introduction to cash-flow statements chapter 3 · pdf fileintroduction to cash-flow statements...

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© 1991–2010 NavAcc LLC, G. Peter & Carolyn R. Wilson

Introduction to Cash-Flow Statements

Chapter 3Cash-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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Navigating Accounting ®

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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INTRODUCTIONA 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 current-period 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 2005-2007. 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.

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Cash Flow Statements

Operating

Investing

Financing

Cash change

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.

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 seCtionThe 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 (6)

Net cash from operations $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 4


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.

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Exercise 3.01Identify the following examples as operating (O), investing (I), or financing (F) activities.

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

Usage IconThis exercise helps you learn how accounting reports are used by investors, creditors, and other stakeholders.

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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 FlowsThree Years Ended December 29, 2007(In Millions) 2007 2006 2005Cash and cash equivalents, beginning of year 6,598$ 7,324$ 8,407$Cash flows provided by (used for) operating activities:

Net income 6,976 5,044 8,664Adjustments to reconcile net income to cash provided by operating activities:

Depreciation 4,546 4,654 4,345Share-based compensation 952 1,375 ──Restructuring, asset impairment, and net loss on retirement of assets 564 635 74Excess of tax benefit from share-based payment arrangements (118) (123) ──Amortization of intangibles and other acquisition related costs 252 258 250(Gains) losses on equity investments, net (157) (214) 45(Gains) on divestitures (21) (612) ──Deferred taxes (443) (325) (413)Tax benefit from employee equity incentive plans ── ── 351Changes in assets and liabilities:

Trading assets (1,429) 324 1,606Accounts receivable 316 1,229 (912)Inventories 700 (1,116) (500)Accounts payable 102 7 303Income taxes payable and receivable (248) (60) 797Other assets and liabilities 633 (444) 241

Total adjustments 5,649 5,588 6,187Net cash provided by operating activities 12,625 10,632 14,851Cash 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 8,433Investments in non-marketable equity instruments (1,459) (1,722) (193)Net proceeds from divestitures 32 752 ──Other investing activities 294 (33) (118)

Net cash used for investing activities (9,926) (4,988) (6,415)Cash flows provided by (used for) financing activities

Increase (decrease) in short-term debt, net (39) (114) 126Proceeds from government grants 160 69 25Excess tax benefit from share-based payment arrangements 118 123 ──Additions to long-term debt 125 ── 1,742Repayments and retirements of long-term debt ── ── (19)Repayments of notes payable ── (581) ──Proceeds from sales of shares through employee equity incentive plans 3,052 1,046 1,202Repurchase and retirement of common stock (2,788) (4,593) (10,637)Payment of dividends to stockholders (2,618) (2,320) (1,958)

Net cash used for financing activities (1,990) (6,370) (9,519)Net increase (decrease) in cash and cash equivalents 709 (726) (1,083)Cash and cash equivalents at the end of the year 7,307$ 6,598$ 7,324$Supplemental disclosures of cash flow information:

Cash paid during the year for:Interest, net of amounts capiatlized of $57 in 2007 and $60 in 2006 15$ 25$ 27$ Income taxes, net of refunds 2,762$ 2,432$ 3,218$ See notes to Consolidated Financial Statements.

Operating

Investing

Financing

Cash ChangeEnding Cash

Beginning Cash

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Cash Flow Statements

Operating

Investing

Financing

Cash change

Intel2007

$12,625

(1,990)

$709

(9,926)

(6,370)

($726)

(4,988)

2006

$10,632

2005

$14,851

(9,519)

($1,083)

(6,415)

© NavAcc LLC, G. Peter & Carolyn R. Wilson

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

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:

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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 seCtionLike 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.











Net Income

Adjustments

Net cash from operations

Total adjustments

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Indirect Format Operating Section

Reconciliation adjustments


Net Income

Intel2007

$6,976

5,649

$12,625

2006

$5,044

5,588

$10,632

2005

$8,664

6,187

$14,851

© NavAcc LLC, G. Peter & Carolyn R. Wilson

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.

Types of AdjustmentsReconciliation 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.

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:

Other Adjustments There are a few other insignificant adjustment types associated with issues beyond the scope of this chapter.

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Gains and losses adjustment

Asset adjustment

Liability adjustment

Gains and Losses Reconciliation AdjustmentsGains and losses reported in net income generally arise from selling assets, which are investing activities. Thus, the cash flows associated with these activities are reported in the investing section, not the operating section. However, gains and losses are included in net income at the top of the operating section. As a result, adjustments are needed to remove gains and losses included in net income (by deducting gains and adding losses) because they do not affect net cash from operations.

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.

Cash inflow from divestitures

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Investing Section of Intel’s Cash Flow Statement

investing seCtionInvesting 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 investments in new factories versus equivalent investments in Treasury bonds. Also, they would want to know the reason why Intel spent nearly $5 billion more on investing activities in 2007 than in 2006. The line items in the investing section can help them better understand the net cash flows related to these investment activities.

These items are relatively easy to identify from their descriptions. For example, Intel reports 2007 additions to property, plant and equipment of ($5,000), representing the cash Intel spent to purchase PP&E. Most companies include net at the end of the description, meaning cash outflows used to purchase PP&E net of cash inflows from selling PP&E. Similar to most companies, Intel signs cash outflows negatively.

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FinanCing seCtionFinancing 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.

When analyzing financing cash flows, it is important to relate them to the business context and, in particular to the company’s development stage and the state of the economy. For example, they will be quite different for a high tech start-up in a booming economy than for a mature airline in an economic downturn. Typically high-tech start-ups tend to use mostly equity financing, because they have very little collateral to offer to debt holders, and they generally do not pay dividends. By contrast, airlines rely heavily on debt financing and they often need to add debt during economic downturns to finance operations.

Financing cash flows can usually be interpreted from their captions. For Intel, the most conspicuous observation is that all of the significant cash flows relate to owners, reflecting the fact that Intel has very little debt. Also, readily apparent is the primary reason that the net financing outflows decreased from $9,519 in 2005 to $1,990 in 2007 is that the cash outflows associated with stock repurchases decreased from $10,637 to $2,788. This decrease was partly offset by an approximately $2 billion increase in the inflows from exercising stock options.





















Financing Section of Intel’s Cash Flow Statement

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supplemental DisClosures oF Cash Flow inFormationCompanies 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 cash-flow 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.

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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.

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easylearn Company

Events and EntriesYou 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 AdjustmentsFirst, 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 COMPANYSCF RECONCILIATION

Operating Activities

Net Income $150

Adjustment ($130)


December 1 - 22, 2009

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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:



Net Income $150

Less net increase in receivables associated with operating entries ($130)


December 1 - 22, 2009

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:”



Net Income $150

Receivables ($130)


December 1 - 22, 2009


Operating Activities E2 E3 Combined

Net Income $150 $150 $0 $150

Receivables ($130) ($150) $20 ($130)

Net cash from operations $20 $0 $20 $20

Reported Behind Reported Numbers

December 1 - 22, 2009

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:

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• 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).

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Receivables

adjustment

Liability Reconciliation AdjustmentsNext we extend the EasyLearn example with the following entries associated with a liability adjustment.

E4 December 23: You run an advertisement in the college newspaper and are invoiced $60. The entry is a $60 increase to accounts payable and advertising expense.

E5 December 31: You pay $15 of the $60 you owe for the advertisement invoiced on December 23. The entry is a $15 decrease to cash and accounts payable.

Combining these entries with E1-E3, we get the income statement, direct cash-flow statement, and balance sheets for December (at the top of the next page):

Working capital adjustments Intel reports separate adjustments for assets and liabilities. By contrast, some companies combine these adjustments into a single “working capital adjustment” and report the separate items in a footnote.

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.)

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EASYLEARN COMPANYINCOME STATEMENTDecember 1 ‐ 31, 2009

Revenues $150Advertising expense (60)Net Income $90

EASYLEARN COMPANYBALANCE SHEETSAssets 31-Dec-09 1-Dec-09Cash $6 $0Accounts receivable 130 0

Total assets $136 $0

Liabilities and stockholders' equityLiabilities

Accounts payable 45 0Total liabilities 45 0Stockholders' equity

Common stock 1 0Retained earnings 90 0

Total stockholders' equity 91Total liabilities and stockholders' equity $136 $0

EASYLEARN COMPANYDIRECT CASH FLOW STATEMENT

December 1 - 31, 2009

Operating ActivitiesSales collections $20Advertising payment ($15)Net cash from operations $5

Financing ActivitiesSale of common stock $1Net cash from financing $1

Change in cash $6

Beginning Cash balance $0Ending cash balance $6


Operating Activities E2 E3 E4 E5 CombinedNet Income $90 $150 $0 ($60) $0 $90Receivables ($130) ($150) $20 ($130)Accounts payable $45 $60 ($15) $45Net cash from operations $5 $0 $20 $0 ($15) $5

December 1 - 31, 2009

Reported Behind Reported Numbers

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:

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.

22













Payables

adjustment

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.

23



Why Do Asset and Liability Adjustments’ Signs Differ?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

+

+ C + AR = + AP + CS + RE + Rev - AdEx + IncS

+ + $0 + + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 + + $0

E2 Recognize revenue + + + 150 = + + + + + 150 - +

E3 Customer collections + + 20 + - 20 = + + + + - +

E4 Advertising expense + + = + + 60 + + + - + 60

E5 Advertising payment + - 15 + = + - 15 + + + -

+ + $5 + + $130 = + + $45 + + $0 + + $0 + + $150 - + $60 + + $0

E1 Issue stock for cash + + 1 + = + + + 1 + + - +

+ + 1 + + 0 = + + + 1 + + 0 + + 0 - + + 0

+ + $6 + + $130 = + + $45 + + $1 + + $0 + + $150 - + $60 + + $0

+ + = + + + + - 150 - - 60 + + 90

+ + = + + + + 90 + - + - 90

+ + $6 + + $130 = + + $45 + + $1 + + $90 + + $0 - + $0 + + $0

December 1, 2009

Ope

ratin

g

Total operations

Fina

ncin

g

Total financing

Assets =

Trial balance

Closing to and from income summary

December 31, 2009

+Owners' Equity

Permanent Net incomeLiabilities

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.

24



EASYLEARN COMPANYConnecting Total Operations Row of BSE to Reconciliation

Cash from operations +

Net increase in accounts

receivable due to operating

entries

=


payable due to operating

entries

+

Net income after adjusting for gains and

losses

+ $5 + $130 + $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 COMPANYRearranging Total Operations Row of BSE

Cash from operations =

Net income after adjusting for gains and

losses

+


payable due to operating

entries

-


receivable due to operating

entries

+ $5 + $90 + $45 + $130

Reconciliationbottom line

Reconciliationtop line

Reconciliation asset and liability adjustments


Operating ActivitiesNet Income $90Receivables ($130)Accounts payable $45Net cash from operations $5

December 1 - 31, 2009

Thus, we can create the equation below from the total operations row of the BSE matrix:

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 non-operating 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) = $2,576 ending 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.

26



Record-Keeping & Reporting (R&R) MapsCreating Financial Statements from the BSE MatrixThe record-keeping and reporting map (R&R Map) below illustrates how EasyLearn’s financial statements can be created from the balance-sheet-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

+


+ + $0 + + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 + + $0





+ + $5 + + $130 = + + $45 + + $0 + + $0 + + $150 - + $60 + + $0


+ + 1 + + 0 = + + + 1 + + 0 + + 0 - + + 0

+ + $6 + + $130 = + + $45 + + $1 + + $0 + + $150 - + $60 + + $0

+ + = + + + + - 150 - - 60 + + 90

+ + = + + + + 90 + - + - 90

+ + $6 + + $130 = + + $45 + + $1 + + $90 + + $0 - + $0 + + $0

December 1, 2009

Op

erat

ing

Total operations

Fin

anci

ng

Total financing

Assets =

Trial balance


December 31, 2009

+Owners' Equity


EASYLEARN COMPANYSTATEMENT OF OWNERS' EQUITY

Retained Earnings

Common Stock

Total

$0 $0 $0Net income 90 90Common stock sale 1 1

$90 $1 $91

December 1, 2009

December 31, 2009

EASYLEARN COMPANYBALANCE SHEETSAssets 12/31/09 12/1/09

Cash $6 $0Accounts receivable 130 0


Liabili�es & owners' equityLiabili�es

Accounts payable 45 0Total liabilities 45 0Stockholders' equity


Total stockholders' equity 91 0Total liabilies & owners' equity $136 $0

EASYLEARN COMPANYINDIRECT CASH FLOW STATEMENT


Net Income $90

Receivables ($130)

Accounts payable $45


Financing Activities

Sale of common stock $1

Net cash from financing $1

Change in cash $6


December 1 - 31, 2009


December 1 - 31, 2009

Operating ActivitiesSales collections $20Advertis ing payment (15)Net cash from operations 5

Financing ActivitiesSale of common stock 1Net cash from financing 1

Change in cash 6

Beginning Cash balance 0Ending cash balance $6

EASYLEARN COMPANYINCOME STATEMENTDecember 1 - 31, 2009

Revenues $150Adver�sing expense (60)Net Income $90

+ + $0 + + $0 = + + $0 + + $0 + + $0

12/1/09

$00

$0

00

000

$0

$0$0 $0December 1, 2009

0$0

= + + $45 + + $1 + + $90+ + $6 + + $130

12/31/09

$6130

$136

4545

19091

$136

$90 $1 $91December 31, 2009

$6$6

+ + $150 - + $60

$150(60)$90

$90

($130)

$45

+ + $130 = + + $45

+ +

+ +

+ +

+ +

+ + $0 + + $0

+ + 1 +

+ + 1 + + 0

+ + $1 + + $0

+ +

+ + + 90

Net income 90Common stock sale 1 1

90

+

+ + 20

+

+ - 15

+ + $5

+ + 1

+ + 1

+ + $6

+

+

$5

$20(15)

5

$1

$1

$6

116

R&R Map: Creating Financial Statements from BSE Matrix

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.

28



Intel Consolidated Statements of Cash FlowsThree Years Ended December 29, 2007(In Millions) 2007 2006 2005Cash and cash equivalents, beginning of year 6,598$ 7,324$ 8,407$ Cash flows provided by (used for) operating activities:


Depreciation 4,546 4,654 4,345Share-based compensation 952 1,375Restructuring, asset impairment, and net loss on retirement of assets 564 635 74Excess of tax benefit from share-based payment arrangements (118) (123)Amortization of intangibles and other acquisition related costs 252 258 250(Gains) losses on equity investments, net (157) (214) 45(Gains) on divestitures (21) (612)Deferred taxes (443) (325) (413)Tax benefit from employee equity incentive plans 351Changes in assets and liabilities:



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 8,433Investments in non-marketable equity instruments (1,459) (1,722) (193)Net proceeds from divestitures 32 752Other investing activities 294 (33) (118)


Increase (decrease) in short-term debt, net (39) (114) 126Proceeds from government grants 160 69 25Excess tax benefit from share-based payment arrangements 118 123Additions to long-term debt 125 1,742Repayments and retirements of long-term debt (19)Repayments of notes payable (581)Proceeds from sales of shares through employee equity incentive plans 3,052 1,046 1,202Repurchase and retirement of common stock (2,788) (4,593) (10,637)Payment of dividends to stockholders (2,618) (2,320) (1,958)

Net cash used for financing activities (1,990) (6,370) (9,519)Net increase (decrease) in cash and cash equivalents 709 (726) (1,083)Cash and cash equivalents at the end of the year 7,307$ 6,598$ 7,324$

Beginning balances

Assets +Liabilities=

Cash OtherAssets

Operating events

Non-operating events +

+

+

=

=

=

+

+

+

+

+

+

NetIncome

+

+OCI

+

Owners' Equities

Permanent +

+

Comprehensive Income

+

Transfer comprehensiveincome to permanent

owners’ equity

Ending balances + = + + +

Net income

excludinggains &losses

Cash fromoperations

Gains & losses

Change inother assets

related tooperations

Change inliabilitiesrelated to

operations

Cash frominvesting

andfinancingactivities

OCI related to

operations

Change in paid in capital

related to operations

(39)160118125

3,052(2,788)(2,618)

(9,926)

(5,000)(76)

(11,728)8,011

(1,459)32

294

(1,990)709

12,6255,649

4,546952564

(118)252

(157)(21)

(443)

(1,429)316700102

(248)633

6,976

excludingegains &

g

losses gg=

Change inother

g

assetsrelated to

operations

Change inliabilities

gg

related tooperations

Cash fromoperations

Cash fromCinvesting

andfinancingactivities

g

6,598$

7,307$

Mapping BSE Template to Intel

The map below demonstrates how the R&R map generalizes to Intel’s statement of cash flows:

29



+


+ + $0 + + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 + + $0





+ + $5 + + $130 = + + $45 + + $0 + + $0 + + $150 - + $60 + + $0


+ + 1 + + 0 = + + + 1 + + 0 + + 0 - + + 0

+ + $6 + + $130 = + + $45 + + $1 + + $0 + + $150 - + $60 + + $0

+ + = + + + + - 150 - - 60 + + 90

+ + = + + + + 90 + - + - 90

+ + $6 + + $130 = + + $45 + + $1 + + $90 + + $0 - + $0 + + $0

December 1, 2009

Op

erat

ing

Total operations

Fin

anci

ng

Total financing

Assets =

Trial balance


December 31, 2009

+Owners' Equity


EASYLEARN COMPANYSTATEMENT OF OWNERS' EQUITY

Retained Earnings

Common Stock

Total

$0 $0 $0Net income 90 90Common stock sale 1 1

$90 $1 $91

December 1, 2009

December 31, 2009

EASYLEARN COMPANYBALANCE SHEETSAssets 12/31/09 12/1/09

Cash $6 $0Accounts receivable 130 0


Liabili�es & owners' equityLiabili�es

Accounts payable 45 0T otal liabilities 45 0Stockholders' equity


Total stockholders' equity 91 0Total liabilies & owners' equity $136 $0

EASYLEARN COMPANYINDIRECT CASH FLOW STATEMENT


Net Income $90

Receivables ($130)

Accounts payable $45


Financing Activities

Sale of common stock $1

Net cash from financing $1

Change in cash $6


December 1 - 31, 2009


December 1 - 31, 2009

Operating ActivitiesSales collections $20Advertis ing payment (15)Net cash from operations 5

Financing ActivitiesSale of common stock 1Net cash from financing 1

Change in cash 6

Beginning Cash balance 0Ending cash balance $6

EASYLEARN COMPANYINCOME STATEMENTDecember 1 - 31, 2009

Revenues $150Adversing expense (60)Net Income $90

+ + 150+ + 150

Accounts receivable 130 0

+ + $130

Retained earnings 90 0

+ + $90

+ + $150

Revenues $150

Net Income $90Net Income $90

Receivables ($130)

+ + $130

+ + 90

Net income 90 90

R&R Map: Determining Entries’ Financial Statement Effects from BSE Matrix

Determining Entries’ Financial Statement Effects from the BSE MatrixThe 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).

30



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 SummaryHere 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

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.

32



Exercise 3.02 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.

(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.

Page 42, P&G’s 2006 Annual Report

Amounts in millions 2006 2005Inventories

Materials and supplies 1,537 1,424Work in process 623 350Finished goods 4,131 3,232

Total inventories 6,291 5,006


Search IconThis exercise helps you search for information

Page 45, P&G’s 2006 Annual Report

Amounts in millions 2006 2005

CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 6,389 4,232

OPERATING ACTIVITIES

Net earnings 8,684 6,923

Depreciation and amortization 2,627 1,884

Share-based compensation expense 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)

Change in other operating assets and liabilities (508) (498)

Other 10 113

TOTAL OPERATING ACTIVITIES 11,375 8,679

(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.

33



aBC Company Events and EntriesWe 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.

34



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 StockThe 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.

35



= +

+ = + +

+ C + AR + Inven + GPPE - AcDep = + AP + CS + RE + Rev - Cgs - DepEx + Intinc + IncS

+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0

E3 Purchase inventory on account + + + + 100 + - = + + 100 + + + - - + +

E4a Recognize revenue + + + 60 + + - = + + + + + 60 - - + +

E4b Recognize cost of sales + + + - 20 + - = + + + + - + 20 - + +

E5 Customer collections + + 40 + - 40 + + - = + + + + - - + +

E6 Supplier payments + - 60 + + + - = + - 60 + + + - - + +

E7 Interest income and collection + + 10 + + + - = + + + + - - + + 10 +

E9 Depreciation expense + + + + - + 10 = + + + + - - + 10 + +

+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0

E2 Purchase building with cash + - 200 + + + + 200 - = + + + + - - + +

+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0

E1 Issue stock for cash + + 1,000 + + + - = + + + 1,000 + + - - + +

E8 Dividend declared and paid + - 20 + + + - = + + + - 20 + - - + +

+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

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Assets Liabilities Owners' Equity

Current Noncurrent Current Permanent Net income


Ending balances

Total investing

Total operations

Total financing

ABC Company Statement of Changes in EquityFirst year of operations

CommonStock

RetainedEarnings Reserves Total

Beginning balances $0 $0 $0 $0Comprehensive income

Net profit 40 40Other comprehensive income 0 0

Total 40 0 40Common stock issued 1,000 1,000Dividend declared (20) 0 (20)Ending balances $1,000 $60 $0 $1,060

ABC Company Balance SheetFirst year of operationsAssets End Bal Beg Bal

CurrentCash $770 $0Accounts receivable 20 0Inventories 80 0Total current assets 870 0

Non-current assetsProperty, plant, and equipment, net

Historical cost of PP&E 200 0Less accumulated depreciation (10) 0

Property, plant and equipment, net 190 0Total non-current assets 190 0

Total assets $1,060 $0

Liabilities and Stockholders' EquityLiabilities

CurrentAccounts payable 40 0Total current liabilities 40 0

Non-current 0 0Total liabilities 40 0Stockholders' equity

Common stock 1,000 0Retained earnings 20 0Total stockholders' equity 1,020 0

Total liabilities and stockholders' equity $1,060 $0

ABC Company Indirect Cash Flow StatementFirst year of operations

Operating ActivitiesNet profit $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40Net cash from operations ($10)

Investing ActivitiesPurchase of building ($200)Net cash (used) for investing ($200)

Financing ActivitiesSale of common stock $1,000Cash dividends ($20)Net cash from financing $980

Change in cash $770Beginning Cash balance $0Ending cash balance $770

ABC Company Direct Cash Flow StatementFirst year of operations

Operating ActivitiesSales collections $40Vendor payments ($60)Interest received $10Net cash from operations ($10)




ABC Statement of Comprehensive IncomeFirst year of operationsOperating profit

Revenues $60Cost of sales (20)Depreciation (10)Operating profit 30

Non-operating profitInterest income 10

Net profit 40Other comprehensive income 0Comprehensive income $40

+ + 1,000 + + 1,000

Cash $770

+ + $770Common stock 1,000

+ + $1,000

Sale of common stock $1,000

Sale of common stock $1,000

Common stock issued 1,000

Event E1 — Issuing $1,000 of common stock for cash

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).

36



E2 — Purchasing a BuildingThe 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.


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.


It does not affect the income statement because it does not affect revenues, expenses, gains or losses.


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.


Same as direct cash-flow statement.


It does not affect the statement because it does not affect any of the owners’ equity accounts.


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.

37



= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0








+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0


+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0



+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

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+ + 200+ - 200

+ + $770 + + $200

Cash $770

Historical cost of PP&E 200

gPurchase of building ($200)

gPurchase of building ($200)

Event E2 — Purchasing a building for $200 cash

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.

38



E3 —Purchasing Inventory on AccountThe entry to record purchasing $100 of inventory on account is highlighted in the R&R map: inventory and accounts payable both increase by $100.


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.


It does not affect revenues, expenses, gains or losses and thus, income.


Cash and thus the direct cash-flow statement is not affected by the entry.


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


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.


No effect, because it does not affect any of the owners’ equity accounts.

39




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.

Event E3 — Purchasing $100 of merchandise on account

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0








+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0


+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0



+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

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+ + 100 + + 100

+ + $80 + + $40

Invevv ntories 80

Accounts payable 40

( )Invevv ntories ($80)

+ + $80 + + $40

N t h f ti ($10)Accounts payable $40

40



E4a — Recognizing Sale on AccountThe 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.


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).


Revenues increases by $60 and thus income increases by $60.




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.


Net income $60

Receivables -$60



Retained earnings increases because the entry affected income.


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.

41



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.

Event E4a — Recognizing $60 revenue for sale on account

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0








+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0


+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0



+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

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+ + 60+ + 60

+ + $20 + + $20

Accounts rerr ceivavv ble 20

Retained earnings 20

Receivavv bles ($20)

+ + $20

+ + $60

Revevv nues $60

Net profit 40

Net prorr fiff t $40

+ + 40

Net prorr fiff t 40

42



E4b — Recognizing Cost of SalesThe entry to recognize $20 of cost of sales is highlighted in the R&R map: inventories decreases $20 and cost of sales increases $20.


Inventories and retained earnings both decrease $20.


Cost of sales increases $20 and thus income decreases $20.




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.


Net income -$20

Inventories +$20



Retained earnings decreases because the entry affected income.


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.

43



Event E4b — Recognizing $20 of cost of sales

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0








+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0


+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0



+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

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- + 20+ - 20

+ + $80 + + $20

Invevv ntories 80


Invevv ntories ($80)

+ + $80

- + $20

Cost of sales (20)

Net profit 40


+ + 40

Net prorr fiff t 40

44



Net Effects of Operating Entries on InventoriesThe 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 Combined

Net income $0 -$20 -$20

Inventories -$100 +$20 -$80

Accounts payable +$100 $0 +$100

Net cash from operations $0 $0 $0

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.

45



= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0








+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0


+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0



+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

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+ + 60+ + 60

- + 20+ - 20

+ + $20 + + $80 + + $20

Accounts rerr ceivavv ble 20Invevv ntories 80


Receivavv bles ($20)Invevv ntories ($80)

+ + $20 + + $80

+ + $60 - + $20

Revevv nues $60Cost of sales (20)

Net profit 40

gNet prorr fiff t $40

+ + 40

Net prorr fiff t 40

Combining E3 and E4b to Assess Net Effects on Inventories

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.

46



• 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 CollectionsThe 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.


Cash increases $40 and accounts receivable decreases $40.


It does not affect revenues, expenses, gains or losses and thus, income.


Sales collections increases $40, which increases cash from operations $40 on the direct and indirect cash-flow statements.



Net income $0

Receivables +$40

Net cash from operations +$40


No effect, because it does not affect any of the owners’ equity accounts.


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

47



Event E5 — Collecting $40 from customers

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0








+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0


+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0



+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

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+ - 40+ + 40

+ + $770 + + $20

Cash $770Accounts rerr ceivavv ble 20

Sales collections $40

Net cash frff or m operarr tions ($10)

Net cash frff orr m operarr tions ($10)

Receivavv bles ($20)

+ + $20

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 cash-flow 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.

48



E6 — Supplier PaymentsThe 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 Combined

Net income $0 -$20 $0 -$20

Inventories -$100 +$20 $0 -$80

Accounts payable +$100 $0 -$60 +$40

Net cash from operations $0 $0 -$60 -$60

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:

Cost of sales -$20

Inventories -$80

Accounts payable +$40

Vendor payments -$60

49



Event E6 — Paying suppliers $60

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0








+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0


+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0



+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

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+ - 60+ - 60

+ + $770 + + $40

Cash $770

Accounts payable 40

Vendor payments ($60)


Net cash frff orr m operarr tions ($10)Accounts payable $40

+ + $40

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.

50



E7 — Recognizing interest income receivedAs 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.



Net income +$10

Adjustments +$0


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.


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.

51



Event E7 — Recognizing $10 of interest income received

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0








+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0


+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0



+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Op

erat

ing

En

trie

sN

on

-op

erat

ing

En

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s

Trial balance




Ending balances

Total investing

Total operations

Total financing


CommonStock






























+ + 10+ + 10

+ + $770 + + $20

Cash $770


+ + 40

Net prorr fiff t 40

+ + $10

Interer st income 10Net profit 40


Interer st rerr ceivevv d $10


Net cash frff orr m operarr tions ($10)

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.

52



E8 — Declare and Pay DividendsAs illustrated in the R&R map, this entry recognizes $20 of dividends declared and paid, which decreases cash and retained earnings.


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.


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.

53



Event E8 — Declare and pay dividend of $20

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0








+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0


+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0



+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Op

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ing

En

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sN

on

-op

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En

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s

Trial balance




Ending balances

Total investing

Total operations

Total financing


CommonStock






























+ - 20 + - 20

+ + $770 + + $20

Cash $770


Cash divivvdends ($20)

Cash divivvdends ($20)

Divivvdend declarerr d (20)

54



E9 — Recognizing DepreciationAs 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.



Net income -$10

Depreciation +$10


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).


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 non-manufacturing 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.

55



Event E9 — Recognize $10 of depreciation

= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0








+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0


+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0



+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Op

erat

ing

En

trie

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on

-op

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En

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s

Trial balance




Ending balances

Total investing

Total operations

Total financing


CommonStock






























- + 10- + 10

- + $10 + + $20

Less accumulated deprerr ciation (10)


Deprerr ciation $10

- + $10

- + $10

Deprer ciation (10)

Net profit 40

gNet prorr fiff t $40

+ + 40

Net prorr fiff t 40

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.

56



= +

+ = + +


+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 - + $0 + + $0 + + $0








+ - $10 + + $20 + + $80 + + $0 - + $10 = + + $40 + + $0 + + $0 + + $60 - + $20 - + $10 + + $10 + + $0


+ - 200 + + 0 + + 0 + + 200 - + 0 = + + 0 + + 0 + + 0 + + 0 - + 0 - + 0 + + 0 + + 0



+ + 980 + + 0 + + 0 + + 0 - + 0 = + + 0 + + 1,000 + - 20 + + 0 - + 0 - + 0 + + 0 + + 0

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + - $20 + + $60 - + $20 - + $10 + + $10 + + $0

+ + + + - = + + + + - 60 - - 20 - - 10 + - 10 + + 40

+ + + + - = + + + + 40 + - - + + - 40

+ + $770 + + $20 + + $80 + + $200 - + $10 = + + $40 + + $1,000 + + $20 + + $0 - + $0 - + $0 + + $0 + + $0

Beginning balances

Op

erat

ing

En

trie

sN

on

-op

erat

ing

En

trie

s

Trial balance




Ending balances

Total investing

Total operations

Total financing


CommonStock






























+ + $0 + + $0 + + $0 + + $0 - + $0 = + + $0 + + $0 + + $0

Beg Bal

$0000

0000

$0

0000

000

$0

Ending balances $1,000 $60 $0 $1,060

$0

$0

+ + $60 - + $20 - + $10 + + $10

40

$60(20)(10)30

10

0$40

$40$10

($20)($80)$40

+ + $20 + + $80 + + $0 - + $10 = + + $40

+ +

+ +

+ +

+ +

+ +

+ +

+ +

+ + $0 + + $0

+ +

+ + 0 + + 0

+ + 1,000 +

+ + - 20

+ + 1,000 + - 20

+ + $1,000 + - $20

+ +

+ + + 40

Comprehensive incomeNet prorr fiff t 40Other comprer hensivevv income 0

ToTT tal 40 0Common stock issued 1,000 1,000Divivvdend declarerr d (20) 0 (20)

400

40

+

+

+

+ + 40

+ - 60

+ + 10

+

+ - $10

+ - 200

+ - 200

+ + 1,000

+ - 20

+ + 980

+ + $770

+

+

($10)

$770$980

$1,000($20)

($200)($200)

($200)($200)

$1,000($20)$980$770

($10)

$40($60)$10

+ + $20= + + $40 + + $1,000+ + $770 + + $20 + + $80 + + $200 - + $10

End Bal

$7702080

870

200(10)190190

$1,060

40400

40

1,00020

1,020$1,060

$0$00 $0Beginning balances $0

$770

$770

Creating Financial Statements From the BSE Matrix

Creating Financial Statements From BSE MatrixThe 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.

57



Combined Effects of Entries on ReconciliationIn 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: $10The 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

58



behind the combined effects of the inventories and payables adjustments when we discuss the payables adjustment next.

Accounts payable Adjustment: $40Two 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

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 AdjustmentsWe 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]

Drill DeeperHere is a three-step process to help you gain a deeper understanding of reconciliation adjustments.

60



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.

61



Exercise 3.03This 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.

Here are the entries for the month of January:

E1 CreativeABCs declares and pays a $100 dividend.

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.

Entries

Operating

Investing

Financing

Beg Bal

Tr Bal

Cls IS

Cls RE

End Bal

Zero

Zero

Revenue

Expenses

Gains & Losses

Assets

Liabilities

Owners' Equity

Net IncomeCash change

cash +other assets = liabilities + permanent OE+ temporary OE

Assets = Liabilities + Owners' EquitiesRECORDKEEPING

REPORTING

Adjustments

Operating Cash

Reconciliations

Net Income

Direct Cash Flows Balance Sheets Income Statements

Record Keeping and Reporting IconThis exercise helps you meet the insider record keeping and reporting challenge.

62



CreativeABC COMPANYBALANCE SHEETS(In Thousands)Assets 31-Dec-10

CurrentCash $2,430Accounts receivable 2,300Short-term investments 5,500Inventories 3,000Total current assets 13,230

Noncurrent 0Total assets $13,230


CurrentAccounts payable $2,500Accrued compensation and benefits 500Income taxes payable 92Total current liabilities 3,092

Non-current 0Total liabilities 3,092Stockholders' equity

Common stock 10,000Retained earnings 138Total stockholders' equity 10,138

Total liabilities and stockholders' equity $13,230

ASSETSCurrent

AR Accounts receivableC CashInven InventoryStInv Short-term investments

LIABILITIES

CurrentAP Accounts payableAcCB Accrued compensation & benefitsTaxP Taxes payable

OWNERS' EQUITY

PermanentCS Common stock (non-par)RE Retained earnings

Net incomeCgs Cost of goods soldMG&A Marketing, general & administrative expenseIncS Income summaryIntinc Interest incomeRev Revenues, netTxExp Tax expense

CreativeABC CompanyChart of Accounts

63



Part (a)Record all entries for the month of January and determine all balances in the BSE matrix:

Cre

ativ

eAB

C C

ompa

ny B

SE fo

r Ent

ries

E1-E

12 a

nd C

losi

ng fo

r Jan

uary

1 -

31, 2

011

+

+C

+A

R+

StIn

v+

Inve

n=

+A

P+

AcC

B+

TaxP

+C

S+

RE

+R

ev-

Cgs

-M

G&

A+

Intin

c-

TxEx

p+

IncS

++

++

=+

++

++

+-

-+

-+

E3Pu

rcha

se in

vent

ory

on a

ccou

nt+

++

+=

++

++

++

--

+-

+

E4a

Rec

ogni

ze re

venu

e+

++

+=

++

++

++

--

+-

+

E4b

Rec

ogni

ze c

ost o

f sal

es+

++

+=

++

++

++

--

+-

+

E5Pa

y w

ages

for D

ec 1

6- J

an15

++

++

=+

++

++

+-

-+

-+

E6Su

pplie

r pay

men

ts+

++

+=

++

++

++

--

+-

+

E7Pa

y la

ndlo

rd fo

r Jan

uary

rent

++

++

=+

++

++

+-

-+

-+

E8C

usto

mer

col

lect

ions

++

++

=+

++

++

+-

-+

-+

E9In

tere

st e

arne

d +

++

+=

++

++

++

--

+-

+

E10

Unp

aid

wag

es fo

r Jan

15-

Jan

31

++

++

=+

++

++

+-

-+

-+

E12

Rec

ogni

ze ta

x ex

pens

e+

++

+=

++

++

++

--

+-

+

++

++

=+

++

++

+-

-+

-+

E2Se

ll de

bt s

ecur

ities

++

++

=+

++

++

+-

-+

-+

++

++

=+

++

++

+-

-+

-+

E1D

ecla

re a

nd p

ay d

ivid

end

++

++

=+

++

++

+-

-+

-+

++

++

=+

++

++

+-

-+

-+

++

++

=+

++

++

+-

-+

-+

++

++

=+

++

++

+-

-+

-+

++

++

=+

++

++

+-

-+

-+

++

++

=+

++

++

+-

-+

-+

Financing

Tota

l fin

anci

ng

Tria

l bal

ance

Clo

sing

to a

nd fr

om in

com

e su

mm

ary

Janu

ary

31, 2

011

Dec

embe

r 31,

201

0

Operating

Tota

l ope

ratio

ns

Investing

Tota

l inv

estin

g

Ass

ets

=Li

abili

ties

+O

wne

rs' E

quity

Perm

anen

tN

et in

com

e

64



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 E2 Sell debt securitiesDebit Credit Debit Credit

E3 Purchase inventory on account E4a Recognize revenueDebit Credit Debit Credit

E4b Recognize cost of sales E5 Pay wages for Dec 16- Jan15Debit Credit Debit Credit

E6 Supplier payments E7 Pay landlord for January rentDebit Credit Debit Credit

E8 Customer collections E9 Interest earned Debit Credit Debit Credit

E10 Unpaid wages for Jan 15- Jan 31 E12 Recognize tax expenseDebit Credit Debit Credit

C1: Income summary C2: Close income to retained earningsDebit Credit Debit Credit

65



Part (c)Complete the T-accounts for January, including beginning and ending balances:

CreativeABC Company: Recording T-accounts for January, 2011C AR StInv Inven

AcCBAP TaxP

MG&ACgs

Intinc TxExp IncS

CS

RE Rev

66



Part (d)Complete the balance sheets, income statement, and statement of owners’ equity:

Cre

ativ

eAB

C C

ompa

ny B

alan

ce S

heet

s

Ass

ets

31-J

an-1

131

-Dec

-10

Cur

rent

Cas

hA

ccou

nts

rece

ivab

leS

hort-

term

inve

stm

ents

Inve

ntor

ies

Tota

l cur

rent

ass

ets

Non

-cur

rent

Tota

l ass

ets

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67



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68



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.

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analyzing reCent Cash FlowsOver 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.


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.

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Intel Cash Flow AnalysisThree Years Ended December 29, 2007(In Millions) 2007 2006 2005Net cash from operations 12,625 10,632 14,851

+ Interest payments 15 25 27+ Income tax payments 2,762 2,432 3,218+ Excess tax benefit from share-based payment arrangements 118 123 ──

Net cash from operations before interest and taxes 15,520 13,212 18,096- CAPX and intangibles needed to maintain current capacity (estimated as depreciation and amortization) (4,798) (4,912) (4,595)

Cash surplus (shortfall) after maintaining current capacity pretax and prefinancing 10 722 8 300 13 501Cash surplus (shortfall) after maintaining current capacity, pretax and prefinancing 10,722 8,300 13,501- Interest payments (15) (25) (27)- Income tax payments (2,762) (2,432) (3,218)- Principal payments on long-term debt and notes payable ── (581) (19)- Short-term debt payments in excess of short-term borrowings (39) (114) 0

Cash surplus (shortfall) after maintaining current capacity and paying debt and taxes 7,906 5,148 10,237- Cash purchases of PP&E to both maintain and expand capacity, net of disposals (5,000) (5,860) (5,871)- 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) 250 719 (309)+ Cash outflows to maintain capacity ( as reported above) 4,798 4,912 4,595

Cash surplus (shortfall) after maintaining and expanding capacity and paying debt and taxes 7,954 4,919 8,652- Share repurchases (2,788) (4,593) (10,637)- Cash dividends (2,618) (2,320) (1,958)

Cash surplus (shortfall) before new financing and securities transactions 2,548 (1,994) (3,943)New financing

+ Proceeds from issuing capital shares 3,052 1,046 1,202+ Proceeds from issuing long term debt 125 ── 1,742+ Short-term borrowings in excess of short-term debt payments 0 0 126

Securities transactions+ Proceeds from selling investment securities and maturities 8,011 7,147 8,433- Purchases of investment securities (13,187) (6,994) (8,668)

Other cash flows 160 69 25Other cash flows 160 69 25Net increase (decrease) in cash 709 (726) (1,083)

AMD Cash Flow AnalysisThree Years Ended December 29, 2007(In Millions) 2007 2006 2005Net cash from operations (310) 1,287 1,483

+ Interest payments 314 79 139+ Income tax payments 26 17 40

Net cash from operations before interest and taxes 30 1,383 1,662- CAPX needed to maintain current capacity (estimated as depreciation and amortization) (1,305) (837) (1,219)

Cash surplus (shortfall) after maintaining current capacity, pretax and prefinancing (1,275) 546 443- Interest paid (314) (79) (139)- Interest paid (314) (79) (139)- Income taxes paid (26) (17) (40)- Principal payments on long-term debt and capital lease obligations (2,291) (539) (316)- Purchase of capped call (182)- Other financing (2) (7)

Cash surplus (shortfall) after maintaining current capacity and paying debt and taxes (4,090) (89) (59)- Cash purchases of PP&E to both maintain and expand capacity, net of disposals (1,612) (1,834) (1,503)- Net cash purchases of other long term assets to both expand and maintain capacity 175 (3,416) (41)

(estimated by all other investing cash flows except those related to marketable securities)+ Cash outflows to maintain capacity ( as reported above) 1,305 837 1,219

Cash surplus (shortfall) after maintaining and expanding capacity and paying debt and taxes (4,222) (4,502) (384)- Repayment of silent partner contributions (46) 0 0

Net cash inflows (outflows) before new financing (4,268) (4,502) (384)New financing

+ Proceeds from issuance of common stock 608 495 0+ Proceeds from sales of shares through employee equity incentive plans 78 231 189+ Short-term borrowings in excess of short-term debt payments 0 0 77+ Additions to long-term debt and notes payable to bank 3,649 3,366 169+ Proceeds from limited partners and sale leaseback 219+ Proceeds from government grants and subsidies 223 210 163

Marketable securities transactionsPurchases of available-for-sale investments (545) (2 119) (1 562)Purchases of available-for-sale investments (545) (2,119) (1,562)Maturities and sales of available-for-sale investments 307 3,066 836

Other cash flows 7Net increase (decrease) in cash 52 747 (286)

Sources: Intel’s 2007 10-K and AMD’s 2007 10-K

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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 long-term 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.

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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 share-based 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 CyclesWe 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.

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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 earningsThe 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

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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.

ABC Company Indirect Statement of Cash FlowsFirst year of operations

Operating ActivitiesNet Income $40 Depreciation $10 Receivables ($20) Inventories ($80) Accounts payable $40Net cash from operations ($10)

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.

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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.

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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

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.

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Exercise 3.04Figure 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.

(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).



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Exercise 3.05Figures 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



80



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 1998-2001. 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.

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2001 2000 1999 1998 1997

Profit marginTurnoverFinancial Leverage(1-tax rate)ROE

ROA

Net revenuesIncome before taxesTax expenseNet IncomeBeginning total assets $6,520Ending total assetsAverage total assetsBeginning owners' equity ($322) ($560) ($1,163) ($1,620) $4,239Ending owners' equityAverage owners' equity

Yum! Brands (Tricon)

(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?

2001 2000 1999 1998 1997

Profit margin 10.54% 9.64%Adjusted profit margin 10.56% 7.16%

Net revenues $6,953 $7,093Income before taxes $733 $684Facility actions (loss) gain ($1) $176Adjusted pretax income $734 $508

Yum! Brands (Tricon)

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Exercise 3.06This 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.

(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?

(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?

(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 Internet-related 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.



Computation IconThis exercise helps you learn how to compute numbers for your analyses using formulas and financial statement information.

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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.

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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.

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Figure 3.01 Intel’s Statement of Cash FlowsThis figure illustrates Intel’s statements of cash flows.











The company’s notes found in its annual report are an integral part of this statement.

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Figure 3.02 Yum! Brands’ Balance SheetsThis figure illustrates Yum! Brands’ balance sheets.

40 TRICON GLOBAL RESTAURANTS, INC. AND SUBSIDIARIES

Consolidated Balance SheetsDecember 29, 2001 and December 30, 2000

(in millions) 2001 2000

ASSETS

Current Assets

Cash and cash equivalents $ 110 $ 133Short-term investments, at cost 35 63Accounts and notes receivable, less allowance: $77 in 2001

and $82 in 2000 175 302Inventories 56 47Prepaid expenses and other current assets 92 68Deferred income tax assets 79 75

Total Current Assets 547 688

Property, plant and equipment, net 2,777 2,540Intangible assets, net 458 419Investments in unconsolidated affiliates 213 257Other assets 393 245

Total Assets $ 4,388 $ 4,149

LIABILITIES AND SHAREHOLDERS’ EQUITY (DEFICIT)

Current Liabilities

Accounts payable and other current liabilities $ 995 $ 978Income taxes payable 114 148Short-term borrowings 696 90

Total Current Liabilities 1,805 1,216

Long-term debt 1,552 2,397Other liabilities and deferred credits 927 848Deferred income taxes — 10

Total Liabilities 4,284 4,471

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 1,097 1,133Accumulated deficit (786) (1,278)Accumulated other comprehensive income (loss) (207) (177)

Total Shareholders’ Equity (Deficit) 104 (322)

Total Liabilities and Shareholders’ Equity (Deficit) $ 4,388 $ 4,149See accompanying Notes to Consolidated Financial Statements.


87



Figure 3.03 Yum! Brands’ Income StatementsThis figure illustrates Yum! Brands’ income statements.


Consolidated Statements of IncomeFiscal years ended December 29, 2001, December 30, 2000 and December 25, 1999

(in millions, except per share data) 2001 2000 1999

Revenues

Company sales $ 6,138 $6,305 $7,099Franchise and license fees 815 788 723

6,953 7,093 7,822

Costs and Expenses, net

Company restaurantsFood and paper 1,908 1,942 2,238Payroll and employee benefits 1,666 1,744 1,956Occupancy and other operating expenses 1,658 1,665 1,814

5,232 5,351 6,008

General and administrative expenses 796 830 895Franchise and license expenses 59 49 25Other (income) expense (23) (25) (16)Facility actions net loss (gain) 1 (176) (381)Unusual items (income) expense (3) 204 51

Total costs and expenses, net 6,062 6,233 6,582

Operating Profit 891 860 1,240Interest expense, net 158 176 202

Income Before Income Taxes 733 684 1,038Income Tax Provision 241 271 411

Net Income $ 492 $ 413 $ 627

Basic Earnings Per Common Share $ 3.36 $ 2.81 $ 4.09

Diluted Earnings Per Common Share $ 3.24 $ 2.77 $ 3.92See accompanying Notes to Consolidated Financial Statements.


88



Figure 3.04 Yum! Brands’ Statements of Cash FlowsThis figure illustrates Yum! Brands’ statements of cash flows.

39

Consolidated Statements of Cash FlowsFiscal years ended December 29, 2001, December 30, 2000 and December 25, 1999

(in millions) 2001 2000 1999

Cash Flows – Operating Activities

Net income $ 492 $ 413 $ 627Adjustments to reconcile net income to net cash provided

by operating activities:Depreciation and amortization 354 354 386Facility actions net loss (gain) 1 (176) (381)Unusual items (6) 120 45Other liabilities and deferred credits (11) (5) 65Deferred income taxes (72) (51) (16)Other non-cash charges and credits, net 15 43 66

Changes in operating working capital, excluding effects of acquisitions and dispositions:Accounts and notes receivable 116 (161) (28)Inventories (8) 11 6Prepaid expenses and other current assets (3) (3) (13)Accounts payable and other current liabilities (13) (94) (215)Income taxes payable (33) 40 23

Net change in operating working capital 59 (207) (227)

Net Cash Provided by Operating Activities 832 491 565

Cash Flows – Investing Activities

Capital spending (636) (572) (470)Proceeds from refranchising of restaurants 111 381 916Acquisition of restaurants (108) (24) (6)AmeriServe funding, net — (70) —Short-term investments 27 (21) 39Sales of property, plant and equipment 57 64 51Other, net 46 5 (8)

Net Cash (Used in) Provided by Investing Activities (503) (237) 522

Cash Flows – Financing Activities

Proceeds from Senior Unsecured Notes 842 — —Revolving Credit Facility activity, by original maturity

Three months or less, net (943) 82 (860)Proceeds from long-term debt 1 — 4Repayments of long-term debt (258) (99) (180)Short-term borrowings — three months or less, net 58 (11) 21Repurchase shares of common stock (100) (216) (134)Other, net 48 37 30

Net Cash Used in Financing Activities (352) (207) (1,119)

Effect of Exchange Rate Changes on Cash and Cash Equivalents — (3) —

Net (Decrease) Increase in Cash and Cash Equivalents (23) 44 (32)

Cash and Cash Equivalents – Beginning of Year 133 89 121

Cash and Cash Equivalents – End of Year $ 110 $ 133 $ 89See accompanying Notes to Consolidated Financial Statements.


89



Figure 3.05 Yum! Brands’ Supplemental Cash Flow Data FootnoteThis figure illustrates the Supplemental Cash Flow Data footnote from Yum! Brands’ Annual Report.

FIGURE 2

SUPPLEMENTAL CASH FLOW DATA

2001 2000 1999

Cash Paid for:Interest $ 164 $ 194 $ 212Income taxes 264 252 340

Significant Non-Cash Investing and Financing Activities:Issuance of promissory note to

acquire an unconsolidated affiliate $ — $ 25 $ —Contribution of non-cash net assets

to an unconsolidated affiliate 21 67 —Assumption of liabilities in connection

with an acquisition 36 6 1Fair market value of assets

received in connection with a non-cash acquisition 9 — —

Capital lease obligations incurred to acquire assets 18 4 4

6NOTE


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Figure 3.06 Yum! Brands’ Five-Year Summary of Select Financial DataThis figure illustrates Yum! Brands’ summary of select financial data.


Selected Financial Data

Fiscal Year(in millions, except per share and unit amounts) 2001 2000 1999 1998 1997

Summary of Operations

System sales(a)

U.S. $ 14,596 $ 14,514 $14,516 $14,013 $13,502International 7,732 7,645 7,246 6,607 6,963

Total 22,328 22,159 21,762 20,620 20,465

RevenuesCompany sales(b) 6,138 6,305 7,099 7,852 9,112Franchise and license fees 815 788 723 627 578

Total 6,953 7,093 7,822 8,479 9,690

Facility actions net (loss) gain(c) (1) 176 381 275 (247)Unusual items income (expense)(c)(d) 3 (204) (51) (15) (184)

Operating profit 891 860 1,240 1,028 241Interest expense, net 158 176 202 272 276

Income (loss) before income taxes 733 684 1,038 756 (35)Net income (loss) 492 413 627 445 (111)Basic earnings per common share(e) 3.36 2.81 4.09 2.92 N/ADiluted earnings per common share(e) 3.24 2.77 3.92 2.84 N/A

Cash Flow Data

Provided by operating activities $ 832 $ 491 $ 565 $ 674 $ 810Capital spending, excluding acquisitions 636 572 470 460 541Proceeds from refranchising of restaurants 111 381 916 784 770

Balance Sheet

Total assets $ 4,388 $ 4,149 $ 3,961 $ 4,531 $ 5,114Operating working capital deficit(f) (707) (634) (832) (960) (1,073)Long-term debt 1,552 2,397 2,391 3,436 4,551Total debt 2,248 2,487 2,508 3,532 4,675

Other Data

Number of stores at year end(a)

Company 6,435 6,123 6,981 8,397 10,117Unconsolidated Affiliates 2,000 1,844 1,178 1,120 1,090Franchisees 19,263 19,287 18,414 16,650 15,097Licensees 2,791 3,163 3,409 3,596 3,408

System 30,489 30,417 29,982 29,763 29,712

U.S. Company same store sales growth(a)

KFC 3% (3)% 2% 3% 2%Pizza Hut — 1% 9% 6% (1)%Taco Bell — (5)% — 3% 2%Blended 1% (2)% 4% 4% 1%

Shares outstanding at year end (in millions) 146 147 151 153 152Market price per share at year end $ 49.24 $ 33.00 $ 37.94 $ 47.63 $ 28.31N/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 oper-ations 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 ownedcompany for that period. To facilitate this presentation, PepsiCo made certain allocations of its previously unallocated interest and general and administrative expenses as well aspro 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. Fiscalyear 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.

(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 unusualitems. 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 torefranchise; (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 relatedpersonnel 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 quartercharge. 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 thedisposal of the Non-core Businesses.

(e) EPS data has been omitted for 1997 as our capital structure as an independent, publicly owned company did not exist.

(f) Operating working capital deficit is current assets excluding cash and cash equivalents and short-term investments, less current liabilities excluding short-term borrowings.


91



Figure 3.07 Cisco’s Statements of Cash FlowsThis figure illustrates Cisco’s statements of cash flows.


92



Figure 3.08 Starbucks’ Statements of Cash FlowsThis figure illustrates Starbucks’ statements of cash flows.

25

CONSOLIDATED STATEMENTS OF CASH FLOWSIn thousands

Fiscal year ended Sept 29, 2002 Sept 30, 2001 Oct 1, 2000 OPERATING ACTIVITIES:Net earnings $ 215,073 $ 181,210 $ 94,564 Adjustments to reconcile net earnings to net cash provided by operating activities:

Depreciation and amortization 221,141 177,087 142,171 Gain on sale of investment (13,361) - -Internet-related investment losses - 2,940 58,792Provision for impairment and asset disposals 26,852 11,044 5,753 Deferred income taxes, net (6,088) (6,068) (18,252) Equity in income of investees (21,972) (15,713) (15,139) Tax benefit from exercise of non-qualified stock options 44,199 30,899 31,131 Cash provided/(used) by changes in operating assets and liabilities:

Net purchases of trading securities (5,699) (4,032) (1,414)Accounts receivable (6,703) (20,399) (25,013) Inventories (41,379) (19,704) (19,495) Prepaid expenses and other current assets (12,460) (10,919) 885 Accounts payable 5,463 54,117 15,561 Accrued compensation and related costs 24,087 12,098 25,415 Accrued occupancy costs 15,343 6,797 6,007 Accrued taxes (16,154) 34,548 5,026 Deferred revenue 15,321 19,594 6,836 Other accrued expenses 34,022 2,806 5,746

Net cash provided by operating activities 477,685 456,305 318,574

INVESTING ACTIVITIES:Purchase of available-for-sale securities (339,968) (184,187) (118,501)Maturity of available-for-sale securities 78,349 93,500 58,750Sale of available-for-sale securities 144,760 46,931 49,238Purchase of businesses, net of cash acquired - - (13,522)Additions to equity and other investments (6,137) (12,874) (43,930)Proceeds from sale of equity investment 14,843 - - Distributions from equity investees 22,834 16,863 14,279Additions to property, plant and equipment (375,474) (384,215) (316,450)Additions to other assets (24,547) (4,550) (3,096)

Net cash used by investing activities (485,340) (428,532) (373,232)

FINANCING ACTIVITIES:Increase/(decrease) in cash provided by checks drawn in excess of bank balances 12,908 5,655 (7,479)Proceeds from sale of common stock under employee stock purchase plan 16,191 12,977 10,258 Proceeds from exercise of stock options 91,276 46,662 58,463Principal payments on long-term debt (697) (685) (1,889)Repurchase of common stock (52,248) (49,788) -

Net cash provided by financing activities 67,430 14,821 59,353Effect of exchange rate changes on cash and cash equivalents 1,560 (174) (297) Net increase in cash and cash equivalents 61,335 42,420 4,398

CASH AND CASH EQUIVALENTS:Beginning of year 113,237 70,817 66,419End of year $ 174,572 $ 113,237 $ 70,817 SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:Cash paid during the year for:

Interest $ 303 $ 432 $ 411 Income taxes 105,339 47,690 51,856

See Notes to Consolidated Financial Statements.


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