Principles of accounting

Nguyen Tan Binh 1 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 1 Principles of Accounting Fulbright Economics Teaching Program Ho Chi Minh City, Vietnam Academic Year: 2005-2006 7/17/2006 Nguyễn Tấn Bình 2 Lecture Notes 4 Statement of Cash Flows Nguyen Tan Binh 2 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 3 The main objective of the statement of cash flows • Shows the relationship between the Net Income and Net Cash Flow • Explains how cash is generated and used during a business period • Evaluates the ability to pay debt in time • This information is very useful to decision makers (managers, lenders, shareholders…) in forecasting the future cash flows 7/17/2006 Nguyễn Tấn Bình 4 The necessity of the statement of cash flows Additionally provides a lot of important information that the balance sheet and the income statement cannot to provide: • The balance sheet only reflects the values and the sources of assets at a certain date (a point of time) 9How to know how much the firm has disbursed for purchases (or collected from liquidations) of fixed assets during a business period? 9How to know how much the firm has borrowed (or paid back) during a business period? Nguyen Tan Binh 3 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 5 The necessity of the statement of cash flows Additionally provides a lot of important information that the balance sheet and the income statement fail to provide: • The income statement is made on the accrual, not the cash, basis of accounting 9Why does a firm show profit but have no cash, and vice versa? 9How to explain changes (increases or decreases) in cash balance from the beginning to the end of the business period? 7/17/2006 Nguyễn Tấn Bình 6 What is called “cash” in the statement of cash flows • Cash, bank deposits, floats, and cash equivalent securities • Cash equivalent securities include – Marketable securities with high liquidity – Easy to be transferred into cash Nguyen Tan Binh 4 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 7 Classification of cash flows A firm of any form or any size has 3 types of activities: 1. Operating 2. Investing 3. Financing The statement of cash flows reflects three cash flows from the three above activities 7/17/2006 Nguyễn Tấn Bình 8 Cash flow from operating • Disbursement flows into and receipt flows from the main operating activity of the firm • There are two methods to calculate the cash flow from operating activity: – Direct method – Indirect method Nguyen Tan Binh 5 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 9 Cash flow from operating Receipt flows (inflows) include: – Collections from customers – Interest receipt, receipt from other operations – Dividend receipt (from investments in other companies) 7/17/2006 Nguyễn Tấn Bình 10 Cash flow from operating Disbursement flows (outflows) include – Payment to suppliers – Interest, tax payments – Salary payment – Payment to other operations Pay to t he o rde r of Nguyen Tan Binh 6 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 11 Cash flows from investing and financing • Only one method to prepare cash flows from investing and financing: the direct method • Shows the actual disbursement and receipt flows 7/17/2006 Nguyễn Tấn Bình 12 Cash flow from investing • Disbursement and receipt flows for purchases and sales of fixed assets, investments, and investment recovery Nguyen Tan Binh 7 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 13 Cash flow from investing • Receipt flows (inflows) include – Liquidations of fixed assets – Sales of marketable securities – Recovery of investment or lending 7/17/2006 Nguyễn Tấn Bình 14 • Disbursement flows (outflows) include – Purchases of fixed assets – Purchases of marketable securities – Lending or capital contribution to other companies Cash flow from investing Nguyen Tan Binh 8 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 15 • Disbursement flows into and receipt flows from financing activity (capital mobilization) for the firm’s operations • Funds raised from owners and lenders Cash flow from financing 7/17/2006 Nguyễn Tấn Bình 16 • Receipt flows (inflows) include – Stock issue – Corporate bond issue – Bank loans Cash flow from financing Nguyen Tan Binh 9 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 17 • Disbursement flows (outflows) include – Repurchases of stock (treasury stock) – Recall or payment of corporate bond – Debt payment – Dividend payment Cash flow from financing 7/17/2006 Nguyễn Tấn Bình 18 Non-cash investing and financing activities Example: – Debt-equity conversion – Purchases and sales of fixed assets on credit • These activities do not generate cash flows, hence, are not shown on the statement of cash flows • However, the endnotes to the statement of cash flows or a separate statement is prepared to explain their changes on the balance sheet Nguyen Tan Binh 10 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 19 Some common transactions and their impacts on the cash flows Operating transactions • Sales of goods/services for cash + • Sales on credit 0 • Interest receipt from investments + • Collections from accounts receivable + • Record of cost of goods sold 0 • Inventory purchases for cash - • Purchases on account 0 • Payment for accounts payable - 7/17/2006 Nguyễn Tấn Bình 20 Some common transactions and their impacts on the cash flows (cont.) Operating transactions • Expense payable 0 • Expense payment - • Taxes payable 0 • Tax payment - • Interest payable 0 • Interest payment - • Prepaid expense (for example, insurance) - • Records decreases in prepaid expense 0 • Records insurance expense 0 Nguyen Tan Binh 11 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 21 Some common transactions and their impacts on the cash flows (cont.) Financing transactions • Purchases of fixed assets for cash - • Purchases of fixed assets on account 0 • Liquidations of assets for cash + • Sales of fixed assets on credit 0 • Purchases of marketable securities - • Sales of marketable securities + • Lending - 7/17/2006 Nguyễn Tấn Bình 22 Some common transactions and their impacts on the cash flow (cont.) Financing transactions • Borrowing (long and short term) + • Debt payment (long and short term) - • Stock issue (common and preferred) + • Stock repurchase - • Interest payment - • Dividend payment - • Debt-equity conversion 0 • Long-term to short-term debt conversion 0 Nguyen Tan Binh 12 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 23 Cash flow concept Conventions on cash flows: ƒ Inflows, or receipt flows ƒ Outflows, or disbursement flows Total net cash flows (from three activities) equal the difference between ending and beginning cash balances Net Cash Flows = Inflows – Outflows 7/17/2006 Nguyễn Tấn Bình 24 Cash flow concept (cont.) Total net cash flows (from three activities) equal the difference between ending and beginning cash balances Remember Beginning balance + Receipts during period – Disbursements during period = Ending balance Î Receipts during period – Disbursements during period = Ending balance – Beginning balance Receipts during period – Disbursements during period = Total net cash flows Nguyen Tan Binh 13 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 25 Preparing the statement of cash flows A statement of cash flow includes three parts Net cash flow from operating (I) Net cash flow from investing (II) Net cash flow from financing (III) Total net cash flows = I + II + III + Beginning cash balance = Ending cash balance 7/17/2006 Nguyễn Tấn Bình 26 Two methods of preparing the statement of cash flows (for net cash flows from operating) Indirect method – Net cash flow from operating is calculated by adjusting from net income – Most of companies use this method Direct method – Net cash flow from operating is calculated from actual receipt and disbursement flows – This method is comprehensible to readers, but few companies use it. Discussion Nguyen Tan Binh 14 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 27 Sources of data used for preparing the statement of cash flows 1. Balance sheet, showing the beginning and ending balances 2. Income statement 3. Notes of financial statements 7/17/2006 Nguyễn Tấn Bình 28 Direct method • The simple direct method uses accounting books such as ledgers and cash book to pick up the receipt and disbursement flows. However, the workload is troublesome, confusing, and infeasible – Cash book is recorded in chronologic order, while the statement of cash flows classifies cash flows into various activities (operating, investing, and financing) – How can outsiders have this book? • This lecture presents the inferential direct method, which infers cash flows from the income statement and the balance sheet Nguyen Tan Binh 15 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 29 Demonstrating the inferential direct method Revenue • Since revenues on the income statement are recognized on the accrual basis of accounting, they are not the accrual receipts • Infer as follows Revenues - (Ending – Beginning) Accounts Receivable = Receipts 7/17/2006 Nguyễn Tấn Bình 30 A numeric example of revenues BBB Company • Beginning-of-year Receivables (1/1/2004) are 4,000 • Ending-of-year Receivables (31/12/2004) are 5,000 • Revenues during 2004 are 80,000 – What are the accrual receipts? Nguyen Tan Binh 16 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 31 A numeric example of revenues Interpretation Customers owe 4,000 at the beginning of the year; they owe an additional amount of 1,000 during the year; they owe 5,000 at the end of the year The difference (ending – beginning balance) is the credit amount accrued (+), or paid (-) during the period Here, (ending – beginning balance) = 5,000 – 4,000 = 1,000 BBB Company • Beginning-of-year Receivables (1/1/2004) are 4,000 • Ending-of-year Receivables (31/12/2004) are 5,000 • Revenues during 2004 are 80,000 – What are the accrual receipts? 7/17/2006 Nguyễn Tấn Bình 32 A numeric example of revenues Interpretation Revenues are 80,000 during the year. The firm thus collects 79,000 because customers owe additionally 1,000 during the period. Accrual collections from customers are : Revenues– (Ending Receivables – Beginning Receivables ) 80,000 – (5,000 – 4,000) = 79,000 BBB Company • Beginning-of-year Receivables (1/1/2004) are 4,000 • Ending-of-year Receivables (31/12/2004) are 5,000 • Revenues during 2004 are 80,000 – What are the accrual receipts? Nguyen Tan Binh 17 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 33 Demonstrating the inferential direct method Expenses • Since expenses on the income statement are recognized on the accrual basis of accounting, they are not the actual disbursements • Infer as follows: Expenses - (Ending - Beginning) Expenses Payable = Disbursements 7/17/2006 Nguyễn Tấn Bình 34 A numeric example of expenses BBB Company • Salaries expense accrued during 2004 is 2,000 • Salaries payable at the beginning of the year (1/1/2004) are 200 • Salaries payable at the end of the year (31/12/2004) are 100 What is the amount paid as salaries? Nguyen Tan Binh 18 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 35 A numeric example of expenses Interpretation The firm owes employees 200 at the beginning of the year; it pays 100 during the year; so it still owes 100 at the end of the year The difference (ending ending– beginning balance) is the amount paid (-) during the year In our example, ending balance – beginning balance = 100 – 200 = -100 BBB Company • Salaries expense accrued during 2004 is 2,000 • Salaries payable at the beginning of the year (1/1/2004) are 200 • Salaries payable at the end of the year (31/12/2004) are 100 What is the amount paid for salaries? 7/17/2006 Nguyễn Tấn Bình 36 A numeric example of expenses Interpretation Salaries expense accrued during the year is 2,000. The firm thus has not only paid all salaries of 2,000, but also paid its dues of 100 The amount actually paid to employees is Accrued salaries – (Ending balance – beginning balance) 2,000 – (100 – 200) = 2,100 BBB Company • Salaries expense accrued during 2004 is 2,000 • Salaries payable at the beginning of the year (1/1/2004) are 200 • Salaries payable at the end of the year (31/12/2004) are 100 What is the amount paid for salaries? Nguyen Tan Binh 19 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 37 Indirect method (*) ƒNet cash flows from operating is calculated from net income, and adjusted as follows: • (+) Depreciation is added, because it has been deducted when we calculate net income, but there is no disbursement • (+/-) Profits (losses) from investing and financing (such as sales of assets, debt payments) are added (subtracted), because they have been directly accounted in the category of Cash Flows from Investing and Financing • (+/-) Changes in working capital (receivables, inventory, payables) are added (subtracted) (*) See Lecture Notes 4a, Preparing the Statement of Cash Flows, Song Ha Company 7/17/2006 Nguyễn Tấn Bình 38 Notes of the two methods • The direct method provides more details of the cash flows from operating – Specifically and clearly shows the disbursement and receipt flows • The indirect method shows the “quality” of income, and points out the factors that affect the cash flows from operating more clearly • In both methods, cash flows from investing and financing are prepared in the direct method • Net cash flows in the two methods must be the same Nguyen Tan Binh 20 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 39 How important is the statement of cash flows? • Shows a more complete picture on the firm’s financial position • Many big firms fail because they are failed to manage their cash flows • And remember, the statement of cash flows is required by the international accounting standard and by many countries’ • In Vietnam? 7/17/2006 Nguyễn Tấn Bình 40 Analysis of the statement of cash flows • The statement of cash flows shows the firm’s overall business activities over various development stages Nguyen Tan Binh 21 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 41 0000Total Net Cash Flows (1) (6)(25)1020Financing (2)(10)(22)(14)Investing 83512(6)Operating VIIIIIIIActivity (1) Assume a zero difference between the ending and the beginning cash balances Analysis of the statement of cash flows Cash flows of the 4 companies, I, II, III, and IV 7/17/2006 Nguyễn Tấn Bình 42 ª Company I is an example of a new firm or a firm that has new products and been rapidly growing. In this stage, the firm shows little profits, receivables increase (due to its credit policy) and inventory rises. Net cash flow from operating is negative (-6) because disbursements exceed receipts. The firm has mobilized so much funds (20) to serve operating and investing (- 14) during this stage Analysis of the statement of cash flows Company I 0000Total Net Cash Flows (1) (6)(25)1020Financing (2)(10)(22)(14)Investing 83512(6)Operating VIIIIIIIActivity Nguyen Tan Binh 22 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 43 Company II reflects a firm that is longer established than Company I; it is still in the growing stage, but its growth rate is slower. It shows profits and generates positive cash flows from operating (12). However, cash flows from operating are not sufficient to invest in PPE (-22), so it still has to mobilize funds (10) Analysis of the statement of cash flows Company II 0000Total Net Cash Flows (1) (6)(25)1020Financing (2)(10)(22)(14)Investing 83512(6)Operating VIIIIIIIActivity 7/17/2006 Nguyễn Tấn Bình 44 Company III reflects a firm in a high and stable development stage, generates large net cash flows from operating (35). The firm uses the proceeds to invest in fixed assets and (possibly) in other firms (-10), pay back debt, and (possibly) pay dividends as a means to pay back capital to shareholders (-25). Analysis of the statement of cash flows Company III 0000Total Net Cash Flows (1) (6)(25)1020Financing (2)(10)(22)(14)Investing 83512(6)Operating VIIIIIIIActivity Nguyen Tan Binh 23 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 45 Company IV reflects a picture of a firm that is going to slow down (after reaching a peak). Net cash flows from operating are still positive, but start to decrease (8). The firm also reduces its investments in PPE since the industry is slowing down (-2). It has used cash flows from operating to pay back debt and pay dividends (-6). Analysis of the statement of cash flows Company IV 0000Total Net Cash Flows (1) (6)(25)1020Financing (2)(10)(22)(14)Investing 83512(6)Operating VIIIIIIIActivity 7/17/2006 Nguyễn Tấn Bình 46 6,438 3,016 3,922 Ending Cash Balance 3,016 3,922 4,846 Beginning Cash Balance 61 2 (26)Change in Exchange Rate 3,361 (908)(898)Total Net Cash Flows (7,213)(10,845)(8,734)Net Cash Flows from Investing INVVESTING (5,223)(4,572)(5,586)Net Cash Flows from Financing FINANCING 15,797 14,509 13,422 Net Cash Flows from Operating 4,365 5,596 4,540 Adjustments of Working Capital 1,439 1,084 1,536 Depreciation 9,993 7,829 7,346 Net Income OPERATING 2,003 2,002 2,001 (million dollars) Fiscal Year ends on June 30 STATEMENT OF CASH FLOWS Microsoft Corporation Nguyen Tan Binh 24 Fulbright Economics Teaching Program 2005-2006 Principles of accounting Lecture 4 7/17/2006 Nguyễn Tấn Bình 47 References Horngren – Sundem – Elliott Introduction to Financial Accounting, 8th Edition, Prentice Hall, 2002. Stickney – Weil Financial Accounting, 8th Edition, The Dryden Press, 1997. Nguyen Tan Binh Ke toan quan tri, Nha xuat ban Dai hoc Quoc gia TPHCM, 2003.