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].
The Statement of Cash Flows is a reconciliation of the Cash account (recall the account analysis tool you studied in Chapter Five) that organizes all of the transactions recorded in the period into three categories: Operating, Investing and Financing. In this Chapter you will study the Indirect Method, which is not as precise as the Direct Method, but it is still GAAP, is much simpler to produce and according to Accounting Trends and Techniques (a reference book produced by the AICPA), is the de-facto standard.
Cash: Not Just Another Asset! The Theory Behind the Statement of Cash Flows
Cash is the lifeblood of any organization. Without it or the ability to quickly acquire it in the financial marketplace[2], a company will fail regardless of its cool technology, potential for growth and assembled intellectual capital. Nobody ever accused the money market of being omnipotent and wise. When trying to sell its I O U in the money market, any organization from any industry will face the same question, namely, what are they going to do with the money they seek? Does the organization need to subsidize its operations? Is the money needed for investment in assets that will help generate future operating income? Will the money be used to refinance the company, paying off current creditors or shareholders? Each of these reasons may be valid depending on the economic situation of the company and the financial market. The Statement of Cash Flows will help investors and lenders evaluate how the company has procured and used cash in the past which will help them predict its future cash transactions.
Intercompany Analysis of Statements of Cash Flows Table 6.1
In Table 6.1 above, you can see the condensed Statements of Cash Flows for five companies in various industries. Since Google is kind enough to host this textbook, lets begin by looking at their data. Google’s Cash increased from $10,198 on January 1, 2010 to $13,630 on December 31, 2010, a net increase of $3,432. By organizing all of the accounting transactions for 2010 into Operating, Investing or Financing[3], Google’s Statement of Cash Flows provides the readers of its financial report with useful information about how Google acquired and spent its cash. Notice that Google produced a net increase to Cash of $11,081 from its operations. Recall that in Chapter Five we isolated Income From Operations on the multi-step Income Statement. While the definition of “Operations” remains the same on the Statement of Cash Flows, the transactions included in this section are a little broader than those included in the Income From Operations section in the Income Statement[4]. Basically this section is informing the reader about the organization’s acquisition and use of cash in its day-to-day operations by presenting a cash-basis Income Statement with some selected transactions removed.
Most business textbooks attempt to bring relevance to this academic material by informing students about the “typical” life cycle of a for-profit enterprise, that an organization uses cash in its operations during startup, but as it matures it produces cash that can be used for investing and repaying debts. This rule of thumb is a logical theory, but in the real world it is worthless because enterprises do not follow a standard rule. As a student you should always be skeptical of simple explanations to complex subjects. In the case of Google in 2010, the organization procured more Cash than it is expended on period costs. If the reverse were true, it would need to subsidize its operations with cash from other sources. Next, notice that Google used $10,680 in Cash on investing activities that its management decided would produce acceptable returns for the organization and finally, notice that Google procured $3,050 from the money market during the year. Like any financial statement, try to avoid jumping to conclusions based on information provided in a financial report. Remember that this type of data is for broad comparison purposes and should serve as a starting point for a more detailed analysis.
Take a few moments and reflect on the data contained in Table 6.1. Why do organizations go to the money market for financing? Should investors care what organizations plan on doing with the cash it borrows? What happens to a company that cannot access financial markets (nobody will accept its I O U’s)? Placing yourself in the shoes of an investor will help you understand the purpose of this financial statement and will make it easier to learn how to prepare a proper GAAP Statement of Cash Flows.
Cash Provided From (Used In) Operations
An organization’s operations are defined as its mission or purpose. For example, consider a supermarket that sells groceries to the public. Purchasing product for resell, paying its employees and paying the monthly rent on its building would all be examples of operational uses of Cash while collecting money from its customers would produce Cash. Since the Balance Sheet (which includes the effect of all transactions recorded in the period) is on an accrual basis (Chapter Four), this section of the Statement of Cash Flows must adjust Net Income to remove the changes in accruals during the period, creating a cash basis Net Income. Since Net Income includes transactions that are not included in Operating Income, some transactions will be identified and removed from the section. Not ALL non-operating transactions are removed. For example, interest income and expense are not adjusted out of this section.
Cash Provided From (Used In) Investing
An organization invests its Cash in something (property, patent, copyright, etc) because it seeks a return on its investment. This section isolates an organization’s sources and uses of Cash related to investing. When an organization purchases an asset, it is using Cash, when it sells an investment (regardless of whether or not there is a gain or loss) it is producing Cash. Using our Supermarket example, a purchase of a cash register represents an investment that will enable the grocer to check people out faster, hence producing more operating income. If the grocer would sell his cash register to generate cash, this would be an example of producing cash from an investment.
Cash Provided From (Used In) Financing
This section details the organization’s interaction with the financial market. Borrowing money or selling shares would be examples of taking Cash out of the market while paying Dividends or paying down principal would be examples of putting Cash into the market.
Building The Statement Of Cash Flows: A Case Study / Tutorial Tables 6.2, 6.3 and 6.4
The spreadsheets used in this chapter are available on Google Docs at Google Docs Ch 6 The companion YouTube lecture is available below.
Please replicate this work, using paper and pencil, on columnar paper[5]. The remainder of this Chapter will be dedicated to constructing the Statement of Cash Flows. The Balance Sheet, since it reflects ALL of the transactions of the period, is the basis for creating the Statement of Cash Flows. By analyzing the changes in the beginning and ending balances of all accounts, transactions can be properly classified into one of the three categories.
The statement is a reconciliation of the Cash account, which reflects a $250 increase from the beginning of the year to the end of the year. Since the Balance Sheets reflect the Accounting Equation (Assets = Liabilities + Owners’ Equity), the net change in Cash must be equal to the net change in the rest of the accounts. For example, a company that increases its assets from $100 to $200 during the year will have a corresponding increase in liabilities and owners’ equity of $100. Therefore, is we isolate the change in one account in the Balance Sheet, Cash, the change in the balance will be offset by the change in all of the other accounts combined. The challenge is to analyze the change that occurred in the account balances during the year and properly classify the transactions that created the changes into operating, investing and financing categories.
Operating Section: Tables 6.5, 6.6 and 6.7
This section converts Net Income on the Income Statement from the accrual basis of accounting to cash basis. Furthermore, certain non-operating transactions are removed from the net balance.
MEMORIZATION: Net Income plus C (changes in current assets and liabilities) L (losses and gains) A (amortization and depreciation) D (deferred taxes).
The first line item in this worksheet, Net Income, comes from our analysis of the Retained earnings balance sheet account (Table 6.6).
Net Income of $300 increased the Retained earnings account (increase in Cash) while the Dividends of $850 decreased the balance. Dividends will be accounted for in the Financing section of this worksheet. This analysis confirms that we have captured all of the transactions related to the change in the Retained earnings account and properly categorized the transactions in the Statement of Cash Flows.
Changes in current assets and liabilities reflect the changes in accruals from the beginning of the year to the end of the year. Showing the changes in these accounts in the operating section converts the accrual basis Net Income to cash basis accounting. These accounts do not require a detailed analysis; just drop the net change into the Operating section. Accounts receivable increased by $300. Recall from Chapter Four (Table 4.7) the type accrual journal entry that gave rise to this transaction.
Sales are included in Net Income, but the cash has not yet been received. Therefore, the Cash needs to be deducted from the Operating section. If Accounts receivable had DECREASED, this would reflect receiving more cash than recorded sales in the period. Inventory and Accounts payable are the other accounts in this tutorial that are analyzed in this manner. When analyzing accounts, always go back to the journal entry that was used to record the transaction that changed the account balance. For example, when Inventory was purchased, Cash went down. When Accounts payable increased, an asset (Cash) increased.
Losses and gains result from selling property or settling liabilities for an amount different than their carrying amount. Since this type of transaction is non-operating, it must be adjusted out of Net Income. Since gains increase Net Income, they must be subtracted from Net Income. On the other hand, losses decrease Net Income and must therefore be added back. In this example, there was one disposal of Equipment during the year that was discovered by analyzing the account (Table 6.7).
Equipment with a net book value of $500 was disposed of during the year (thrown away) resulting in a $500 loss. If it had been sold, the proceeds would be included in the Investing section as an increase in Cash.
While depreciation is an operating expense, it results from accrual accounting of a purchase of a long-term asset. Since we capture new Property plant and equipment purchases in the Investing section in the period in which they occur, depreciation needs to be added back to the Operating section to adjust Net Income to cash basis. Amortization related to a premium or discount on Bonds, a subject we will cover in a subsequent Chapter. The theory is the same as depreciation. As you can see in Table 6.7 above, depreciation of $300 is added back to Net Income in the Operating section.
Finally, the changes in Deferred taxes must be added back or subtracted from Net Income as appropriate. In the Lizzie Incorporated example in Chapter Five, I demonstrated a simple example of an accrual of income taxes at period end. If the liability increases, then it is added to the Operating section (a decrease in the liability would reflect a payment of Cash). Technically, if it is a current liability (short-term timing item) then it could be treated like any other current liability. However, accounting for income taxes is generally much more complicated. You will study this in much more detail during Intermediate Accounting.
Investing Section: Table 6.8
From our analysis of Equipment (Table 6.7 above), we learned that XYZ purchased $1,300 of new equipment during the year. This is the only Investing transaction in this tutorial. As discussed above, if XYZ had received any proceeds from the disposal equipment, it would have been included here as an increase in Cash.
As discussed earlier in the Chapter, organizations invest in order to seek a return. What does it tell you about an organization that is producing a great deal of Cash from its investing section? Is it selling off productive assets that are needed for operations in order to generate Cash? What does this mean for its future? Is there any good business reason to sell assets (hint... think change in business focus)?
Financing Section: Tables 6.9, 6.10 and 6.11
XYZ had three transactions during the year with the financial market. From our analysis of Retained earnings in Table 6.6 above, we discovered that a dividend of $850 was paid, a use of Cash. In Table 6.9 below, the analysis of Bonds payable is presented.
The repayment of principal on the Bond represents a use of Cash during the period. If there had been new borrowings, they would have been presented in the financing section as a source of Cash. By analyzing the Common stock account below (Table 6.10) we discovered that the sale of stock provided $300 in Cash during the period.
These transactions are presented in the financing section as follows:
Completing the Statement of Cash Flows Table 6.12
We have now accounted for the change in all of XYZ’s balance sheet accounts and have categorized all of the transactions during the period as operating, investing or financing.
While the example presented in this tutorial is basic, the approach is the same one that you will use to prepare a Statement of Cash Flows for an organization with millions of transactions, some of them quite complex. Please practice with the tutorial in Google Docs and revisit the Statements of Cash Flows and supporting worksheets presented in Chapters Four and Five (Lizzie Incorporated).
Kuhn Paradigm Science… The Importance of PRACTICE
Kuhn’s observations can be extrapolated to society at large because a scientific community is a social system organized around a single paradigm just as society is organized around an economic paradigm. The framework is the foundation upon which the community is built, providing its rules for communication and social interaction. Without the framework the community does not exist. Understanding the framework, how it was established, its rules, terms of communication, tools, boundaries and even its known flaws is invaluable in understanding its product. Kuhn (1996) declared that the paradigm is not theoretical for its members, rather, it is part of their life and each member has personally observed evidence of its accuracy.
If, for example, the student of Newtonian dynamics ever discovers the meaning of terms like force, mass, space, and time, he does so less from the incomplete though sometimes helpful definitions in this text then by observing and participating in the application of these concepts to problem-solving (p. 46-47).
What this means to you is that this practice is NOT a waste of your time or merely busy work. It is HOW you learn the function of the financial accounting paradigm.
[2] The absolute worst time to seek financing is when the cash is gone and the organization is desperate.
[3] Exchange rate changes are changes in Cash that are part of comprehensive income (i.e. not on the Income Statement). You will cover this topic in Advanced Accounting.
[4] One of my favorite managers, Amos Galon of Haifa, used to say: “I’d rather be roughly correct than precisely wrong.” FASB adopted the same approach here.
[5] http://www.printablepaper.net/category/columnar
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