Transcript Babson College Accounting 7000

Agenda
 Review Accrual Basis Income Statements
 Importance of Cash Flow
 Preparation of Statement of Cash Flows
 Interpretation of Statement of Cash Flows
© 1999 by Robert F. Halsey
Accrual accounting has two principal components:
The Revenue Recognition Principle, which states that
revenue is recorded when it is “earned”, and
The Matching Principle, which states that expenses
recognized when “incurred”
Neither the recognition of revenue nor that of expense
necessarily involves the receipt or payment of cash.
Accrual basis earnings, therefore, do not convey much
information about cash inflows to and outflows from the
business.
© 1999 by Robert F. Halsey
Information about cash inflows and outflows is important,
however:
Dividends and Debt Payments are made with cash, not
profit, and
Investors and creditors may be interested in the firm’s
sources of cash (will they be recurring or are they onetime events, like the sale of assets) and where the firm
is investing its cash inflows (into areas for which the
company has some management expertise, as outflows
to the company’s investors or creditors, etc.)
Over the life of the firm, profit equals net cash flow. In any
one period, as we have seen, however, the two will not be
equal because of accrual accounting. Analysts have
learned that the difference between reported earnings and
cash flows may provide clues about the “quality of
earnings” (i.e., whether the firm is managing its earnings)
© 1999 by Robert F. Halsey
Preparation of the Statement of Cash Flows
As a first step in learning to prepare the statement of cash
flows, you need to understand that
 Cash is generated by reductions in assets or increases in
liabilities.
»Collection of accounts receivable increase cash and
reduce receivables, an asset, and
»Increases in a bank loan increases cash and liabilities
 Cash is used to increase assets or to pay liabilities
»Cash is reduced to purchase fixed assets
»Cash is also reduced for Debt repayment
© 1999 by Robert F. Halsey
Think of assets as dividing up the pie
Cash
Cash
decreases
A/R
A/R
As A/R gets
bigger
Inventories
Inventories
PP&E
PP&E
Cash
© 1999 by Robert F. Halsey
and, increases in liabilities and equity affect the size of the pie
Cash
Cash
A/R
A/R
Inventories
Inventories
PP&E
PP&E
© 1999 by Robert F. Halsey
The statement of cash flows is divided into three sections:
» Net cash from Operations - cash inflows and outflows
relating to the firm’s normal business activities (i.e., cash
operating profit and new cash flows from current assets and
current liabilities)
» Net cash from Investing activities - purchases and sales of
long-term assets and marketable securities
» Net cash from Financing activities - changes in long-term
debt and equity, and the payment of dividends
Notice that the statement of cash flows combines both the
income statement and the balance sheet. The sum of the
three sections, therefore, yields the net change in cash for
the period.
There is always a built in check on the accuracy of the
statement. Net cash flow plus the beginning balance in
cash (last year’s ending balance) will always equal the
ending balance in cash this year.
© 1999 by Robert F. Halsey
The first section of the statement, net cash from operations,
begins with net income and adjusts reported profit for
depreciation and gains and losses on sales of assets.
Next, cash generated from changes in current assets and current
liabilities is added. The sum of all of these items is the net cash
flows from operating activities, as follows:
Net Income
+ Depreciation
- Gains (+Losses) on asset sales
 Changes in Current Assets and Liabilities
————————————————————
= Net Cash Flows from Operating Activities
© 1999 by Robert F. Halsey
The adjustment to net income for depreciation and gains
(losses) on the sale of assets may, at first, be difficult to
understand.
Let’s consider first the issue of depreciation. The cash relating to
the purchase of fixed assets flows out of the firm on the date the
assets are purchased. Depreciation expense is merely the
allocation of this cost over the useful life of the asset to match its
expense with the revenues it produces.
There is no cash relating to depreciation expense and, as a
result, we do not want to consider it in the preparation of the
statement of cash flows.
Since depreciation expense was deducted in the computation
of net profit, we add it back in order to zero it out.
© 1999 by Robert F. Halsey
This can be more easily seen by the use of an example. If we
expand net income, the beginning of the statement of cash
flows would look like this:
Sales
- wage expense
- depreciation expense
Since depreciation expense
is deducted in computing
net income
- tax expense
net income
It must be added back in order
to zero it out in the statement
+ depreciation expense
of cash flows
 changes in current assets and current liabilities
= net cash flow from operating activities
© 1999 by Robert F. Halsey
The next section is the net cash flow from investing
activities.
In this section, we are concerned with changes in the longterm portion of the asset section of the balance sheet:
property, plant and equipment, and other long-term
investments.
As with previous changes in balance sheet accounts,
increases in these assets are recorded as cash outflows
and decreases are recorded as cash inflows.
© 1999 by Robert F. Halsey
The last section deals with net cash flows from financing
activities.
These include changes in long-term debt, sales and
repurchases of stock, and dividends.
Increases in liabilities and equity are recorded as cash
inflows and decreases as cash outflows. Dividends are
also reflected as a cash outflow.
© 1999 by Robert F. Halsey
So, we have included the income statement through net
income and the associated adjustments for non-cash
expenses or gains and losses.
And we have
Used
included
for net all
cash
of the
flowbalance
from operations
sheet
accounts:
Current assets
Current Liabilities
Long-term Assets
Long-Term Liabilities
Stockholder’s Equity
Used for net cash
flowfor
from
Used
netfinancing
cash flowactivities
from investing activities
© 1999 by Robert F. Halsey
But, what about accumulated depreciation and
retained earnings?
We can ignore accumulated depreciation because we
are ignoring depreciation expense (it is non-cash).
And we have already considered retained earnings by
our inclusion of net income and dividends.
So, all of the components of the balance sheet have
been accounted for.
© 1999 by Robert F. Halsey
Let’s look at a simple example to give you some
practice.
Consider the following comparative balance sheet and
income statement:
© 1999 by Robert F. Halsey
1998
1999
Change
Assets
Sales
Expenses:
Cost of Goods sold
Salaries expense
Depreciation Expense
Loss on sale of fixed assets
Net income
Cash
25,500
4,400
21,100
Accounts Receivable
59,000
35,000
24,000
Inventories
30,000
50,000
20,000
Fixed Assets
165,000
180,000
15,000
Accumulated Depreciation
(61,900)
(80,400)
18,500
Note:
Fixed Assets (net)
103,100
99,600
3,500
Total Assets
217,600
189,000
28,600
Fixed assets originally costing $35,000
with Accumulated Depreciation of
$5,000 were sold for $25,000
87,500
56,000
23,500
5,000
13,500
Dividends declared and paid during the
year were $10,000
Liabilities
Accounts Payable
62,600
40,500
22,100
Bonds Payable (long-term)
50,000
40,000
10,000
Common Stock
100,000
100,000
0
Retained Earnings
5,000
8,500
3,500
Total Liabilities and Equity
217,600
189,000
28,600
Equity
© 1999 by Robert F. Halsey
185,500
Try to compute the statement
of cash flows yourself before
looking at the solution…
Net income
Depreciation
Loss on sale
Accounts Receivable
Inventory
Accounts Payable
Net cash from operations
13500
23500
5000
24000
(20000)
(22100)
23900
Sale of fixed assets
Purchase of fixed assets
Net cash flow – investing
25000
(50000)
(25,000)
Bonds
Dividends
Net cash flow – financing
(10000)
(10000)
(20000)
Net change in cash
Beginning cash
Ending cash
(21100)
25500
4400
This is the statement of cash
flows
© 1999 by Robert F. Halsey
We start with net income
Then we add back
depreciation and the loss
on sale of assets (we are
only concerned with the
cash proceeds, not the
loss)
Accounts receivable went
down, so this generated
cash.
Inventories went up, so this
used cash
Accounts payable
decreased, thus using
cash
Net income
Depreciation
Loss on sale
Accounts Receivable
Inventory
Accounts Payable
Net cash from operations
13500
23500
5000
24000
(20000)
(22100)
23900
Sale of fixed assets
Purchase of fixed assets
Net cash flow – investing
25000
(50000)
(25,000)
Bonds
Dividends
Net cash flow – financing
(10000)
(10000)
(20000)
Net change in cash
Beginning cash
Ending cash
(21100)
25500
4400
© 1999 by Robert F. Halsey
The sale of the fixed assets
resulted in the following
journal entry:
Cash
25000
Accum dep
5000
Loss
5000
Assets
35000
And since fixed assets
reported a net increase (at
cost) of $15,000, after a
reduction of $35,000,
there must have been
purchases of $50,000
Net income
Depreciation
Loss on sale
Accounts Receivable
Inventory
Accounts Payable
Net cash from operations
13500
23500
5000
24000
(20000)
(22100)
23900
Finally, bonds
decreased by $10,000
and we used $10,000
for the payment of
dividends.
Sale of fixed assets
Purchase of fixed assets
Net cash flow – investing
25000
(50000)
(25,000)
Bonds
Dividends
Net cash flow – financing
(10000)
(10000)
(20000)
The net change in cash,
therefore, is a reduction of
$21,100 (23,900 - 25,000 20,000)
Net change in cash
Beginning cash
Ending cash
(21100)
25500
4400
© 1999 by Robert F. Halsey
When we subtract this
from the beginning
balance of $25,500, we
get the ending balance of
$4,400 that appears on
the balance sheet at yearend
Let’s take a look at the statement of cash flows from Toys
R Us to get some practice interpreting the information it is
telling us
© 1999 by Robert F. Halsey
Part
differenceisis
Mostofofthe
it, however,
because
the losseven
includes
due
to restructuring
During
FY1999,
$255
million
of million
charges
of $546
though
the
company
lost
depreciation
on
that
profits,
$132reduced
million,expense
Toys R but
Us
its
store
buildings,
fixtures
did
not involve
cash
generated
$964a million
in
and
outflow
since
they
cashequipment.
from
operations.
related to the write-off of
assets and the accrual of
employee severance
expense
© 1999 by Robert F. Halsey
The company also spent $422
million on capital expenditures
Finally, the company borrowed
a net amount of $359 million
and used the proceeds
together with its operating
cash flow to repurchase $723
million of common stock.
Why? Perhaps the company
felt its stock was undervalued
since it was trading at about
$15, down from $35 fifteen
months earlier.
© 1999 by Robert F. Halsey
Components of Earnings
From the operating section of the statement of cash
flows we see the following relation:
Net Income
+ Accruals
= Net Cash Flows from Operating Activities
Or, Net income = NCFO + Accruals.
Net Income is comprised of two components:
cash earnings and accruals
© 1999 by Robert F. Halsey
Accruals are of two types:
Long-term
(like depreciation), and
Short-term (changes in current assets and
liabilities) this Remember
Short-term accruals generally reverse in the next
accounting period.
– Therefore, it is very difficult to shift income more than
one period.
– Companies can change income in the current period,
but when the accruals reverse income will also
reverse.
That is why analysts look to the relation between profit and
cash flow to get clues whether the company is managing its
earnings. When the relation between the two figures changes
significantly, we need to know why the accruals are behaving
the way they are.
© 1999 by Robert F. Halsey
The End
© 1999 by Robert F. Halsey