+ 20
-
-
+ $10
-
+
+
= +
-
+
+
+
+ + $200
+0
+
+
+
= +
+0
-
+
+
+
+
- 60
= +
-
+
+
+
+
-
+
+ $80
+
+ $20
-
= +
- 20
+
Rev
-
+0
+
+
-
+
+
RE
-
+
Net income
+
+
+
+
Permanent
CS
+
+ $20
+
+
+
- 20
+ 980
+ $770
+ $0
Current
Owners' Equity
AP
+
+ $770
+
-
= +
+
+
+
- AcDep
=
+
+
+
Noncurrent
Inven
+
- 40
+
+
+
+ 60
+
E5
Total operations
Non-operating Entries
+
= Liabilities +
$40
$10
($20)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 40
+
+ $0
Assets
Current
Cash
Accounts receivable
Inventories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Cost of sales
Depreciation
Operating profit
Non-operating profit
Interest income
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
Comprehensive income
Net profit
Other comprehensive income
Total
Common stock issued
1,000
Dividend declared
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 39
Event E3 — Purchasing $100 of merchandise on account
ABC Company Balance Sheet
First year of operations
Assets
Current
Beginning balances
Operating Entries
E3
Purchase inventory on account
C
+
+ $0
+
AR
+
+ $0
+
+
E4a Recognize revenue
+
+
E4b Recognize cost of sales
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
E2
Purchase building with cash
Total investing
E1
Issue stock for cash
E8
Dividend declared and paid
Total financing
Trial balance
Closing to and from income summary
Ending balances
+
+ 10
+
+
- $10
+
+
- 200
+
+
- 200
+
+
+ 1,000
+
+
+
GPPE
+
+ $0
+
+ $0
+
+ 100
+
-
+
-
= +
+
+ $0
+
+ $0
+
+ $0
+
+ $0
= +
+ 100
+
+
+
+
+
+
= +
= +
+
+
+
= +
+ $0
-
+ $10
= +
+
+ 200
-
+0
+
+ 200
-
+
+
+
+0
+
+0
+
+ $20
+
+
+ $80
+
+
+ $80
= +
+ $0
-
+ $0
+ $0
+
+
+
-
+
+
-
+
+
-
+ 20
+
-
-
+
+
-
-
+
+
+ $40
+
+
+
+
+
+
+0
+
+
+ 1,000
+
+ 1,000
+
+
+0
= +
+
+
+0
= +
+0
+
= +
+ $40
+
+ $1,000 +
+
-
+
+
+
-
+ + $200
-
= +
+ $40
+
+
+
+ $1,000 +
-
+
+ $0
+
+0
+
+
+ $10
= +
+
+
+ $0
-
-
+ $60
+
-
+ 10
+
-
+ $10
+
+0
-
+0
+
-
+0
+
-
+
-
+ $20
-
-
-
+
+ $0
+
+
+0
+
+0
+
- 20
+
- 20
+
+0
-
+0
-
+0
+
+0
+
+0
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
+
- 60
-
- 20
-
- 10
+
- 10
+
+ 40
+ $0
-
+ 40
+
+
-
+
+
- $20
+ $20
-
+ 10
+ $10
+
-
+ $0
-
+
-
+
+
+ $0
+
Operating Activities
Sales collections
Vendor payments
Interest received
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating Activities
Net profit
Depreciation
Receivables
Inventories
Inve
v ntories
Accounts payable
Net
operations
N t cash
h from
f
ti
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+ $0
-
-
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
+
-
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
IncS
+
-
= +
-
+
+
-
+ $10
Intinc
+
+ + $200
+0
+
- DepEx +
+
= +
-
+
Cgs
+
= +
+0
-
+
+
+
+ 60
-
- 60
= +
+ 10
+
+
+
-
+ $80
+
+ $20
= +
= +
- 20
+
Rev
-
+0
+
+
-
+ 980
+ $770
RE
-
+
Net income
+
+
+
+
Permanent
CS
+
+
+
+
+
- 20
+ $770
+
+ $0
Current
Owners' Equity
AP
+
+
+
-
= +
+
+ $20
+
- AcDep
=
+
+
+
Noncurrent
Inven
+
- 40
+
+
+
+ 60
+
E5
Total operations
Non-operating Entries
+
= Liabilities +
$40
$10
($20)
(
)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 40
+
+ $0
Assets
Current
Cash
Accounts receivable
Inventories
Inve
v ntories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Cost of sales
Depreciation
Operating profit
Non-operating profit
Interest income
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
Comprehensive income
Net profit
Other comprehensive income
Total
Common stock issued
1,000
Dividend declared
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 41
Event E4a — Recognizing $60 revenue for sale on account
ABC Company Balance Sheet
First year of operations
Assets
Current
Beginning balances
Operating Entries
E3
Purchase inventory on account
C
+
+ $0
+
AR
+
+ $0
+
+
E4a Recognize revenue
+
+
E4b Recognize cost of sales
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
E2
Purchase building with cash
Total investing
+
+ 60
+
E5
Total operations
Non-operating Entries
+
+ 10
+
+
- $10
+
+
- 200
+
+
- 200
+
Noncurrent
+
GPPE
+
+ $0
+
+ $0
+
+ 100
+
-
+
-
= +
+
- AcDep
=
Inven
-
+ $0
= +
+
RE
+
Rev
-
Cgs
- DepEx +
Intinc
+
IncS
= +
+ $0
+
+ $0
+
+ $0
+
+ $0
-
+ $0
-
+ $0
+ $0
+
+ $0
= +
+ 100
+
+
+
-
-
+
+
+
+
+
+ 60
-
-
+
+
-
+
+
-
= +
+
-
= +
+
-
= +
+
+
+
+0
+
-
+
+
+ 10
= +
+
+ $0
-
+ $10
= +
+
+ 200
-
+0
+
+ 200
-
= +
-
-
+
+
-
-
+
+
+ $40
+
+0
+
+
+
+0
+
+ 1,000
+
+
+
+ 1,000
+
+
+
-
= +
+
+
- 20
+
+
+
-
= +
+
+
+ 980
+
+0
+
+0
+
+ $770
+
+ $20
+
+ $80
Closing to and from income summary
Ending balances
+
+
+
+
+
+
+ $770
+
+
+ $20
+
+ $80
-
+0
= +
+0
+
+ + $200
-
+ $10
= +
+ $40
+
+
-
+
-
+ + $200
-
= +
= +
+
+ 1,000
+ $40
+
+ $1,000 +
+
+0
+
+
+
+ $1,000 +
-
-
+ $60
-
+0
-
+
+
-
+ 10
+
+ $20
-
+ $10
+
+0
-
+0
+
-
-
+
+ $0
+
-
-
+
+
+
-
-
+
+
+0
- 20
+
+0
-
+0
-
+0
+
+0
+
+0
- $20
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
- 20
-
- 10
+
+
+ 40
+ 40
+
+ $20
+
+ $0
-
+ $0
+
+
- 60
-
+ $0
-
-
- 10
+
Operating Activities
Sales collections
Vendor payments
Interest received
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating Activities
Net profit
pro
r fift
Depreciation
Receivables
Receiva
v bles
Inventories
Accounts payable
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+
+0
+
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
+
+
+
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
+ 10
+ $10
- 20
+
+
-
+
+ $0
+
+
= +
+ $10
+
+
+ $0
Dividend declared and paid
+0
+
+
Issue stock for cash
+
+ 20
+
+
E1
Total financing
-
+
+
E8
Trial balance
+
+
+
= +
+0
+
+
- 60
= +
-
+ $80
+
Net income
+
CS
+
+ $20
Permanent
+
+
+
- 20
Current
Owners' Equity
AP
+
+
+
+
+
+
+
- 40
= Liabilities +
$40
$10
($20)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 40
+
+ $0
Assets
Current
Cash
Accounts re
rreceivable
ceiva
v ble
Inventories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Reve
v nues
Cost of sales
Depreciation
Operating profit
Non-operating profit
Interest income
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
Comprehensive income
profit
Net pro
r fift
Other comprehensive income
Total
Common stock issued
1,000
Dividend declared
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 43
Event E4b — Recognizing $20 of cost of sales
ABC Company Balance Sheet
First year of operations
Assets
Current
Beginning balances
Operating Entries
E3
Purchase inventory on account
C
+
+ $0
+
AR
+
+ $0
+
+
E4a Recognize revenue
+
+
E4b Recognize cost of sales
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
E2
Purchase building with cash
Total investing
+
GPPE
+
+ $0
+
+ $0
+
+ 100
+
-
+
-
= +
+
- AcDep
=
+
-
+ $0
= +
+
RE
+
Rev
-
Cgs
- DepEx +
Intinc
+
IncS
= +
+ $0
+
+ $0
+
+ $0
+
+ $0
-
+ $0
-
+ $0
+ $0
+
+ $0
= +
+ 100
+
+
+
-
-
+
+
+
+
+
+ 60
-
-
+
+
-
+
+
-
= +
+
-
= +
+
-
= +
+
+
+
+0
+
-
+
+
+ 10
= +
+
+ $0
-
+ $10
= +
+
+ 200
-
+0
+
+ 200
-
-
-
+
+
-
-
+
+
+ $40
+
+0
+
- 20
+ 980
+
+0
+
+0
+
+ $20
+
+ $80
+
+
+
+
+
+
+ $770
+
+
+ $20
+
+ $80
+
+
+
- 20
+
+
+0
= +
+0
+
= +
+ $40
+
+
-
+
-
+ + $200
-
= +
+
+ $40
+
-
+ $10
= +
+0
-
-
= +
-
+ 1,000
+
+ $1,000 +
+
+
+
+ $1,000 +
-
+
+ $0
+
+0
- 20
+
+0
-
+0
-
+0
+
+0
+
+0
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
- 20
-
- 10
+
+
+ 40
+ 40
+
+ $20
+
+ $0
-
+ $0
+
+
- 60
-
+ $0
-
-
- 10
+
Operating Activities
Sales collections
Vendor payments
Interest received
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating Activities
Net profit
pro
r fift
Depreciation
Receivables
Inventories
Inve
v ntories
Accounts payable
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+
+0
+
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
+ $10
- $20
+
+
-
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
+
+
-
-
+ $10
+0
+ 10
-
+ + $200
+0
+
+
+
-
+
+
+
= +
+0
+
+ 10
+ $10
+
= +
-
+ $770
-
+
-
+
+
-
-
+ 1,000
+
+0
+
+ $60
-
+
+
+
+ $20
+0
+
+ $0
-
+
+
+
-
+
+
+
+
= +
+
+
+ $0
+ 1,000
Dividend declared and paid
+
+
+
+
+ 20
+
+
+
+
-
+
+
- 200
= +
+
+
+
- 200
+0
+
+
- 60
= +
-
+ $80
+
Net income
+
CS
+
+
Permanent
+
+
+ $20
+
Owners' Equity
AP
+
- 20
Current
+
+
Ending balances
Noncurrent
Inven
+
Issue stock for cash
Closing to and from income summary
+
+
+
+
+
- 40
+
- $10
E1
Total financing
+ 10
+
+
E8
Trial balance
+ 60
+
E5
Total operations
Non-operating Entries
+
= Liabilities +
$40
$10
($20)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 40
+
+ $0
Assets
Current
Cash
Accounts receivable
Inventories
Inve
v ntories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Cost of sales
Depreciation
Operating profit
Non-operating profit
Interest income
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
Comprehensive income
profit
Net pro
r fift
Other comprehensive income
Total
Common stock issued
1,000
Dividend declared
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$1,060
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
$0
-$20
-$20
Inventories
-$100
+$20
-$80
Accounts payable +$100
$0
+$100
$0
$0
$0
Net income Net cash from operations
Combined
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 45
Combining E3 and E4b to Assess Net Effects on Inventories
Assets
Current
Beginning balances
Operating Entries
E3
Purchase inventory on account
C
+
+ $0
+
AR
+
+ $0
+
+
E4a Recognize revenue
+
+
E4b Recognize cost of sales
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
E2
Purchase building with cash
Total investing
+
GPPE
+
+ $0
+
+ $0
+
+ 100
+
-
+
-
= +
+
- AcDep
=
+
-
+ $0
= +
+
RE
+
Rev
-
Cgs
- DepEx +
Intinc
+
IncS
= +
+ $0
+
+ $0
+
+ $0
+
+ $0
-
+ $0
-
+ $0
+ $0
+
+ $0
= +
+ 100
+
+
+
-
-
+
+
+
+
+
+ 60
-
-
+
+
-
+
+
-
= +
+
-
= +
+
-
= +
+
+
+
+0
+
-
+
+
+ 10
= +
+
+ $0
-
+ $10
= +
+
+ 200
-
+0
+
+ 200
-
-
-
+
+
-
-
+
+
+ $40
+
+0
+
- 20
+ 980
+
+0
+
+0
+
+ $20
+
+ $80
+
+
+
+
+
+
+ $770
+
+
+ $20
+
+ $80
+
+
+
- 20
+
+
+0
= +
+0
+
= +
+ $40
+
+
-
+
-
+ + $200
-
= +
+
+ $40
+
-
+ $10
= +
+0
-
-
= +
-
+ 1,000
+
+ $1,000 +
+
+
+
+ $1,000 +
-
+
+ $0
+
+0
- 20
+
+0
-
+0
-
+0
+
+0
+
+0
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
- 20
-
- 10
+
+
+ 40
+ 40
+
+ $20
+
+ $0
-
+ $0
+
+
- 60
-
+ $0
-
-
- 10
+
Operating Activities
Sales collections
Vendor payments
Interest received
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating
g Activities
Net profit
pro
r fift
Depreciation
Receivables
Receiva
v bles
Inventories
Inve
v ntories
Accounts payable
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+
+0
+
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
+ $10
- $20
+
+
-
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
+
+
-
-
+ $10
+0
+ 10
-
+ + $200
+0
+
+
+
-
+
+
+
= +
+0
+
+ 10
+ $10
+
= +
-
+ $770
-
+
-
+
+
-
-
+ 1,000
+
+0
+
+ $60
-
+
+
+
+ $20
+0
+
+ $0
-
+
+
+
-
+
+
+
+
= +
+
+
+ $0
+ 1,000
+
+
+
+
+
+ 20
+
+
+
+
-
+
+
- 200
= +
+
+
+
- 200
+0
+
+
- 60
= +
-
+ $80
+
Net income
+
CS
+
+
Permanent
+
+
+ $20
+
Owners' Equity
AP
+
- 20
Current
+
Dividend declared and paid
Ending balances
Noncurrent
Inven
+
Issue stock for cash
Closing to and from income summary
+
+
+
+
+
- 40
+
- $10
E1
Total financing
+ 10
+
+
E8
Trial balance
+ 60
+
E5
Total operations
Non-operating Entries
+
= Liabilities +
ABC Company Balance Sheet
First year of operations
$40
$10
($20)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 40
+
+ $0
Assets
Current
Cash
Accounts re
rreceivable
ceiva
v ble
Inventories
Inve
v ntories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Reve
v nues
Cost of sales
Depreciation
Operating profit
Non-operating profit
Interest income
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
Comprehensive income
profit
Net pro
r fift
Other comprehensive income
Total
Common stock issued
1,000
Dividend declared
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 47
Event E5 — Collecting $40 from customers
ABC Company Balance Sheet
First year of operations
Assets
Current
Beginning balances
Operating Entries
E3
Purchase inventory on account
C
+
+ $0
+
AR
+
+ $0
+
+
E4a Recognize revenue
+
+
E4b Recognize cost of sales
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
+
E2
Purchase building with cash
E1
Issue stock for cash
E8
Dividend declared and paid
+ 10
+
Total investing
+
+
- 200
+
+
- 200
+
+
+ 1,000
+
GPPE
AP
+
CS
+
RE
+
Rev
+
+ $0
= +
+ $0
+
+ $0
+
+ $0
+
+ $0
+
-
= +
+ 100
+
+
+
+
-
= +
+
+
+
+
-
= +
+
-
= +
+
+
-
= +
- 20
+
+
+
+0
+
+
= +
+ $0
-
+ $10
= +
+
+ 200
-
+0
+
+ 200
-
+
+
+
+
+0
+
+0
+
+ $20
+
+
+ $80
+
+
+
+ $80
= +
+ $0
+
-
+
+
-
+
+
-
+ 20
+
-
-
+
+
-
-
+
+
+ $40
+
+
+
+
+
+
+0
+
+
+ 1,000
+
+ 1,000
+
+
+0
= +
= +
+0
+
= +
+ $40
+
+
-
+
-
+ + $200
-
= +
+
= +
+ $40
+
+ $1,000 +
+
+0
+
+
+
+ $1,000 +
-
-
+ $60
+
-
-
+
-
+ 10
+
+ $20
-
+ $10
+
+0
-
+0
+
-
+0
+
-
-
+
+ $0
+
+0
+
+
+0
+
- 20
+
- 20
+
+0
-
+0
-
+0
+
+0
+
+0
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
- 20
-
+
+ 40
+ $0
-
+
+ 40
+
+ $20
+
- 60
-
-
+
+
+
-
-
+ 10
+ $10
- $20
+
+
-
+
+ $0
+
+
+0
+ $10
+
+
+ $0
-
+ $0
-
+
- 10
-
+
+
- 10
+
+ $0
+
Operating Activities
Sales collections
Vendor payments
Interest received
operations
Net cash fr
ffrom
rom opera
r tions
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating Activities
Net profit
Depreciation
Receivables
Receiva
v bles
Inventories
Accounts payable
Net cash from
from operations
fr
opera
r tions
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+ $0
-
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
IncS
+
+
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
+
+
+
-
= +
+ $0
-
+
-
+ $10
Intinc
-
+
= +
-
+
- DepEx +
+ $0
+
+ + $200
+0
+
Cgs
-
+
= +
+0
-
+
+
+
+ 60
-
- 60
= +
+ 10
+
+
+ $20
-
+ $80
- 20
+
+ $0
+
+
+
Net income
+
+
+ $20
+
Permanent
+ $0
+ 980
+ $770
+
+ 100
-
= +
Current
Inven
+
- AcDep
=
+
+ $770
+
Noncurrent
Owners' Equity
+
+
+
Ending balances
+
+
+
Closing to and from income summary
+
- $10
+
+
- 40
+
+
+
Total financing
Trial balance
+ 60
+
E5
Total operations
Non-operating Entries
+
= Liabilities +
$40
$10
($20)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 40
+
+ $0
Assets
Current
Cash
Accounts re
rreceivable
ceiva
v ble
Inventories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Cost of sales
Depreciation
Operating profit
Non-operating profit
Interest income
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
Comprehensive income
Net profit
Other comprehensive income
Total
Common stock issued
1,000
Dividend declared
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
$0
-$20
$0
-$20
Inventories
-$100
+$20
$0
-$80
Accounts payable +$100
$0
-$60
+$40
$0
$0
-$60
-$60
Net income Net cash from operations
Combined
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:
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Cost of sales
-$20
Inventories
-$80
Accounts payable +$40
Vendor payments
-$60
Introduction to Cash-Flow Statements 49
Event E6 — Paying suppliers $60
Assets
Current
Beginning balances
Operating Entries
E3
Purchase inventory on account
C
+
+ $0
+
AR
+
+ $0
+
+
E4a Recognize revenue
+
+
E4b Recognize cost of sales
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
E2
Purchase building with cash
Total investing
E1
Issue stock for cash
E8
Dividend declared and paid
Total financing
Trial balance
Closing to and from income summary
Ending balances
+
+ 10
+
+
- $10
+
+
- 200
+
+
- 200
+
+
+ 1,000
+
GPPE
+
+ $0
+
+ $0
+
+ 100
+
-
+
-
= +
+
= +
+ $0
+
+ $0
+
+ $0
+
+ $0
= +
+ 100
+
+
+
+
+
+
= +
= +
= +
+0
+
+
+
= +
+ $0
-
+ $10
= +
+
+ 200
-
+0
+
+ 200
-
+
+
+
+0
+
+0
+
+ $20
+
+
+ $80
+
+
+ $80
= +
+ $0
-
+ $0
+ $0
+
+
+
-
+
+
-
+
+
-
+ 20
+
-
-
+
+
-
-
+
+
+ $40
+
+
+
+
+
+
+0
+
+
+ 1,000
+
+ 1,000
+
+
+0
= +
= +
+0
+
= +
+ $40
+
+
-
+
-
+ + $200
-
= +
+
= +
+ $40
+
+ $1,000 +
+
+0
+
+
+
+ $1,000 +
-
-
+ $60
+
-
-
+
-
+ 10
+
+ $20
-
+ $10
+
+0
-
+0
+
-
+0
+
-
-
+
+ $0
+
+0
+
+
+0
+
- 20
+
- 20
+
+0
-
+0
-
+0
+
+0
+
+0
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
- 20
-
+
+ 40
+ $0
-
+
+ 40
+
+ $20
+
- 60
-
-
+
+
+
-
-
+ 10
+ $10
- $20
+
+
-
+
+ $0
+
+
+0
+ $10
+
+
+ $0
-
+ $0
-
+
- 10
-
+
+
- 10
+
+ $0
+
Operating Activities
Sales collections
Vendor payments
Interest received
operations
Net cash fr
ffrom
rom opera
r tions
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating Activities
Net profit
Depreciation
Receivables
Inventories
Accounts payable
Net cash from
from operations
fr
opera
r tions
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+ $0
-
-
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
+
-
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
IncS
+
-
= +
-
+
+
-
+ $10
Intinc
+
= +
-
+
- DepEx +
+
+ + $200
+0
+
Cgs
+
= +
+0
-
+
+
+
+ 60
-
- 60
= +
+ 10
+
+
+
-
+ $80
+
+ $20
Rev
-
- 20
+
+
-
+
+
RE
-
+
Net income
+
+
+
+
Permanent
CS
+
- 20
+
+
+
+ $20
+
+ $0
Current
Owners' Equity
AP
+
+ 980
+ $770
-
= +
+
+ $770
+
- AcDep
=
+
+
+
Noncurrent
Inven
+
+
= Liabilities +
+
+
+
- 40
+
+
+
+ 60
+
E5
Total operations
Non-operating Entries
+
ABC Company Balance Sheet
First year of operations
$40
$10
($20)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 40
+
+ $0
Assets
Current
Cash
Accounts receivable
Inventories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Cost of sales
Depreciation
Operating profit
Non-operating profit
Interest income
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
Comprehensive income
Net profit
Other comprehensive income
Total
Common stock issued
1,000
Dividend declared
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 51
Event E7 — Recognizing $10 of interest income received
Assets
Current
Beginning balances
Operating Entries
E3
Purchase inventory on account
C
+
+ $0
+
AR
+
+ $0
+
+
E4a Recognize revenue
+
+
E4b Recognize cost of sales
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
E2
Purchase building with cash
Total investing
E1
Issue stock for cash
E8
Dividend declared and paid
Total financing
Trial balance
Closing to and from income summary
Ending balances
+
+ 10
+
+
- $10
+
+
- 200
+
+
- 200
+
+
+ 1,000
+
+
+
GPPE
+
+ $0
+
+ $0
+
+ 100
+
-
+
-
= +
+
-
Cgs
- DepEx +
Intinc
+
IncS
= +
+ $0
+
+ $0
+
+ $0
+
+ $0
-
+ $0
-
+ $0
+ $0
+
+ $0
= +
+ 100
+
+
+
-
-
+
+
+
+
+
+ 60
-
-
+
+
-
+
+
= +
= +
+
+
+
= +
+ $0
-
+ $10
= +
+
+ 200
-
+0
+
+ 200
-
+
+
+
+0
+
+0
+
+ $20
+
+
+ $80
+
+
+ $80
= +
-
+
+
-
+
+
+ $40
+
+0
+
+
+
+
+
+0
+
+
+ 1,000
+
+ 1,000
+
+
= +
= +
+0
+
= +
+ $40
+
+
-
+
-
+ + $200
-
= +
+
= +
+ $40
+
+ $1,000 +
+
+0
+
+
+
+ $1,000 +
-
-
+ $60
-
+0
-
+
+
-
+ 10
+
+ $20
-
+ $10
+
+0
-
+0
+
-
+
-
-
+0
+
+
+
+0
-
+0
-
+0
+
+0
+
+0
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
- 20
-
- 10
+
+
+ 40
+ $0
-
+ $0
+
+
+ 40
+
+ $20
+
- 60
-
+ $0
-
+
-
+
- 10
+
Operating Activities
Sales collections
Vendor payments
Interest
Intere
r st re
rreceived
ceive
v d
operations
Net cash fr
ffrom
rom opera
r tions
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating Activities
Net profit
pro
r fift
Depreciation
Receivables
Inventories
Accounts payable
Net cash from
from operations
fr
opera
r tions
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 20
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
+
- 20
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
+
+0
+
-
+
+
+
-
-
+ 10
+ $10
- $20
+
+
-
+
+ $0
+
+
+0
+ $10
+
+
+ $0
-
= +
+ 20
-
-
+ $10
-
+
+
= +
-
+
+
+
+ + $200
+0
+
+
+
= +
+0
-
+
+
+
+
- 60
= +
+ 10
+
+
+
-
+ $80
+
+ $20
Rev
= +
- 20
+
+
-
+0
+
RE
-
+
Net income
+
+
-
+
Permanent
CS
+
+
+
+
+
+ $20
+
+ $0
Current
Owners' Equity
AP
+
- 20
+ 980
+ $770
-
= +
+
+ $770
+
- AcDep
+
+
+
=
+
+
+
Noncurrent
Inven
+
- 40
+
+
+
+ 60
+
E5
Total operations
Non-operating Entries
+
= Liabilities +
ABC Company Balance Sheet
First year of operations
$40
$10
($20)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 40
+
+ $0
Assets
Current
Cash
Accounts receivable
Inventories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Cost of sales
Depreciation
Operating profit
Non-operating profit
Intere
r st income
Interest
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
Comprehensive income
profit
Net pro
r fift
Other comprehensive income
Total
Common stock issued
1,000
Dividend declared
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 53
Event E8 — Declare and pay dividend of $20
ABC Company Balance Sheet
First year of operations
Assets
Current
Beginning balances
Operating Entries
E3
Purchase inventory on account
C
+
+ $0
+
AR
+
+ $0
+
+
E4a Recognize revenue
+
+
E4b Recognize cost of sales
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
E2
Purchase building with cash
Total investing
E1
Issue stock for cash
E8
Dividend declared and paid
Total financing
Trial balance
Closing to and from income summary
Ending balances
+
+ 10
+
+
- $10
+
+
- 200
+
+
- 200
+
+
+ 1,000
+
+
+
GPPE
AP
+
CS
+
RE
+
Rev
+
+ $0
= +
+ $0
+
+ $0
+
+ $0
+
+ $0
+
-
= +
+ 100
+
+
+
+
-
= +
+
+
+
+
-
= +
+
-
= +
+
+
-
= +
- 20
+
+
+
+
+0
+
+
= +
+ $0
-
+ $10
= +
+
+ 200
-
+0
+
+ 200
-
+
+
- 20
+
+
+0
+
+0
+
+ $20
+
+
+ $80
+
+
+
+ $20
+
+ $80
= +
+ $0
+
-
+
+
-
+
+
-
+ 20
+
-
-
+
+
-
-
+
+
+ $40
+
+
+
+
+
+
+0
+
+
+ 1,000
+
+
+0
= +
+
+
+0
= +
+0
+
= +
+ $40
+
+ $1,000 +
+
-
+
+
+
-
+ + $200
-
= +
+ $40
+ 1,000
+
+
+
+
+ $1,000 +
-
+
+ $0
+
+0
+
+
+ $10
= +
+
+
+ $0
-
-
+ $60
+
-
+ 10
+
-
+ $10
+
+0
-
+0
+
-
+0
+
-
+
-
+ $20
-
-
-
+
+ $0
+
+0
+
+
+0
+
- 20
+
- 20
+
+0
-
+0
-
+0
+
+0
+
+0
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
- 60
-
- 20
-
- 10
+
- 10
+
+ 40
+ $0
-
+ $0
+
+ 40
+
+ $20
+
-
+
+
- $20
+
-
+ 10
+ $10
+
-
+ $0
-
+
-
+
+
Operating Activities
Sales collections
Vendor payments
Interest received
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
dividends
Cash divi
v dends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating Activities
Net profit
Depreciation
Receivables
Inventories
Accounts payable
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
divi
v dends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+ $0
-
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
IncS
+
+
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
+
+
+
-
= +
+ $0
-
+
-
+ $10
Intinc
-
+
+ + $200
+0
+
- DepEx +
+ $0
+
= +
-
+
Cgs
-
+
= +
+0
-
+
+
+
+ 60
-
- 60
= +
+ 10
+
+
+
-
+ $80
+ 980
+ $770
+ $0
+
+ $770
+
Net income
+
+
+
+
Permanent
+ $0
+ $20
+
+
+ 100
-
= +
Current
Inven
+
- AcDep
=
+
+
+
Noncurrent
Owners' Equity
+
+
- 40
+
+
+
+ 60
+
E5
Total operations
Non-operating Entries
+
= Liabilities +
$40
$10
($20)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 40
+
+ $0
Assets
Current
Cash
Accounts receivable
Inventories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Cost of sales
Depreciation
Operating profit
Non-operating profit
Interest income
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
Comprehensive income
Net profit
Other comprehensive income
Total
Common stock issued
1,000
Dividend
Divi
v dend declared
declare
r d
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$1,060
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 55
Event E9 — Recognize $10 of depreciation
Assets
Current
Beginning balances
Operating Entries
E3
Purchase inventory on account
C
+
+ $0
+
AR
+
+ $0
+
+
E4a Recognize revenue
+
+
E4b Recognize cost of sales
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
E2
Purchase building with cash
Total investing
E1
Issue stock for cash
E8
Dividend declared and paid
Total financing
Trial balance
Closing to and from income summary
Ending balances
+
+ 10
+
+
- $10
+
+
- 200
+
+
- 200
+
+
+ 1,000
+
+
GPPE
AP
+
CS
+
RE
+
Rev
-
Cgs
- DepEx +
Intinc
+
IncS
+
+ $0
= +
+ $0
+
+ $0
+
+ $0
+
+ $0
-
+ $0
-
+ $0
+ $0
+
+ $0
+
-
= +
+ 100
+
+
+
+
-
= +
+
+
+
+
-
= +
+
-
= +
+
+
-
= +
- 20
+
+
+
+
+0
+
+
= +
+ $0
-
+ $10
= +
+
+ 200
-
+0
+
+ 200
-
+
+
+
+
+0
+
+0
+
+ $20
+
+
+ $80
+
+
+ $20
+
+ $80
= +
-
+
+
-
+
+
-
+ 20
+
-
-
+
+
+
-
-
+
+
+ $40
+
+0
+
+
+
+
+
+0
+
+
+ 1,000
+
+ 1,000
+
+
= +
= +
+0
+
= +
+ $40
+
+
-
+
-
+ + $200
-
= +
+
= +
+ $40
+
+ $1,000 +
+
+0
+
+
+
+ $1,000 +
-
-
+ $60
-
+0
-
+
+
-
+ 10
+
+ $20
-
+ $10
+
+0
-
+0
+
-
+
-
-
+0
+
+
+
+0
-
+0
-
+0
+
+0
+
+0
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
- 20
-
- 10
+
+
+ 40
+ $0
-
+ $0
+
+
+ 40
+
+ $20
+
- 60
-
+ $0
-
+
-
+
- 10
+
Operating Activities
Sales collections
Vendor payments
Interest received
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating
g Activities
Net profit
pro
r fift
Depreciation
Depre
r ciation
Receivables
Inventories
Accounts payable
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 20
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
+
- 20
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
+
+0
+
-
+
+
+
-
-
+ 10
+ $10
- $20
+
+
-
+
+ $0
+
+
+0
+ $10
+
+
+ $0
-
= +
-
+
-
+ $10
+
+
= +
-
+
+
+
+ + $200
+0
+
-
+
= +
+0
-
+
+
+
+ 60
+
-
- 60
= +
+ 10
+
- 20
+
-
+ $80
+
+
+ $0
+
+ $20
+
Net income
+
+
+ 980
+ $770
Permanent
+ $0
-
= +
+
+ 100
+
- AcDep
Current
Inven
+ $770
+
=
+
+
+
Noncurrent
Owners' Equity
+
+
+
= Liabilities +
+
+
- 40
+
+
+
+ 60
+
E5
Total operations
Non-operating Entries
+
ABC Company Balance Sheet
First year of operations
+ $0
+
- 40
+
+ $0
$40
$10
($20)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
Assets
Current
Cash
Accounts receivable
Inventories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
depre
r ciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Cost of sales
Depre
r ciation
Depreciation
Operating profit
Non-operating profit
Interest income
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
Comprehensive income
profit
Net pro
r fift
Other comprehensive income
Total
Common stock issued
1,000
Dividend declared
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
56
Navigating Accounting
®
Creating Financial Statements From the BSE Matrix
ABC Company Balance Sheet
First year of operations
Assets
Current
Operating Entries
+
AR
+
+ $0
Net income
+
Inven
+
GPPE
AP
+
CS
+
RE
+
Rev
-
Cgs
- DepEx +
Intinc
+
IncS
+
+ $0
+
+ $0
= +
+ $0
+
+ $0
+
+ $0
+
+ $0
-
+ $0
-
+ $0
+ $0
+
+ $0
+ 100
+
-
= +
+ 100
+
+
+
-
-
+
+
+
+
-
= +
+
+
+
+ 60
-
-
+
+
E4b Recognize cost of sales
+
+
+
-
+
+
+
+
+
-
-
+
+
+
+
+
-
-
+
+
+
Customer collections
+
+ 40
+
E6
Supplier payments
+
- 60
+
E7
Interest income and collection
E9
Depreciation expense
E2
Purchase building with cash
Total investing
+
+ 10
+
+
- 40
+
- $10
+
+
- 200
+
+
- 200
+
+ $0
+
-
= +
+
+
-
= +
+
+
-
= +
- 20
+
+
+
-
= +
Permanent
+
E5
- AcDep
+
+
+ 60
+
Current
+
Total operations
Non-operating Entries
C
=
+
Purchase inventory on account
+ $0
Noncurrent
+
E3
+
+
Owners' Equity
E4a Recognize revenue
Beginning balances
+
= Liabilities +
+
+
+ $20
+
+0
+
-
+
= +
-
+ 10
= +
+ $80
+
+ $0
-
+ $10
= +
+
+ 200
-
+0
+
+ 200
-
+
- 60
+
= +
+0
= +
+
+
+ 1,000
+
Issue stock for cash
+
+ 1,000
+
+
+
-
= +
+
Dividend declared and paid
+
- 20
+
+
+
-
= +
+
+
+ 980
+
+0
+
+0
+
+ $770
+
+ $20
+
+ $80
Total financing
Closing to and from income summary
Ending balances
+
+
+
+
+
+
+ $770
+
+
+ $20
+
+ $80
+
-
+0
= +
+0
+
+ + $200
-
+ $10
= +
+ $40
+
+
-
+
-
+ + $200
-
+0
= +
+
= +
+ $10
= +
+ $40
+
+0
+
+
+0
E1
+ $0
+ 1,000
+
+
+ $1,000 +
+0
-
+
-
+ 10
+
+ $20
-
+ $10
+
+0
-
+0
+
-
-
+
+ $0
+
-
-
+
+
+
-
-
+
+
+0
- 20
+
+0
-
+0
-
+0
+
+0
+
+0
+
+ $60
-
+ $20
-
+ $10
+
+ $10
+
+ $0
- 20
-
- 10
+
+
+ 40
+ 40
+
+ $20
+
+ $0
-
+ $0
+
+
- 60
-
+ $0
-
-
- 10
+
Operating Activities
Sales collections
Vendor payments
Interest received
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
Operating Activities
Net profit
Depreciation
Receivables
Inventories
Accounts payable
Net cash from operations
Investing Activities
Purchase of building
Net cash (used) for investing
Financing Activities
Sale of common stock
Cash dividends
Net cash from financing
Change in cash
Beginning Cash balance
Ending cash balance
$1,000
($20)
$980
$770
$0
$770
+
+0
+
ABC Company Indirect Cash Flow Statement
First year of operations
($200)
($200)
+
+
+
ABC Company Direct Cash Flow Statement
First year of operations
$40
($60)
$10
($10)
+ 10
+ $10
- 20
+
+
-
- $20
+ $1,000 +
+
-
-
+ $60
+
+
+ 20
-
+
+
+
-
+
+
+ $0
+
+0
E8
Trial balance
+
+
+ $40
+
+
$40
$10
($20)
($80)
$40
($10)
($200)
($200)
$1,000
($20)
$980
$770
$0
$770
+ $0
+
- 40
+
+ $0
Assets
Current
Cash
Accounts receivable
Inventories
Total current assets
Non-current assets
Property, plant, and equipment, net
Historical cost of PP&E
Less accumulated depreciation
Property, plant and equipment, net
Total non-current assets
Total assets
End Bal Beg Bal
Liabilities and Stockholders' Equity
Liabilities
Current
Accounts payable
Total current liabilities
Non-current
Total liabilities
Stockholders' equity
Common stock
Retained earnings
Total stockholders' equity
Total liabilities and stockholders' equity
$770
20
80
870
$0
0
0
0
200
(10)
190
190
$1,060
0
0
0
0
$0
40
40
0
40
0
0
0
0
1,000
20
1,020
$1,060
0
0
0
$0
ABC Statement of Comprehensive Income
First year of operations
Operating profit
Revenues
Cost of sales
Depreciation
Operating profit
Non-operating profit
Interest income
Net profit
Other comprehensive income
Comprehensive income
$60
(20)
(10)
30
10
40
0
$40
ABC Company Statement of Changes in Equity
First year of operations
Common
Stock
Beginning balances
$0
0
Comprehensive income
profit
Net pro
r fift
comprehensive
Other compre
r hensive
v income
Total
T
To
tal
1,000
Common stock issued
Dividend
Divi
v dend declared
declare
r d
Ending balances
$1,000
Retained
Earnings
$0
Reserves
$0
40
40
0
0
(20)
$60
0
$0
Total
$0
40
0
40
1,000
(20)
$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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
• 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
Drill Deeper
Here is a three-step
process to help you gain a
deeper understanding of
reconciliation 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]
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 61
Exercise 3.03
R
E
C
O
R
D
K
E
E
P
I
N
G
A
=L
=
iabilities
+O
wners'
liabilities + permanent OE+
E
quities
temporary OE
Zero
E
n
t
r
i
e
s
Tr Bal
Cls IS
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.
Cls RE
End Bal
Direct Cash Flows
R
E
P
O
R
T
I
N
G
ssets
cash +other assets
Beg Bal
Zero
Balance Sheets
Income Statements
Operating
Assets
Investing
Liabilities
Expenses
Financing
Owners' Equity
Gains & Losses
Cash change
Here are the entries for the month of January:
Revenue
Net Income
Reconciliations
E1 CreativeABCs declares and pays a $100 dividend.
Net Income
Adjustments
Operating Cash
Record Keeping
and Reporting
Icon
This exercise helps
you meet the insider
record keeping and
reporting challenge.
E2 CreativeABCs sells debt securities for $1,500 cash.
E3 CreativeABCs buys inventories on account from TrustySupplier for
$5,000.
E4 CreativeABCs sells inventories that cost $2,000 for $5,000 on
account. The company recognizes revenues when sells occur.
E5 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 CreativeABCs pays its landlord $800 for store space rented during
January.
E8 CreativeABCs collects $4,930 from customers for previously
recognized revenues associated with sales on account.
E9 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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
62
Navigating Accounting
®
CreativeABC COMPANY
BALANCE SHEETS
(In Thousands)
Assets
Current
Cash
Accounts receivable
Short-term investments
Inventories
Total current assets
Noncurrent
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
31-Dec-10
$2,430
2,300
5,500
3,000
13,230
0
$13,230
$2,500
500
92
3,092
0
3,092
10,000
138
10,138
$13,230
CreativeABC Company
Chart of Accounts
ASSETS
Current
AR
C
Inven
StInv
Accounts receivable
Cash
Inventory
Short-term investments
LIABILITIES
Current
AP
AcCB
TaxP
Accounts payable
Accrued compensation & benefits
Taxes payable
OWNERS' EQUITY
Permanent
CS
RE
Common stock (non-par)
Retained earnings
Net income
Cgs
MG&A
IncS
Intinc
Rev
TxExp
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Cost of goods sold
Marketing, general & administrative expense
Income summary
Interest income
Revenues, net
Tax expense
Sell debt securities
Declare and pay dividend
January 31, 2011
Closing to and from income summary
Trial balance
Total financing
E1
Total investing
E2
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
C
+
+
+
+
+
+
Total operations
+
Interest earned
E9
+
+
Customer collections
E8
E12 Recognize tax expense
+
Pay landlord for January rent
E7
+
+
Supplier payments
E6
E10 Unpaid wages for Jan 15- Jan 31
+
Pay wages for Dec 16- Jan15
E5
+
E4b Recognize cost of sales
+
+
Purchase inventory on account
+
+
E4a Recognize revenue
E3
December 31, 2010
Operating
Financing Investing
AR
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
Assets
StInv
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
Inven
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
= +
=
CreativeABC Company BSE for Entries E1-E12 and Closing for January 1 - 31, 2011
AP
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
AcCB
Liabilities
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
TaxP
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
CS
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
Permanent
RE
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
Rev
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
Cgs
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
MG&A
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
Intinc
Net income
Owners' Equity
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
+
- TxExp +
IncS
Introduction to Cash-Flow Statements 63
Part (a)
Record all entries for the month of January and determine all balances in the BSE matrix:
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
E3
Purchase inventory on account
E4b Recognize cost of sales
E6
Supplier payments
E8
Customer collections
E10 Unpaid wages for Jan 15- Jan 31
C1: Income summary
Debit
Credit
Debit
Credit
Debit
Credit
Debit
Credit
Debit
Credit
Debit
Credit
Debit
Credit
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
E2
Sell debt securities
E4a Recognize revenue
E5
Pay wages for Dec 16- Jan15
E7
Pay landlord for January rent
E9
Interest earned
E12 Recognize tax expense
C2: Close income to retained earnings
Debit
Credit
Debit
Credit
Debit
Credit
Debit
Credit
Debit
Credit
Debit
Credit
Debit
Credit
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
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
31-Jan-11
31-Dec-10
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
0
(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
CreativeABC Company Statement of Changes in Owners' 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
Comprehensive income
Navigating Accounting
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
Assets
Current
Cash
Accounts receivable
Short-term investments
Inventories
Total current assets
Non-current
Total assets
CreativeABC Company Balance Sheets
66
®
Part (d)
Complete the balance sheets, income statement, and statement of owners’ equity:
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 Direct Cash Flow Statement
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
Introduction to Cash-Flow Statements 67
Part (e)
Complete the direct and indirect cash-flow statements:
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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 2007.
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 2007. As
we shall see shortly, AMD increased its debt significantly over this period.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
70
Navigating Accounting
®
Intel Cash Flow Analysis
Three Years Ended December 29, 2007
(In Millions)
Net cash from operations
+ Interest payments
+ Income tax payments
+ Excess tax benefit from share-based payment arrangements
Net cash from operations before interest and taxes
- CAPX and intangibles needed to maintain current capacity (estimated as depreciation and amortization)
Cash surplus (shortfall) after maintaining current capacity,
capacity pretax and prefinancing
- Interest payments
- Income tax payments
- Principal payments on long-term debt and notes payable
- Short-term debt payments in excess of short-term borrowings
Cash surplus (shortfall) after maintaining current capacity and paying debt and taxes
- Cash purchases of PP&E to both maintain and expand capacity, net of disposals
- 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)
+ Cash outflows to maintain capacity ( as reported above)
Cash surplus (shortfall) after maintaining and expanding capacity and paying debt and taxes
- Share repurchases
- Cash dividends
Cash surplus (shortfall) before new financing and securities transactions
New financing
+ Proceeds from issuing capital shares
+ Proceeds from issuing long term debt
+ Short-term borrowings in excess of short-term debt payments
Securities transactions
+ Proceeds from selling investment securities and maturities
- Purchases of investment securities
Other cash flows
Net increase (decrease) in cash
2007
12,625
15
2,762
118
15,520
(4,798)
10 722
10,722
(15)
(2,762)
──
(39)
7,906
(5,000)
2006
10,632
25
2,432
123
13,212
(4,912)
8 300
8,300
(25)
(2,432)
(581)
(114)
5,148
(5,860)
250
4,798
7,954
(2,788)
(2,618)
2,548
719
4,912
4,919
(4,593)
(2,320)
(1,994)
(309)
4,595
8,652
(10,637)
(1,958)
(3,943)
3,052
125
0
1,046
──
0
1,202
1,742
126
8,011
(13,187)
160
709
7,147
(6,994)
69
(726)
8,433
(8,668)
25
(1,083)
2007
(310)
314
26
30
(1,305)
(1,275)
(314)
(26)
(2,291)
(182)
(2)
(4,090)
(1,612)
175
2006
1,287
79
17
1,383
(837)
546
(79)
(17)
(539)
2005
1,483
139
40
1,662
(1,219)
443
(139)
(40)
(316)
(89)
(1,834)
(3,416)
(7)
(59)
(1,503)
(41)
1,305
(4,222)
(46)
(4,268)
837
(4,502)
0
(4,502)
1,219
(384)
0
(384)
608
78
0
3,649
495
231
0
3,366
223
210
0
189
77
169
219
163
──
2005
14,851
27
3,218
18,096
(4,595)
13 501
13,501
(27)
(3,218)
(19)
0
10,237
(5,871)
AMD Cash Flow Analysis
Three Years Ended December 29, 2007
(In Millions)
Net cash from operations
+ Interest payments
+ Income tax payments
Net cash from operations before interest and taxes
- CAPX needed to maintain current capacity (estimated as depreciation and amortization)
Cash surplus (shortfall) after maintaining current capacity, pretax and prefinancing
- Interest paid
- Income taxes paid
- Principal payments on long-term debt and capital lease obligations
- Purchase of capped call
- Other financing
Cash surplus (shortfall) after maintaining current capacity and paying debt and taxes
- Cash purchases of PP&E to both maintain and expand capacity, net of disposals
- Net cash purchases of other long term assets to both expand and maintain capacity
(estimated by all other investing cash flows except those related to marketable securities)
+ Cash outflows to maintain capacity ( as reported above)
Cash surplus (shortfall) after maintaining and expanding capacity and paying debt and taxes
- Repayment of silent partner contributions
Net cash inflows (outflows) before new financing
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
+ Proceeds from limited partners and sale leaseback
+ Proceeds from government grants and subsidies
Marketable securities transactions
Purchases of available-for-sale investments
Maturities and sales of available-for-sale investments
Other cash flows
Net increase (decrease) in cash
(545)
307
52
(2,119)
(2
119)
3,066
747
(1,562)
(1
562)
836
7
(286)
Sources: Intel’s 2007 10-K and AMD’s 2007 10-K
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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 2005-2006
but fell short by $1,275 in 2007.
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 2005-2007 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 2007.
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 2005-2007, 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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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 2007. 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 2005-2007, 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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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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
First year of operations
Operating Activities
Net Income
Depreciation
Receivables
Inventories
Accounts payable
Net cash from operations
$40
$10
($20)
($80)
$40
($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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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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
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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Exercise 3.04
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learn how accounting
reports are used by
investors, creditors, and
other stakeholders.
Figure 3.02-4 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, 2002.
(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.
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(c) True or False: Income tax expense was $241 for 2001.
(d) True or False: As indicated on the balance sheet, income tax payments
were $114 for 2001.
(e) True or False: As indicated on the income statement, the Company
likely collected $6,953 from its customers during 2001.
(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 2001.
(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 2001.
(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).
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 79
Exercise 3.05
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learn how accounting
reports are used by
investors, creditors, and
other stakeholders.
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Figures 3.02-4 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, 2002.
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 indicates that the
number of franchised restaurants increased from 15,097 at the end of
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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Navigating Accounting
®
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 1997-2001 financial-statement consequences
of Tricon’s strategy to sell stores to franchisees to generate cash to reduce
its debt.
(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 1999-2001 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
2001.
(g) Estimate the average royalty rate that the franchisees and licensees
were charged by Tricon during 2001.
(h) Complete the three tables at the top of the next page for 19982001. 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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 81
Yum! Brands (Tricon)
2001
2000
1999
1998
1997
Profit margin
Turnover
Financial Leverage
(1-tax rate)
ROE
ROA
Net revenues
Income before taxes
Tax expense
Net Income
$6,520
Beginning total assets
Ending total assets
Average total assets
($322)
Beginning owners' equity
($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 1997-2001?
(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 1997-2001. 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)
2001
2000
Profit margin
10.54%
9.64%
Adjusted profit margin
10.56%
7.16%
Net revenues
$6,953
$7,093
$733
$684
Income before taxes
Facility actions (loss) gain
Adjusted pretax income
($1)
$734
1999
1998
1997
$176
$508
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Exercise 3.06
This exercise pertains to the cash-flow statements for Cisco and Starbucks
in Figures 3.07-3.08, respectively. It also pertains to their income
statements which are in Figures 2.02 and 2.04 in Chapter 2.
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learn how accounting
reports are used by
investors, creditors, and
other stakeholders.
(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?
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(c) Estimate the cash that Cisco spent on in-process research and
development during 2002.
(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 2000-2002
because the government permits companies to deduct stock options
as compensation?
Computation Icon
This exercise helps you
learn how to compute
numbers for your
analyses using formulas
and financial statement
information.
(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 2002.
(h)True or False: Starbucks paid $41,379 for inventories during 2002.
(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.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 83
KEY TAKE-AWAYS
• The purpose of cash-flow statements is to help users predict a
company’s future cash flows and assess the quality of net income.
This is accomplished in two ways: (1) cash-flow statements help
users predict future cash flows by explaining the change in cash in
terms of operating, investing, and financing activities and (2) they
reconcile differences between net income and cash from operations,
which helps users assess the quality of net income and predict when
income will be converted to cash.
• Operating cash flows mostly pertain to ongoing activities in a
company’s primary business 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).
• GAAP defines operating activities as a residual concept to include
all activities that are not investing or financing activities. As a result,
cash from operations includes a few items that have very little to
do with operating activities such as tax and interest payments, and
interest and dividends received from investments.
• On indirect cash-flow statements, the line items above net cash from
operations are adjustments and help explain the reasons net income
differs from cash from operations. Generally, they are not cash flows.
• Investing and financing sections of cash-flow statements primarily
correspond to direct cash inflows and outflows. The exceptions are
beyond the scope of this chapter.
• Operating entries always affect the reconciliation of income to cash
from operations. Specifically, they always affect one or more line
items: net income, adjustments, or cash from operations.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
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• Adjustments reflect the net effects of all operating entries. Thus, some
adjustments are not really needed to reconcile income to cash from
operations. In this case, there are off-setting adjustments with a $0
overall net effect.
• Adjustments associated with assets are the opposite, or the negative
of the net effect of the operating entries on the related assets. In
particular, negative adjustments are associated with increases in the
related asset and positive adjustments with decreases.
• Adjustments associated with liabilities are the same as the net effect
of the operating entries on related liabilities. In particular, positive
adjustments are associated with increases in the related liability and
negative adjustments with decreases.
• The difference between an adjustment on the cash-flow statement
and the total change in the related balance sheet item is the net effect
of non-operating events, such as acquisitions or divestitures (taking
into account that adjustments associated with assets are the negative
of the balance sheet effect).
• The better you understand the entries behind reconciliation
adjustments, the more prepared you will be for analyzing cash-flow
statements. Almost every accounting decision requiring judgment
affects one or more adjustment. This includes many decisions
associated with revenue recognition, expense recognition, and gains
and losses recognition.
• By understanding the entries’ effects on the financial statements, the
better prepared you will be to find related information and use it
with other information to analyze the combined effects.
• Business context matters. It is important to know when you can use
information to reliably estimate items that are not disclosed. For
example, estimating vender payments from cash-flow statement and
income-statement information is problematic for some companies,
like manufacturing.
• Many accounting scandals stem from judgments that increase income
but not cash from operations. The consequences of these judgments
can be traced to reconciliation adjustments of net income to net
cash from operations. When the numbers reported as reconciliations
are unusually large or small relative to historic trends or competitors’
numbers, you should analyze them skeptically.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 85
Figure 3.01 Intel’s Statement of Cash Flows
This figure illustrates Intel’s statements of cash flows.
Intel Consolidated Statements of Cash Flows
Three Years Ended December 29, 2007
(In Millions)
Cash and cash equivalents, beginning of year
Cash flows provided by (used for) operating activities:
Net income
Adjustments to reconcile net income to cash provided by operating activities:
Depreciation
Share-based compensation
Restructuring, asset impairment, and net loss on retirement of assets
Excess of tax benefit from share-based payment arrangements
Amortization of intangibles and other acquisition related costs
(Gains) losses on equity investments, net
(Gains) on divestitures
Deferred taxes
Tax benefit from employee equity incentive plans
Changes in assets and liabilities:
Trading assets
Accounts receivable
Inventories
Accounts payable
Income taxes payable and receivable
Other assets and liabilities
Total adjustments
Net cash provided by operating activities
Cash flows provided by (used for) investing activities
Additions to property, plant, and equipment
Acquisitions, net of cash acquired
Purchases of available-for-sale investments
Maturities and sales of available-for-sale investments
Investments in non-marketable equity instruments
Net proceeds from divestitures
Other investing activities
Net cash used for investing activities
Cash flows provided by (used for) financing activities
Increase (decrease) in short-term debt, net
Proceeds from government grants
Excess tax benefit from share-based payment arrangements
Additions to long-term debt
Repayments and retirements of long-term debt
Repayments of notes payable
Proceeds from sales of shares through employee equity incentive plans
Repurchase and retirement of common stock
Payment of dividends to stockholders
Net cash used for financing activities
Net increase (decrease) in cash and cash equivalents
Cash and cash equivalents at the end of the year
Supplemental disclosures of cash flow information:
Cash paid during the year for:
Interest, net of amounts capiatlized of $57 in 2007 and $60 in 2006
Income taxes, net of refunds
$
2007
6,598
$
2006
7,324
$
2005
8,407
6,976
5,044
8,664
4,546
952
564
(118)
252
(157)
(21)
(443)
──
4,654
1,375
635
(123)
258
(214)
(612)
(325)
──
4,345
──
74
──
250
45
──
(413)
351
(1,429)
316
700
102
(248)
633
5,649
12,625
324
1,229
(1,116)
7
(60)
(444)
5,588
10,632
1,606
(912)
(500)
303
797
241
6,187
14,851
(5,000)
(76)
(11,728)
8,011
(1,459)
32
294
(9,926)
(5,860)
──
(5,272)
7,147
(1,722)
752
(33)
(4,988)
(5,871)
(191)
(8,475)
8,433
(193)
──
(118)
(6,415)
$
(39)
160
118
125
──
──
3,052
(2,788)
(2,618)
(1,990)
709
7,307
$
(114)
69
123
──
──
(581)
1,046
(4,593)
(2,320)
(6,370)
(726)
6,598
$
126
25
──
1,742
(19)
──
1,202
(10,637)
(1,958)
(9,519)
(1,083)
7,324
$
$
15
2,762
$
$
25
2,432
$
$
27
3,218
See notes to Consolidated Financial Statements.
The company’s notes found in its annual report are an integral part of this statement.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
86
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Figure 3.02 Yum! Brands’ Balance Sheets
This figure illustrates Yum! Brands’ balance sheets.
Consolidated Balance Sheets
December 29, 2001 and December 30, 2000
(in millions)
2001
2000
$ 110
35
$ 133
63
175
56
92
79
302
47
68
75
547
688
2,777
458
213
393
2,540
419
257
245
$ 4,388
$ 4,149
$ 995
114
696
$ 978
148
90
1,805
1,216
1,552
927
—
2,397
848
10
4,284
4,471
—
—
ASSETS
Current Assets
Cash and cash equivalents
Short-term investments, at cost
Accounts and notes receivable, less allowance: $77 in 2001
and $82 in 2000
Inventories
Prepaid expenses and other current assets
Deferred income tax assets
Total Current Assets
Property, plant and equipment, net
Intangible assets, net
Investments in unconsolidated affiliates
Other assets
Total Assets
LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)
Current Liabilities
Accounts payable and other current liabilities
Income taxes payable
Short-term borrowings
Total Current Liabilities
Long-term debt
Other liabilities and deferred credits
Deferred income taxes
Total Liabilities
Shareholders’ Equity (Deficit)
Preferred stock, no par value, 250 shares authorized; no shares issued
Common stock, no par value, 750 shares authorized; 146 and 147 shares
issued in 2001 and 2000, respectively
Accumulated deficit
Accumulated other comprehensive income (loss)
Total Shareholders’ Equity (Deficit)
Total Liabilities and Shareholders’ Equity (Deficit)
1,097
(786)
(207)
1,133
(1,278)
(177)
104
(322)
$ 4,388
$ 4,149
See accompanying Notes to Consolidated Financial Statements.
The company’s notes found in its annual report are an integral part of this statement.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
Introduction to Cash-Flow Statements 87
Figure 3.03 Yum! Brands’ Income Statements
This figure illustrates Yum! Brands’ income statements.
Consolidated Statements of Income
Fiscal years ended December 29, 2001, December 30, 2000 and December 25, 1999
2001
2000
1999
$ 6,138
815
$ 6,305
788
$ 7,099
723
6,953
7,093
7,822
1,908
1,666
1,658
1,942
1,744
1,665
2,238
1,956
1,814
5,232
5,351
6,008
830
49
(25)
(176)
204
895
25
(16)
(381)
51
6,062
6,233
6,582
891
158
860
176
1,240
202
Net Income
$
733
241
492
684
271
$ 413
1,038
411
$ 627
Basic Earnings Per Common Share
$ 3.36
$ 2.81
$ 4.09
Diluted Earnings Per Common Share
$ 3.24
$ 2.77
$ 3.92
(in millions, except per share data)
Revenues
Company sales
Franchise and license fees
Costs and Expenses, net
Company restaurants
Food and paper
Payroll and employee benefits
Occupancy and other operating expenses
General and administrative expenses
Franchise and license expenses
Other (income) expense
Facility actions net loss (gain)
Unusual items (income) expense
796
59
(23)
1
(3)
Total costs and expenses, net
Operating Profit
Interest expense, net
Income Before Income Taxes
Income Tax Provision
See accompanying Notes to Consolidated Financial Statements.
The company’s notes found in its annual report are an integral part of this statement.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
88
Navigating Accounting
®
Figure 3.04 Yum! Brands’ Statements of Cash Flows
This figure illustrates Yum! Brands’ statements of cash flows.
Consolidated Statements of Cash Flows
Fiscal years ended December 29, 2001, December 30, 2000 and December 25, 1999
(in millions)
2001
2000
$ 492
$ 413
1999
Cash Flows – Operating Activities
Net income
Adjustments to reconcile net income to net cash provided
by operating activities:
Depreciation and amortization
Facility actions net loss (gain)
Unusual items
Other liabilities and deferred credits
Deferred income taxes
Other non-cash charges and credits, net
Changes in operating working capital, excluding effects of
acquisitions and dispositions:
Accounts and notes receivable
Inventories
Prepaid expenses and other current assets
Accounts payable and other current liabilities
Income taxes payable
Net change in operating working capital
$
627
354
1
(6)
(11)
(72)
15
354
(176)
120
(5)
(51)
43
386
(381)
45
65
(16)
66
116
(8)
(3)
(13)
(33)
(161)
11
(3)
(94)
40
(28)
6
(13)
(215)
23
59
(207)
(227)
832
491
565
Capital spending
Proceeds from refranchising of restaurants
Acquisition of restaurants
AmeriServe funding, net
Short-term investments
Sales of property, plant and equipment
Other, net
(636)
111
(108)
—
27
57
46
(572)
381
(24)
(70)
(21)
64
5
(470)
916
(6)
—
39
51
(8)
Net Cash (Used in) Provided by Investing Activities
Cash Flows – Financing Activities
(503)
(237)
522
—
—
(943)
1
(258)
58
(100)
48
82
—
(99)
(11)
(216)
37
(860)
4
(180)
21
(134)
30
(352)
(207)
(1,119)
Net Cash Provided by Operating Activities
Cash Flows – Investing Activities
Proceeds from Senior Unsecured Notes
Revolving Credit Facility activity, by original maturity
Three months or less, net
Proceeds from long-term debt
Repayments of long-term debt
Short-term borrowings — three months or less, net
Repurchase shares of common stock
Other, net
Net Cash Used in Financing Activities
Effect of Exchange Rate Changes on Cash and Cash Equivalents
Net (Decrease) Increase in Cash and Cash Equivalents
Cash and Cash Equivalents – Beginning of Year
Cash and Cash Equivalents – End of Year
842
—
(3)
—
(23)
44
(32)
133
89
$ 110
$ 133
121
$
See accompanying Notes to Consolidated Financial Statements.
The company’s notes found in its annual report are an integral part of this statement.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
89
Introduction to Cash-Flow Statements 89
Figure 3.05 Yum! Brands’ Supplemental Cash Flow Data Footnote
This figure illustrates the Supplemental Cash Flow Data footnote from Yum! Brands’ Annual Report.
FIGURE 2
NOTE
6
SUPPLEMENTAL CASH FLOW DATA
Cash Paid for:
Interest
Income taxes
Significant Non-Cash Investing
and Financing Activities:
Issuance of promissory note to
acquire an unconsolidated affiliate
Contribution of non-cash net assets
to an unconsolidated affiliate
Assumption of liabilities in connection
with an acquisition
Fair market value of assets
received in connection with
a non-cash acquisition
Capital lease obligations incurred
to acquire assets
2001
2000
1999
$ 164
264
$ 194
252
$ 212
340
$ —
$ 25
$ —
21
67
—
36
6
1
9
—
—
18
4
4
The company’s notes found in its annual report are an integral part of this statement.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
90
Navigating Accounting
®
Figure 3.06 Yum! Brands’ Five-Year Summary of Select Financial Data
This figure illustrates Yum! Brands’ summary of select financial data.
Selected Financial Data
2001
2000
$ 14,596
7,732
$ 14,514
7,645
22,328
Fiscal Year
1999
1998
1997
$ 14,516
7,246
$ 14,013
6,607
$ 13,502
6,963
22,159
21,762
20,620
20,465
6,138
815
6,305
788
7,099
723
7,852
627
9,112
578
6,953
7,093
7,822
8,479
9,690
176
(204)
381
(51)
275
(15)
(247)
(184)
(in millions, except per share and unit amounts)
Summary of Operations
System sales(a)
U.S.
International
Total
Revenues
Company sales(b)
Franchise and license fees
Total
Facility actions net (loss) gain(c)
Unusual items income (expense)(c)(d)
(1)
3
Operating profit
Interest expense, net
891
158
860
176
1,240
202
1,028
272
241
276
Income (loss) before income taxes
Net income (loss)
Basic earnings per common share(e)
Diluted earnings per common share(e)
733
492
3.36
3.24
684
413
2.81
2.77
1,038
627
4.09
3.92
756
445
2.92
2.84
(35)
(111)
N/A
N/A
Cash Flow Data
Provided by operating activities
Capital spending, excluding acquisitions
Proceeds from refranchising of restaurants
$
832
636
111
$
491
572
381
$
565
470
916
$
674
460
784
$
810
541
770
Balance Sheet
Total assets
Operating working capital deficit(f)
Long-term debt
Total debt
$ 4,388
(707)
1,552
2,248
$ 4,149
(634)
2,397
2,487
$ 3,961
(832)
2,391
2,508
$ 4,531
(960)
3,436
3,532
$ 5,114
(1,073)
4,551
4,675
6,435
2,000
19,263
2,791
6,123
1,844
19,287
3,163
6,981
1,178
18,414
3,409
8,397
1,120
16,650
3,596
10,117
1,090
15,097
3,408
30,489
30,417
29,982
29,763
29,712
3%
—
—
1%
146
$ 49.24
(3)%
1%
(5)%
(2)%
147
$ 33.00
2%
9%
—
4%
151
$ 37.94
3%
6%
3%
4%
153
$ 47.63
2%
(1)%
2%
1%
152
$ 28.31
Other Data
Number of stores at year end(a)
Company
Unconsolidated Affiliates
Franchisees
Licensees
System
U.S. Company same store sales growth(a)
KFC
Pizza Hut
Taco Bell
Blended
Shares outstanding at year end (in millions)
Market price per share at year end
N/A – Not Applicable.
TRICON Global Restaurants, Inc. and Subsidiaries (“TRICON”) became an independent, publicly owned company on October 6, 1997 through the spin-off of the restaurant operations of its former parent, PepsiCo, Inc. (“PepsiCo”), to its shareholders. The 1997 consolidated financial data was prepared as if we had been an independent, publicly owned
company for that period. To facilitate this presentation, PepsiCo made certain allocations of its previously unallocated interest and general and administrative expenses as well as
pro forma computations, to the extent possible, of separate income tax provisions for its restaurant segment. Fiscal years 2001, 1999, 1998 and 1997 include 52 weeks. Fiscal
year 2000 includes 53 weeks. The selected financial data should be read in conjunction with the Consolidated Financial Statements and the Notes thereto.
(a) Excludes Non-core Businesses, which were disposed of in 1997. See Note 22 to the Consolidated Financial Statements.
(b) Declining Company sales are largely the result of our refranchising initiatives.
The company’s notes found in its annual report are an integral part of this statement.
(c) In the fourth quarter of 1997, we recorded a $530 million charge of which $410 million was recorded in facility actions net (loss) and $120 million was recorded in unusual
items. The charge included (a) costs of closing stores; (b) reductions to fair market value, less cost to sell, of the carrying amounts of certain restaurants that we intended to
refranchise; (c) impairments of certain restaurants intended to be used in the business; (d) impairments of certain unconsolidated affiliates to be retained; and (e) costs of related
personnel reductions. In 1999, we recorded favorable adjustments of $13 million in facility actions net gain and $11 million in unusual items related to our 1997 fourth quarter
charge. In 1998, we recorded favorable adjustments of $54 million in facility actions net gain and $11 million in unusual items related to our 1997 fourth quarter charge.
(d) See Note 5 to the Consolidated Financial Statements for a description of unusual items income (expense) in 2001, 2000 and 1999. 1997 included $54 million related to the
disposal of the Non-core Businesses.
(e) EPS NavAcc
data has been
omitted
1997 as &
ourCarolyn
capital structure
as an independent, publicly owned company did not exist.
© 1991–2010
LLC,
G.forPeter
R. Wilson
(f) Operating working capital deficit is current assets excluding cash and cash equivalents and short-term investments, less current liabilities excluding short-term borrowings.
Introduction to Cash-Flow Statements 91
Figure 3.07 Cisco’s Statements of Cash Flows
This figure illustrates Cisco’s statements of cash flows.
The company’s notes found in its annual report are an integral part of this statement.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson
92
Navigating Accounting
®
Figure 3.08 Starbucks’ Statements of Cash Flows
This figure illustrates Starbucks’ statements of cash flows.
CONSOLIDATED STATEMENTS
In thousands
OF
CASH FLOWS
Fiscal year ended
OPERATING ACTIVITIES:
Net earnings
Adjustments to reconcile net earnings to net cash provided by operating activities:
Depreciation and amortization
Gain on sale of investment
Internet-related investment losses
Provision for impairment and asset disposals
Deferred income taxes, net
Equity in income of investees
Tax benefit from exercise of non-qualified stock options
Cash provided/(used) by changes in operating assets and liabilities:
Net purchases of trading securities
Accounts receivable
Inventories
Prepaid expenses and other current assets
Accounts payable
Accrued compensation and related costs
Accrued occupancy costs
Accrued taxes
Deferred revenue
Other accrued expenses
Net cash provided by operating activities
Sept 29, 2002
Sept 30, 2001
$
$
INVESTING ACTIVITIES:
Purchase of available-for-sale securities
Maturity of available-for-sale securities
Sale of available-for-sale securities
Purchase of businesses, net of cash acquired
Additions to equity and other investments
Proceeds from sale of equity investment
Distributions from equity investees
Additions to property, plant and equipment
Additions to other assets
Net cash used by investing activities
FINANCING ACTIVITIES:
Increase/(decrease) in cash provided by checks drawn in excess of bank balances
Proceeds from sale of common stock under employee stock purchase plan
Proceeds from exercise of stock options
Principal payments on long-term debt
Repurchase of common stock
Net cash provided by financing activities
Effect of exchange rate changes on cash and cash equivalents
Net increase in cash and cash equivalents
CASH AND CASH EQUIVALENTS:
Beginning of year
End of year
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for:
Interest
Income taxes
See Notes to Consolidated Financial Statements.
$
$
215,073
181,210
Oct 1, 2000
$
94,564
221,141
(13,361)
26,852
(6,088)
(21,972)
44,199
177,087
2,940
11,044
(6,068)
(15,713)
30,899
142,171
58,792
5,753
(18,252)
(15,139)
31,131
(5,699)
(6,703)
(41,379)
(12,460)
5,463
24,087
15,343
(16,154)
15,321
34,022
477,685
(4,032)
(20,399)
(19,704)
(10,919)
54,117
12,098
6,797
34,548
19,594
2,806
456,305
(1,414)
(25,013)
(19,495)
885
15,561
25,415
6,007
5,026
6,836
5,746
318,574
(339,968)
78,349
144,760
(6,137)
14,843
22,834
(375,474)
(24,547)
(485,340)
(184,187)
93,500
46,931
(12,874)
16,863
(384,215)
(4,550)
(428,532)
(118,501)
58,750
49,238
(13,522)
(43,930)
14,279
(316,450)
(3,096)
(373,232)
12,908
16,191
91,276
(697)
(52,248)
67,430
1,560
61,335
5,655
12,977
46,662
(685)
(49,788)
14,821
(174)
42,420
(7,479)
10,258
58,463
(1,889)
59,353
(297)
4,398
113,237
174,572
303
105,339
$
$
70,817
113,237
432
47,690
$
$
66,419
70,817
411
51,856
The company’s notes found in its annual report are an integral part of this statement.
© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson