Chapter 3. Cash-Flow Statements

Introduction to Cash-Flow Statements 1 Chapter 3 Cash-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

2 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

Introduction to Cash-Flow Statements 3 INTRODUCTION A 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 currentperiod 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.

4 Navigating Accounting 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.

Introduction to Cash-Flow Statements 5 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. Cash Flow Statements Operating Investing Financing Cash change 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 Section The 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

6 Navigating Accounting 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 Net cash from operations $14 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.

Introduction to Cash-Flow Statements 7 Exercise 3.01 Identify the following examples as operating (O), investing (I), or financing (F) activities. Usage Icon This exercise helps you learn how accounting reports are used by investors, creditors, and other stakeholders. 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

8 Navigating Accounting 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 Flows Three Years Ended December 29, 2007 Beginning Cash (In Millions) 2007 2006 2005 Cash 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 8,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 4,546 4,654 4,345 Share-based compensation 952 1,375 Restructuring, asset impairment, and net loss on retirement of assets 564 635 74 Excess 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 351 Changes in assets and liabilities: Operating Trading assets (1,429) 324 1,606 Accounts receivable 316 1,229 (912) Inventories 700 (1,116) (500) Accounts payable 102 7 303 Income taxes payable and receivable (248) (60) 797 Other assets and liabilities 633 (444) 241 Total adjustments 5,649 5,588 6,187 Net cash provided by operating activities 12,625 10,632 14,851 Cash 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 8,433 Investing Investments 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) 126 Proceeds from government grants 160 69 25 Excess tax benefit from share-based payment arrangements 118 123 Additions to long-term debt 125 1,742 Repayments and retirements of long-term debt Financing (19) Repayments of notes payable (581) Proceeds from sales of shares through employee equity incentive plans 3,052 1,046 1,202 Repurchase 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 Change 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: Ending Cash 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.

Introduction to Cash-Flow Statements 9 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: Cash Flow Statements Operating Investing Intel 2007 2006 2005 $12,625 $10,632 $14,851 (9,926) (4,988) (6,415) Financing (1,990) (6,370) (9,519) Cash change $709 ($726) ($1,083) 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

10 Navigating Accounting 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 Section Like 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 Intel Consolidated Statements of Cash Flows Three Years Ended December 29, 2007 (In Millions) 2007 2006 2005 Cash 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 8,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 4,546 4,654 4,345 Share-based compensation 952 1,375 Restructuring, asset impairment, and net loss on retirement of assets 564 635 74 Excess 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 351 Changes in assets and liabilities: Trading assets (1,429) 324 1,606 Accounts receivable 316 1,229 (912) Inventories 700 (1,116) (500) Accounts payable Total adjustments 102 7 303 Income taxes payable and receivable (248) (60) 797 Other assets and liabilities 633 (444) 241 Total adjustments 5,649 5,588 6,187 Net cash provided by operating activities 12,625 10,632 14,851

Introduction to Cash-Flow Statements 11 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: Indirect Format Operating Section Net Income 2007 $6,976 Intel 2006 $5,044 2005 $8,664 Reconciliation adjustments 5,649 5,588 6,187 Net cash from operations $12,625 $10,632 $14,851 Other Adjustments There are a few other insignificant adjustment types associated with issues beyond the scope of this chapter. 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 Adjustments Reconciliation 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.

12 Navigating Accounting Gains and losses adjustment Asset adjustment Liability adjustment Cash inflow from divestitures Intel Consolidated Statements of Cash Flows Three Years Ended December 29, 2007 (In Millions) 2007 2006 2005 Cash 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 8,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 4,546 4,654 4,345 Share-based compensation 952 1,375 Restructuring, asset impairment, and net loss on retirement of assets 564 635 74 Excess 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 351 Changes in assets and liabilities: Trading assets (1,429) 324 1,606 Accounts receivable 316 1,229 (912) Inventories 700 (1,116) (500) Accounts payable 102 7 303 Income taxes payable and receivable (248) (60) 797 Other assets and liabilities 633 (444) 241 Total adjustments 5,649 5,588 6,187 Net cash provided by operating activities 12,625 10,632 14,851 Cash 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 8,433 Investments in non-marketable equity instruments (1,459) (1,722) (193) Net proceeds from divestitures 32 752 Other investing activities 294 (33) (118) Gains and Losses Reconciliation Adjustments Gains 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.

Introduction to Cash-Flow Statements 13 Investing Section Investing 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. Investing Section of Intel s Cash Flow Statement Three Years Ended December 29, 2007 (In Millions) 2007 2006 2005 Cash 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 8,433 Investments 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)

14 Navigating Accounting Financing Section Financing 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 Three Years Ended December 29, 2007 (In Millions) 2007 2006 2005 Cash flows provided by (used for) financing activities Increase (decrease) in short-term debt, net (39) (114) 126 Proceeds from government grants 160 69 25 Excess tax benefit from share-based payment arrangements 118 123 Additions to long-term debt 125 1,742 Repayments 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 1,202 Repurchase 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)

Introduction to Cash-Flow Statements 15 Supplemental Disclosures of Cash Flow Information Companies 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 cashflow 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.

16 Navigating Accounting 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.

Introduction to Cash-Flow Statements 17 EasyLearn Company Events and Entries You 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 Adjustments First, 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 COMPANY SCF RECONCILIATION December 1-22, 2009 Operating Activities Net Income $150 Adjustment ($130) Net cash from operations $20

18 Navigating Accounting 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: EASYLEARN COMPANY SCF RECONCILIATION December 1-22, 2009 Operating Activities Net Income $150 Less net increase in receivables associated with operating entries ($130) Net cash from operations $20 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: EASYLEARN COMPANY SCF RECONCILIATION December 1-22, 2009 Operating Activities Net Income $150 Receivables ($130) Net cash from operations $20 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: EASYLEARN COMPANY SCF RECONCILIATION December 1-22, 2009 Reported Behind Reported Numbers Operating Activities E2 E3 Combined Net Income $150 $150 $0 $150 Receivables ($130) ($150) $20 ($130) Net cash from operations $20 $0 $20 $20

Introduction to Cash-Flow Statements 19 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).

20 Navigating Accounting 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.) Receivables adjustment Intel Consolidated Statements of Cash Flows Three Years Ended December 29, 2007 (In Millions) 2007 2006 2005 Cash 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 8,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 4,546 4,654 4,345 Share-based compensation 952 1,375 Restructuring, asset impairment, and net loss on retirement of assets 564 635 74 Excess 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 351 Changes in assets and liabilities: Trading assets (1,429) 324 1,606 Accounts receivable 316 1,229 (912) Inventories 700 (1,116) (500) Accounts payable 102 7 303 Income taxes payable and receivable (248) (60) 797 Other assets and liabilities 633 (444) 241 Total adjustments 5,649 5,588 6,187 Net cash provided by operating activities 12,625 10,632 14,851 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. Liability Reconciliation Adjustments Next 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):

Introduction to Cash-Flow Statements 21 EASYLEARN COMPANY INCOME STATEMENT December 1 31, 2009 Revenues $150 Advertising expense (60) Net Income $90 EASYLEARN COMPANY BALANCE SHEETS Assets 31-Dec-09 1-Dec-09 Cash $6 $0 Accounts receivable 130 0 Total assets $136 $0 EASYLEARN COMPANY DIRECT CASH FLOW STATEMENT December 1-31, 2009 Operating Activities Sales collections $20 Advertising payment ($15) Net cash from operations $5 Financing Activities Sale of common stock $1 Net cash from financing $1 Change in cash $6 Beginning Cash balance $0 Ending cash balance $6 Liabilities and stockholders' equity Liabilities Accounts payable 45 0 Total liabilities 45 0 Stockholders' equity Common stock 1 0 Retained earnings 90 0 Total stockholders' equity 91 Total liabilities and stockholders' equity $136 $0 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: EASYLEARN COMPANY SCF RECONCILIATION December 1-31, 2009 Reported Behind Reported Numbers Operating Activities E2 E3 E4 E5 Combined Net Income $90 $150 $0 ($60) $0 $90 Receivables ($130) ($150) $20 ($130) Accounts payable $45 $60 ($15) $45 Net cash from operations $5 $0 $20 $0 ($15) $5 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 Navigating Accounting 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. Payables adjustment Intel Consolidated Statements of Cash Flows Three Years Ended December 29, 2007 (In Millions) 2007 2006 2005 Cash 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 8,664 Adjustments to reconcile net income to cash provided by operating activities: Depreciation 4,546 4,654 4,345 Share-based compensation 952 1,375 Restructuring, asset impairment, and net loss on retirement of assets 564 635 74 Excess 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 351 Changes in assets and liabilities: Trading assets (1,429) 324 1,606 Accounts receivable 316 1,229 (912) Inventories 700 (1,116) (500) Accounts payable 102 7 303 Income taxes payable and receivable (248) (60) 797 Other assets and liabilities 633 (444) 241 Total adjustments 5,649 5,588 6,187 Net cash provided by operating activities 12,625 10,632 14,851

Introduction to Cash-Flow Statements 23 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. 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 Assets = Liabilities + Permanent Owners' Equity + Net income December 1, 2009 + C + AR = + AP + CS + RE + Rev - AdEx + IncS + + $0 + + $0 = + + $0 + + $0 + + $0 + + $0 - + $0 + + $0 E2 Recognize revenue + + + 150 = + + + + + 150 - + Operating E3 Customer collections + + 20 + - 20 = + + + + - + E4 Advertising expense + + = + + 60 + + + - + 60 E5 Advertising payment + - 15 + = + - 15 + + + - Total operations + + $5 + + $130 = + + $45 + + $0 + + $0 + + $150 - + $60 + + $0 Financing E1 Issue stock for cash + + 1 + = + + + 1 + + - + Total financing + + 1 + + 0 = + + + 1 + + 0 + + 0 - + + 0 Trial balance Closing to and from income summary December 31, 2009 + + $6 + + $130 = + + $45 + + $1 + + $0 + + $150 - + $60 + + $0 + + = + + + + - 150 - - 60 + + 90 + + = + + + + 90 + - + - 90 + + $6 + + $130 = + + $45 + + $1 + + $90 + + $0 - + $0 + + $0

24 Navigating Accounting Thus, we can create the equation below from the total operations row of the BSE matrix: EASYLEARN COMPANY Connecting Total Operations Row of BSE to Reconciliation Cash from operations + Net increase in accounts receivable due to operating entries = Net increase in accounts 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 COMPANY Rearranging Total Operations Row of BSE Cash from operations = Net income after adjusting for gains and losses + Net increase in accounts payable due to operating entries - Net increase in accounts receivable due to operating entries + $5 + $90 + $45 + $130 Reconciliation bottom line Reconciliation top line Reconciliation asset and liability adjustments EASYLEARN COMPANY SCF RECONCILIATION December 1-31, 2009 Operating Activities Net Income $90 Receivables ($130) Accounts payable $45 Net cash from operations $5