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More free books @ www.BingEbook.com Chapter 1: Elements of Business Accounting Partitioning the Statement of Cash Flows You could argue that the statement of cash flows is the most important of the three primary financial statements. Why? Because in the long run everything comes down to cash flows. Profit recorded on the accrual basis of accounting has to be turned into cash — and the sooner the better. Otherwise, profit doesn’t provide money for growing the business and paying distributions to owners. By themselves, the income statement and balance sheet don’t provide information about the cash flow generated by the business’s profit-making, or operating, activities. But people who use financial reports (business managers, lenders, and investors) want to see cash flow information. In short, financial reporting standards require a statement of cash flows. The statement begins with reporting the cash flow from operating activities and also reports the other sources and uses of cash during the period, which are divided into the following: ⻬ Investing activities: Include the purchase and construction of long-term operating assets such as land, buildings, equipment, machinery, vehicles, and tools. If a business realizes cash from the disposal of such assets, the proceeds are included in this category of cash flows. ⻬ Financing activities: Include borrowing money from debt sources and paying loans at maturity as well as raising capital from shareowners and returning capital to them. Cash distributions from profit are included in this category of cash flows. Q. The statement of cash flows for a business’s most recent year is presented as follows. Based on the information provided, is it possible to determine the amount of cash flow from operating activities? Cash flow from operating activities: ????? Cash flow from investing activities: Capital expenditures ($2,345,000) $225,000 ($2,120,000) Proceeds from disposal of real estate Issue of capital stock shares You can determine the amount of cash flow from operating activities by the following calculations: $2,120,000 net cash needed for capital expenditures + $355,000 cash balance increase = $2,475,000 total cash needed $2,475,000 total cash needed – $1,775,000 net cash provided from financing activities = $700,000 cash flow from operating activities Cash flow from operating activities is explained in more detail in Chapter 8. You can condense a statement of cash flows, such as the one for the example, into its four basic components as follows (negative numbers appear in parentheses): Cash flow from financing activities: Increase in debt A. Cash flow from operating activities $1,625,000 $550,000 Cash dividends to shareholders ($400,000) $1,775,000 Net cash increase during year $355,000 $700,000 Cash flow from investing activities ($2,120,000) Cash flow from financing activities $1,775,000 Net increase in cash during the year $355,000 17 More free books @ www.BingEbook.com 18 Part I: Business Accounting Basics If you know three of the four components in a condensed statement of cash flows, you can determine the fourth factor. Suppose you know the increase or decrease in cash during the year (which is easy enough to determine by comparing the ending cash balance with the beginning cash balance). And suppose you can quickly determine the cash flow from investing activities and the cash flow from financing activities (because there aren’t many transactions of these two types during the year). Knowing these three factors, you can quickly determine the cash flow from operating activities. The remainder of the increase or decrease in cash during the year is attributable to operating activities. Questions 17 through 20 give you three of the four components in a condensed statement of cash flows and ask you to solve for the unknown factor. 17. Three of the four components of cash flow for the year of a business are as follows: 18. Three of the four components of cash flow for the year of a business are as follows: Cash flow from operating activities $450,000 Cash flow from operating activities $2,680,000 Cash flow from investing activities ($725,000) Cash flow from investing activities ???? Cash flow from financing activities $50,000 Cash flow from financing activities $1,250,000 Net increase (decrease) in cash during the year ???? Determine the increase or decrease in cash during the year. Solve It Net increase (decrease) in cash during the year $400,000 Determine cash flow from investing activities for the year. Solve It More free books @ www.BingEbook.com Chapter 1: Elements of Business Accounting 19. Three of the four components of cash flow for the year of a business are as follows: 20. Three of the four components of cash flow for the year of a business are as follows: Cash flow from operating activities $650,000 Cash flow from operating activities Cash flow from investing activities ($925,000) Cash flow from investing activities ($480,000) Cash flow from financing activities ($150,000) Net increase (decrease) in cash during the year $150,000 Cash flow from financing activities Net increase (decrease) in cash during the year ???? ($65,000) Determine cash flow from financing activities for the year. Solve It ???? Determine cash flow from operating activities for the year. Solve It Tracing How Dishonest Accounting Distorts Financial Statements It goes without saying that a business should keep its accounting system as honest as the day is long. In preparing its financial statements, a business should be forthright and not misleading. As the late sportscaster Howard Cosell would say, “Tell it like it is.” I regret to tell you that some businesses cheat in their accounting and financial reporting. Now, there’s cheating and then there’s real cheating. So what’s the difference? Many businesses perform cosmetic surgery on their accounts, touching up their financial condition and profit performance. This practice is popularly called massaging the numbers. Professional investors (as in mutual fund managers) and lenders (as in banks) know that a certain amount of accounting manipulation goes on by many businesses, and as a practical matter not much can be done about it. On another level, some businesses resort to accounting fraud to put a better sheen on profit performance and conceal financial problems. Accounting fraud is popularly called cooking the books. Think of massaging the numbers as fibbing or putting a spin on the truth and accounting fraud as out-and-out lying with the intent to deceive and mislead. In recent years the incidence of accounting fraud has risen alarmingly. (Do Enron, WorldCom, and Waste Management ring any bells?) Accounting fraud is illegal and perpetrators are subject to prosecution under criminal law. Plus, victims can sue the persons responsible for the fraud. 19 More free books @ www.BingEbook.com 20 Part I: Business Accounting Basics Q. Suppose a business has engaged in some accounting fraud to boost its profit for the year just ended. Assume that the business didn’t commit any accounting fraud before this year (which may not be true, of course). As the result of fraudulent entries in its accounts, the $2,340,000 bottom-line profit reported in its income statement was overstated $385,000. How does this dishonest accounting distort the business’s balance sheet? A. 21. Suppose a business commits accounting fraud by deliberately not writing down its inventory of $268,000, which is the cost of certain products that it can no longer sell and will be thrown in the junk heap. How should its balance sheet be adjusted to correct for this accounting fraud, ignoring income tax effects? (Use the answer template provided.) Owners’ equity is overstated $385,000 because profit increases owners’ equity. And the overstatement of profit may have involved the overstatement of assets, the understatement of liabilities, or a combination of both. To correct this error, owners’ equity should be decreased $385,000. As well, assets should be decreased $385,000, or liabilities should be increased $385,000 (or some combination of both). Solve It Cash Accounts Payable Accounts Receivable Notes Payable Inventory Owners’ Equity Fixed Assets (Net of Accumulated Depreciation) Total Assets 22. _____ _____ Total Liabilities and Owners’ Equity Suppose a business commits accounting fraud by deliberately not recording $465,000 liabilities for unpaid expenses at the end of the year. How should its balance sheet be adjusted to correct for this accounting fraud, ignoring income tax effects? (Use the answer template provided.) Solve It Cash Accounts Payable Accounts Receivable Notes Payable Inventory Owners’ Equity Fixed Assets (Net of Accumulated Depreciation) Total Assets _____ _____ Total Liabilities and Owners’ Equity More free books @ www.BingEbook.com Chapter 1: Elements of Business Accounting Answers to Problems on Elements of Business Accounting The following are the answers to the practice questions presented earlier in this chapter. a Which of the following is the normal way to present the accounting equation? c. Assets = Liabilities + Owners’ equity The other three accounting equations are correct from the algebraic equation point of view. However, the accounting equation is usually shown with assets on one side and the two broad classes of claims against the assets on the other side. Note: You see answer (b) (Assets – Liabilities = Owners’ equity) when the purpose is to emphasize the net worth of a business, or its assets less its liabilities. b A business has $485,000 total liabilities and $1,200,000 total owners’ equity. What is the amount of its total assets? Total assets = $1,685,000, which is the total of $485,000 liabilities plus $1,200,000 owners’ equity. c A business has $250,000 total liabilities. When it was started the owners invested $500,000 in the business. Unfortunately, the business has suffered a cumulative loss of $200,000 up to the present time. What is the amount of its total assets at the present time? Total assets = $550,000, which is the total of $250,000 liabilities plus $300,000 owners’ equity. Notice that the original $500,000 that the owners invested in the business is reduced by the $200,000 cumulative loss of the business, and owners’ equity is now only $300,000. d A business has $175,000 total liabilities. Originally, at the time of starting the business, the owners invested $250,000 capital. The business has earned $190,000 cumulative profit since it started (all of which has been retained in the business). What is the total amount of its assets? Total assets = $615,000, which is the total of $175,000 liabilities and $440,000 owners’ equity. Notice that in addition to the original $250,000 capital invested by owners, the business has earned $190,000 profit, so its total owners’ equity is $440,000. e What would be the amount of accrual-basis sales revenue for the year if the business’s year-end receivables had been $92,000? (For the original numbers, see the section “Distinguishing Between Cash- and Accrual-Basis Accounting.”) Sales revenue ($558,000 cash receipts + $92,000 year-end receivables) = $650,000 f What would be the amount of accrual-basis cost of products sold expense for the year if the business’s cost of products held in inventory at year-end had been $95,000? (For the original numbers, see the section “Distinguishing Between Cash- and Accrual-Basis Accounting.”) Cost of products sold ($375,000 cash payments – $95,000 year-end inventory) = $280,000 g What would be the amount of accrual-basis other expenses for the year if the business’s liability for unpaid expenses at year-end had been $30,000? (For the original numbers, see the section “Distinguishing Between Cash- and Accrual-Basis Accounting.”) Other expenses ($340,000 cash payments + $30,000 year-end liability) = $370,000 21 More free books @ www.BingEbook.com 22 Part I: Business Accounting Basics h Based on the changes to the example given in Questions 5, 6, and 7, determine the profit or loss of the business for its first year. In this case, the total of the two expenses (cost of products sold and other expenses) happens to be $650,000, which is exactly equal to sales revenue. So the business breaks even for the year. This outcome is unusual, of course; the total of expenses for the year is almost always different than total sales revenue for the year. i One rule of income statement reporting is that interest expense and income tax expense be reported separately. The $10,010,000 “Other expenses” in the income statement for the answer to the example question includes $350,000 interest expense and $910,000 income tax. Rebuild the income statement given the information for these additional two expenses. Hint: Profit before interest expense is usually labeled “operating earnings,” and profit after interest and before income tax expense is usually labeled “earnings before income tax.” Income Statement for Year Sales revenue Cost of goods sold Gross margin Other expenses Operating earnings Interest expense Earnings before income tax Income tax expense Net income $26,000,000 14,300,000 $11,700,000 8,750,000 $2,950,000 350,000 $2,600,000 910,000 $1,690,000 Burying interest expense or income tax expense in a broader expense category such as “other expenses” or “general expenses” is unacceptable. Interest and income tax expenses are reported toward the bottom of the income statement. They’re viewed as nonoperating expenses, which means that they depend on how the business is financed and its income tax situation. j No specific rule governs income statement disclosure of advertising expense. Suppose the $10,010,000 “Other expenses” in the income statement for the answer to the example question includes $5,000,000 of advertising expense. Would you favor reporting this as a separate expense in the income statement? Hint: This question calls for your opinion only. Well, there’s no rule against disclosure of advertising expense — that’s for sure. Because it’s such a large expense, I favor disclosing it in the income statement. But most businesses are very sensitive about disclosing their advertising expense and, in fact, don’t disclose this expense in their income statements. k No specific rule governs income statement disclosure of executive-level compensation. Suppose the $10,010,000 “Other expenses” in the income statement for the answer to the example question includes $3,000,000 of executive-level compensation that includes both base salaries and generous bonuses. Would you favor reporting this as a separate expense in the income statement? Hint: This question calls for your opinion only. Oh boy! This is a hot potato question. I’m all for open, frank, and transparent disclosure in financial reports, but this is like believing in Santa Claus. Most businesses are very reluctant to disclose executive-level compensation in their income statements or elsewhere in their financial reports. With no rule forcing such disclosure in their income statements, most businesses don’t reveal this piece of information. You can ask for executive-level compensation information if you’re on the board of directors of the business, but as an outside shareowner, don’t expect to get this information. More free books @ www.BingEbook.com Chapter 1: Elements of Business Accounting l Please refer to the income statement for the answer to the example question. Suppose the business distributed $650,000 cash to its shareowners from its profit (net income) for the year. Is this cash disbursement treated as an expense? No, cash distributions from profit to the shareowners of a business aren’t an expense. In other words, net income is before any distributions to shareowners. Income statements generally don’t disclose information regarding distributions from profit (net income) during the year. To be more accurate, I should say that an income statement doesn’t have to disclose this information. However, some businesses don’t end their income statements at bottom-line net income: They add net income to the retained earnings balance at the start of the year and deduct distributions from net income during the year to arrive at the year-end balance of retained earnings. But such disclosure isn’t common practice. Distributions from net income usually are reported in a separate financial statement called the Statement of Changes in Owners’ Equity, which I discuss in Chapter 8. m Suppose $950,000 of owners’ equity consists of profit earned and not distributed by the business. What is this amount usually called in the balance sheet? And, what is the other amount of owners’ equity called in the balance sheet? The $950,000 of owners’ equity over and above the amount of capital invested by the owners typically is called retained earnings. To be more precise, business corporations and limited liability companies use this term. (If a business is organized legally as a partnership, it follows different practices for reporting the partners’ equity.) n It appears that the business can’t pay its liabilities. The two liabilities total $938,000, but the business has a cash balance of only $396,000. Do you agree? A business isn’t expected to hold cash equal to the total of its liabilities. In my opinion, this business wouldn’t be judged insolvent, although this judgment depends on how conservative or strict you are in evaluating solvency. The business’s cash flow prospects are the key factor. The accounts receivable will be collected in the short-run, and this incoming cash will be available for paying the business’s liabilities. Also, the inventory held by the business will be sold during the short-run and will generate cash flow. o Can you tell the amount of profit the business earned in the period just ended? No, a balance sheet doesn’t report profit (net income) for the most recent period. You look to its income statement for this key figure. p In a balance sheet, assets usually are listed in the order of their “nearness” to cash. Cash is listed first, followed by the asset closest to being converted into cash, and so on. Is the sequence of assets according to normal rules for presenting assets in balance sheets? Yes, the sequence is correct according to conventional rules for reporting assets in a balance sheet. Cash is listed first, followed by assets according to their “nearness” to cash. In the example, the business doesn’t have short-term investments in marketable securities. So, its accounts receivable asset is listed second, after cash, because these receivables will be collected in the short-term. Inventory is listed after accounts receivable because this asset consists of products that have to be sold before they can be converted into cash. q Based on the three of four components of cash flow for the year of a business that follow, determine the increase or decrease in cash during the year. Cash flow from operating activities $450,000 Cash flow from investing activities ($725,000) Cash flow from financing activities $50,000 Net increase (decrease) in cash during the year Cash decreased $225,000 during the year. ???? 23 More free books @ www.BingEbook.com 24 Part I: Business Accounting Basics r Based on the three of four components of cash flow for the year of a business that follow, determine cash flow from investing activities for the year. Cash flow from operating activities $2,680,000 Cash flow from investing activities ???? Cash flow from financing activities $1,250,000 Net increase (decrease) in cash during the year $400,000 Cash flow from investing activities for the year is a negative $3,530,000. In other words, the net cash decrease from investing activities was $3,530,000 during the year. s Based on the three of four components of cash flow for the year of a business that follow, determine cash flow from financing activities for the year. Cash flow from operating activities $650,000 Cash flow from investing activities ($925,000) Cash flow from financing activities ???? Net increase (decrease) in cash during the year ($65,000) Cash flow from financing activities for the year is $210,000. In other words, the net cash increase from financing activities was $210,000 during the year. t Based on the three of four components of cash flow for the year of a business that follow, determine cash flow from operating activities for the year. Cash flow from operating activities ???? Cash flow from investing activities ($480,000) Cash flow from financing activities ($150,000) Net increase (decrease) in cash during the year $150,000 Cash flow from operating activities for the year is $780,000. In other words, the net cash increase from sales and expense (operating) activities was $780,000 during the year. u Suppose a business commits accounting fraud by deliberately not writing down its inventory of $268,000, which is the cost of certain products that it can no longer sell and will be thrown in the junk heap. How should its balance sheet be adjusted to correct for this accounting fraud, ignoring income tax effects? The changes in the balance sheet to correct the fraudulent error are: Cash Accounts Payable Accounts Receivable Notes Payable Inventory ($268,000) Owners’ Equity ($268,000) Fixed Assets (Net of Accumulated Depreciation) ________ _________ Total Assets ($268,000) Total Liabilities and Owners’ Equity ($268,000) More free books @ www.BingEbook.com Chapter 1: Elements of Business Accounting v Suppose a business commits accounting fraud by deliberately not recording $465,000 liabilities for unpaid expenses at the end of the year. How should its balance sheet be adjusted to correct for this accounting fraud, ignoring income tax effects? The changes in the balance sheet to correct the fraudulent error are: Cash Accounts Payable Accounts Receivable Notes Payable $465,000 Inventory Owners’ Equity ($465,000) Fixed Assets (Net of Accumulated Depreciation) Total Assets ________ ________ Total Liabilities and Owners’ Equity 25 More free books @ www.BingEbook.com 26 Part I: Business Accounting Basics