BIBLIOGRAPHY AND REFERENCES
3. Owner’s equity (the difference between assets and liabilities)
2.4 THE CASH FLOW STATEMENT
Profit before taxes: This is calculated as the total income from operations less the net interest expense, that is, interest expense minus interest income.
Income taxes: These include all federal and state income taxes. Taxes are recorded based on when the income was earned, not when it is due to be paid. Assuming that the income tax expense will be positive for the year, it is traditional to calculate the effective average tax rate for the year and apply this rate to each month’s income before taxes. This means that if there is a loss for an individual month, the income tax expense will be negative for that month, reflecting the tax savings that resulted from the loss. If there is no income tax expense for the full year, which is common for businesses that lose money, zero income tax expense should be estimated.
Net income after taxes: This is calculated as the total income before taxes less the total income taxes.
2.3.1 Cash Accounting Versus Accrual Accounting
The income statement is normally prepared by making use of the accrual principle of account-ing. Under the accrual principle, revenue is considered earned and is recognized in state-ments for the period when the revenue transaction occurred, regardless of when the related cash is collected. For example, under the accrual method, a practice’s earnings are posted at the time services are provided. Similarly, expenses are incurred at the moment the liability is incurred, regardless of payment terms. This principle is very different from the cash-basis accounting system. Under the cash-basis method of accounting, revenue is not recognized until it is received and expenses are not recognized until they are paid. The accrual principle of accounting is widely used and is the one that we will use for the projections we make in the rest of this book.
Standards Board (FASB)2 requires that a statement of cash flows accompany the income statement and the balance sheet. The FASB also requires that cash flows should be classi-fied as operating, investing, and financing activities. The statement of cash flows must sum-marize the cash flows so that net cash provided or used by each of the 3 types of activities is reported.
2.4.1 Operating Activities
The statement provides information about the cash generated from a company’s primary oper-ating activities. Operoper-ating activities relate to a company’s primary revenue-generoper-ating activi-ties, and include customer collections from sales of products or services, receipts of interest and dividends, and other operating cash receipts. Operating activities that create cash outflows include payments to suppliers, payments to employees, interest payments, payment of income taxes, and other operating cash payments.
2.4.2 Investing Activities
Investing activities include lending money and collecting interest on those loans, buying and selling productive assets that are expected to generate revenues over long periods, and buying and selling securities not classified as cash equivalents. Cash inflows generated by investing activities include sales of assets such as property, plant, and equipment, sales of debt or equity instruments, and the collection of loans.
2.4.3 Financing Activities
Financing activities include borrowing and repaying money from creditors, obtaining resources from shareholders, for example through a share capital increase, and providing a return to shareholders in the form of dividends.
2.4.4 Income Flows and Cash Flows
As we mentioned earlier, the income statement and balance sheet are based on accrual account-ing which was developed based on the concept of matchaccount-ing. The matchaccount-ing principle states that revenues generated and the expenses incurred to generate those revenues should be reported in the same income statement. This emphasizes the cause-and-effect association between rev-enue and expense. Many revrev-enues and expenses result from accruals and allocations that do not affect cash. There are 2 classes of items that cause differences between income flows and cash flows: items that appear on the income statement that do not represent inflows and outflows of cash, such as depreciation, or items whose cash effects do not relate to operating activities, such as gains on the sale of fixed assets; and operating cash inflows and outflows that do not appear on the income statement, that must be reported on the statement of cash flows. For example a company may collect in the current period cash arising from credit sales made in a previous period. As a rule of thumb we can use the table in Exhibit 2.9 as a guide to determine the effect of balance changes. The table states that a decrease in an asset balance and an increase in a liability or equity account are cash inflows. The opposite holds true for increases in an asset balance or a decrease in a liability or equity account, which results in a cash outflow.
2.4.5 Preparing the Statement of Cash Flows
Information used to prepare this statement is obtained from the income statement for the year and comparative balance sheets for the last 2 years. Net income is adjusted in order to convert the accrual basis income statement to cash flows. As discussed earlier, the state-ment which follows is divided into operating, investing, and financing activities. There are 2 methods of calculating and reporting the net cash flow from operating activities. The direct method reports gross cash inflows and gross outflows from operating activities but is not as widely used as the indirect method as it is more complex to implement. The indirect method uses a format that differs from the direct method only in the section where net cash provided or used by operating activities is calculated. The investing and financing sections of the statement of cash flows are exactly the same under either method. When we use the indirect method to determine cash flows, we start with the net income figure from the income state-ment and adjust the net income amount to determine the net amount of cash provided or used in operating activities. In other words, we are reconciling the accrual method of accounting to the cash basis of accounting. We also examine the changes in current assets and current liabilities.
Below is a mathematical derivation of the cash flow statement under the indirect method.
Let us use the accounting equation and modify it slightly by splitting cash from assets.
Cash + Non-Cash Assets = Liabilities + Equity If we solve for Cash, we have:
Cash = Liabilities + Equity − Non-Cash Assets
We use the symbol Δ(delta) to define “change in” and apply it to the revised accounting equation:
ΔCash = ΔLiabilities + ΔEquity − ΔNon-Cash Assets
This means that by examining the liabilities, equity, and non-cash asset accounts for changes from one period to another we are able to explain the change in the cash account.
If we split now:
Non-Cash Assets into Fixed Assets (FA) = CAPital EXpenditure (CAPEX) − Depreciation (Dep), Accounts Receivable (AR) and Inventory (INV),
Liabilities into Long-Term Debt (LTD), Short-Term Debt (STD) and Accounts Payable (AP), and
Equity into Share Capital (SC) and Retained Earnings (RE) = Net Income (NI) − Dividends (Div)
Cash Inflow Cash Outflow
A Decrease in an Asset Account An Increase in an Asset Account An Increase in a Liability Account A Decrease in a Liability Account An Increase in an Equity Account A Decrease in an Equity Account
EXHIBIT 2.9 Cash effects of balance sheet account changes
Exhibits 2.11 and 2.12 present a sample statement of cash flows derived by both the direct method and the indirect method for the ABC Corporation for the fiscal year ended 20XX. A comparison of the direct method with the indirect method indicates that either method will generate the same results in terms of the operating activities of ABC for 20XX.