Chapter 6 The Statement of Cash Flows: The Foundational Theory and A Case Study Tutorial

Introduction

In Chapter Two you were introduced to the Monetary Unit Assumption that limits financial accounting to transactions that can be measured in money.  As you further studied in Chapter Two, this limitation means that other (non-monetary) information that is important to financial markets needs to be provided from sources outside the financial accounting paradigm.  Since the financial accounting portion of the financial market information pie is limited, and some would say shrinking, the FASB wanted to make the information that it did provide as useful as possible.  So in 1987, FAS 95 required the Cash Flow Statement in GAAP financial reports. 

The authoritative foundation of the Statement of Cash Flows is in Statement of Financial Accounting Concepts No. 1: Objectives of Financial Reporting by Business Enterprises.

49. Financial reporting should provide information about how an enterprise obtains and spends cash, about its borrowing and repayment of borrowing, about its capital transactions, including cash dividends and other distributions of enterprise resources to owners, and about other factors that may affect an enterprise’s liquidity or solvency. For example, although reports of an enterprise’s cash receipts and cash outlays during a period are generally less useful than earnings information for measuring enterprise performance during a period and for assessing an enterprise’s ability to generate favorable cash flows (paragraphs 42–46), information about cash flows or other funds flows may be useful in understanding the operations of an enterprise, evaluating its financing activities, assessing its liquidity or solvency, or interpreting earnings information provided. Information about earnings and economic resources, obligations, and owners’ equity may also be useful in assessing an enterprise’s liquidity or solvency[1].

Chapter 5 Refining Financial Statements: Classified Balance Sheet and Multi-Step Income Statement

Introduction

In this Chapter, you will incrementally refine your financial accounting knowledge base by studying the Classified Balance Sheet and Multi-Step Income Statement.  If you are not proficient in the base financial accounting rules, mechanics and terminology, then the material presented in this Chapter will be quite confusing.  On the other hand, if you have mastered the foundational accounting language and are confident in your ability to analyze basic economic transactions and to complete a full accounting cycle as outlined in Chapters One through Four, you will find this Chapter to be very simple.  Since I am writing this book for the best students who want to be challenged, refining a couple of financial statements isn’t enough meat for a full Chapter so I am going to supplement it with the most important (and most interesting and challenging) topic that an accounting student can study.  I do not expect you to find easy answers, I want you to embark on an academic journey that begins by asking the question: Is There a Crisis in the Financial Accounting Paradigm?

Chapter 4 Accrual Accounting

The Periodicity Assumption

Recall that in Chapter Two you were introduced to the Generally Accepted Accounting Principle Periodicity Assumption that financial reports are prepared at yearend, regardless of an economic entity’s operating cycle[1].  An organization’s operating cycle describes how quickly it turns its cash (used to buy or manufacture Inventory) into cash it receives from its customers (including any time to collect Accounts receivable).  To illustrate this concept, consider two companies described in Table 4.1.

Table 4 1

Chapter 3 Analyzing and Recording Transactions

Chapter 3

Measuring Wealth

In Chapters One and Two you studied why financial accounting is an important component of our financial market.  Without standardized financial reporting in accordance with rules issued by an authoritative body (FASB), investors would have a difficult time comparing competing financial instruments (IOU’s), and markets would be less efficient.  In the next two chapters you begin to investigate what information financial accounting is designed to record and report in a standardized format.  At the dawn of the Industrial Revolution, Adam Smith observed and painstakingly documented a phenomenon with empirical evidence gathered though observation and quantitative data analysis.  His findings were the basis for a new scientific paradigm devoted to studying England’s new economic culture.  Wherever you live, Smith’s words from 1776 are still relevant to you today.  Please read: Volume One Introduction and Plan of the Work and Book I, Chapter I Of the Division of Labor http://www.econlib.org/library/Smith/smWN.html.  This reading should take no more than 30 minutes, that is if you are able to stop…

In Chapter One, you studied the “invisible hand” that moves the economy.  Adam Smith described the economy’s change in focus from King and country to the motivation of each individual citizen.  Whereas Socrates described the economic benefit of teaching men to work for the greater good, Smith asserted that expecting a benevolent economic architect to create a greater good was an impossible and unrealistic dream.  Smith observed that a rational man acting in his own self-interest produced the greatest amount of wealth.  Through specialization and division of labor, each man becomes more productive by deciding for himself how best to spend his time.  In short, the paradigm can be described as thinking small, concentrating on the individual desires and motivation of men, in order to accomplish something grand, creating the greatest amount of wealth.

Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. (Smith, 1776, Book 1, Chapter II, Paragraph 2)

The idea to provide ALL men with the knowledge and freedom to act in their own best interest was revolutionary and represented the destruction of the previous “top-down” economic paradigm and is the philosophical basis of our free market economy.

Chapter 2 Financial Reporting

Chapter 2

Money Market

Lets begin with the kindergartner’s explanation.  A market is a place where buyers and sellers meet to trade.  When a person needs food, he goes to the supermarket to purchase groceries (trading money for products); hence he is a “consumer” or “buyer.”  A farmer produces food and sells it to the supermarket; hence he is a “producer” or “seller.”  Your friendly grocer is an intermediary (middleman) who provides a valuable service for which he is compensated.  Without the supermarket it would be a terrible hassle to visit a ranch to buy beef, a baker to buy bread, etc.  A common name for our money market (there is only 1 market for the world) is “Wall Street”, and it serves the same basic function as your local grocery store.

A person who has too much money, more than he or she can spend immediately, needs to save it for future use.  He is called a “saver,” “lender” or “investor.”  This individual is motivated by self-interest to get the best deal possible.  This means selecting the financial instrument (from all that are available) with the least risk and highest returns on investment.  A person who needs money (a “borrower”) must create an IOU (financial instrument) with terms that may include interest and promises to keep the money as safe as possible.  The borrower must fashion his IOU to be more attractive to investors than his competition, the IOU’s of other borrower.  However, the self-interest of the borrower is to provide the least security along with the lowest returns, exactly the opposite of the interest of the lender.  Savers and borrowers can use an intermediary, like a bank, or they can deal directly with one another.  In any case, the philosophy of a money market is simple…  people trade money for financial instruments (IOU’s).  Since an IOU is not tangible, the money market requires faith in order to operate.  If savers lose confidence in markets, they will refuse to purchase IOU’s and the economy will grind to a screeching halt.

Chapter 1 Introduction to Financial Accounting

Chapter 1

Welcome to Accounting 1

Before we dive into the mechanics of accounting, the debits and credits, journal entries and financial statements that will dominate your life this semester, we are going to investigate how financial accounting fits into our culture.  I am taking this approach to counter what I consider to be a fundamental flaw with many college level accounting and finance textbooks that focus almost exclusively on financial accounting mechanics and are supplemented with a plethora of glossy photos and irrelevant “feature stories” that provide students little guidance in understanding the context of their academic work.  The drawback to this method of teaching accounting is that students learn which buttons to push on their calculator and in what order… without knowing why.  Another motivation was to battle with what I consider to be outrageous pricing of textbooks used in American higher education.   There is little competition in the accounting textbook market and unsurprisingly, all of the books I reviewed retail for roughly the same price… what a coincidence.