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$0.50 beginning balance of prepaid expenses
$8.90 Expenses recorded during year but not paid during year


THE STATEMENT OF CASH FLOWS
The third primary financial statement in the external financial
reports of a business to its shareowners and lenders is the
statement of cash flows. This financial statement summarizes
the cash inflows and outflows of a business during the same
period as the income statement. Figure 2.4 presents this
financial statement for the business example. The second and
third sections of the statement of cash flows are relatively
straightforward. In the investing activities section, note that
the business invested $3.6 million in new long-term operating
assets during the year to replace old ones that reached the
end of their useful lives and to expand the production and

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FINANCIAL REPORTING




Note: Amounts are in millions of dollars.

Cash flow from operating activities
Cash collections from revenue $25.7
Cash payments for expenses ($22.4) $3.3

Cash flow from investing activities
Investments in new long-term operating assets ($3.6)

Cash flow from financing activities
Increase in short-term notes payable $ 0.5
Increase in long-term notes payable $ 0.5
Issuance of additional capital stock shares $ 0.2
Cash distributions from profit to shareowners ($ 0.5) $0.7

Net increase of cash during year $0.4
Beginning cash balance $1.6
Ending cash balance $2.0

Note: Cash flow from operating activities is presented according to the
direct method, and cash outflows for expenses are condensed into one
amount.
FIGURE 2.4 Format of external statement of cash flows for year.




warehouse capacity of the business. (Proceeds from disposals
of long-term operating assets would have been reported as a
cash inflow in this section.)
The financing activities section in the statement of cash
flows summarizes cash flows of borrowing and payments on
short-term and long-term debt and investment of additional
capital by shareowners during the year as well as return of
capital (if any) to them. Usually, the dealings with debt sources
of capital are reported net (i.e., only the net increase or
increase is disclosed). Reporting practices are not completely
uniform in this regard however. It is acceptable to report bor-
rowings separate from payments on debt instead of just the
net increase or decrease. Generally, the issuance of new own-
ership shares should be reported separately from the return
of capital to shareowners.

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I N T R O D U C I N G F I N A N C I A L S TAT E M E N T S


The first section of the statement of cash flows, called cash
flow from operating activities (which is not the best designa-
tion in the world, in my opinion), reports the cash increase or
decrease during the year from sales revenue and expense
activities. This key figure also is called operating cash flow or
cash flow from profit. To be frank, this is not an easy number
to understand. In Figure 2.4, I present cash flow from operat-
ing activities about as briefly and simply as you can. Cash
inflow from sales revenue was $25.7 million during the year,
and cash outflow for expenses was $22.4 million during the
year, which yields the $3.3 million cash flow from profit oper-
ating activities. This manner of presentation is referred to as
the direct method.

Instead of the direct method, a business has the option of
using an alternative method for presenting cash flow from
operating activities, which is called the indirect method. The
large majority of businesses elect the indirect method as a
matter of fact”even though the financial reporting rule-
making body of the accounting profession has expressed a
preference for the direct method. The indirect method is
explained next.


Indirect Method of Reporting Cash Flow
from Operating Activities
Based on changes in the operating assets and liabilities from
the beginning of the year to the end of the year, Figure 2.5
shows how the business™s cash flow from operating activities
would be presented in its statement of cash flows for the year.
The indirect method starts with net income for the year,
then “adjusts” net income for the cash flow effects due to
changes in the assets and liabilities that are directly connected
with recording sales revenue and expenses (called operating
assets and liabilities). Of course, the $3.3 million cash flow
from operating activities for the year is the same whether the
direct or the indirect method of presentation is used in the
statement of cash flows. To follow the indirect method of pre-
sentation, keep in mind the following basic points:
• An increase in operating assets causes a negative effect on
cash flow from profit, and a decrease causes a positive
effect.

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FINANCIAL REPORTING




Net income $2.2
Accounts receivable increase (0.5)
Inventories increase (0.8)
Prepaid expenses increase (0.1)
Depreciation expense 1.7
Advance payments from customers increase 0.2
Accounts payable increase 0.4
Accrued expenses payable increase 0.2
Cash flow from operating activities $3.3
FIGURE 2.5 Indirect method of reporting cash flow from operating
activities.




• An increase in operating liabilities causes a positive effect
on cash flow from profit, and a decrease causes a negative
Y
effect.
FL
In most situations, the largest decrease in an operating
asset is the depreciation expense recorded for the year. Depre-
ciation expense is recorded in order to allocate a portion of
AM


the total cost of a business™s long-term operating assets to the
year. Recording depreciation expense is not a cash outlay;
rather, it is the write-down of the long-term operating assets
TE




of the business that were bought and paid for in previous
years. Note in Figure 2.5 that depreciation expense is by far
the largest single factor in cash flow from operating activities.



s END POINT
A business makes regular financial reports to its shareowners
and lenders. Because they supply capital to the business, they
are entitled to receive regular reports about what the business
has done with their money. The hard core of these reports
consists of three primary financial statements. They are called
external financial statements because the information is
released outside the business.
The income statement reports the revenue, expenses, and
profit or loss of the business for the period. Recording revenue
and expenses is based on accrual-basis accounting methods.
The chapter begins by explaining the key differences between
cash flows and accrual-basis profit accounting. Then the format

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I N T R O D U C I N G F I N A N C I A L S TAT E M E N T S


and content of each of the three primary financial statements
is illustrated and explained for a typical business.
The external financial statements are oriented to the out-
side shareowners and lenders of the business who are not
involved in managing the business. The development of the
standards and conventions for presenting external financial
statements has been guided by this basic orientation. For
their decision-making and control functions, business man-
agers need more useful internal profit reports, which I
develop in the next chapter.




25
3
CHAPTER




Reporting Profit
to Managers



M
Managers have to keep on top of the unending stream of
changes in today™s business environment. Few factors remain
constant very long. Managers need to quickly assess the profit
and other financial impacts of these changes. Deciding on the
best response to changes is never easy, but one thing is clear:
Managers need all relevant information for their profit-
making decision analysis.


USING THE EXTERNAL INCOME STATEMENT FOR
DECISION-MAKING ANALYSIS
The external income statement (see Figure 2.2) is useful up to
a point for decision-making analysis, but it does not present
all the information about operating expenses that is needed by
managers. To demonstrate this important point, consider the
following situation. Suppose you have done extensive market
research and you™re convinced that reducing sales prices
across the board next year by just 5 percent would result in a
25 percent increase in sales volume across the board. In order
to concentrate on this basic decision, assume zero cost infla-
tion next year (don™t you wish!). Would this be a good move?
Of course, your prediction of a 25 percent sales volume
DANGER!
increase is critical. This big jump in sales volume may or
may not materialize. Such a large response to shaving sales
prices implies that sales demand is very sensitive to sales

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FINANCIAL REPORTING


prices. In other words, you face a very elastic demand curve,
as economists say. Does the external income statement pro-
vide all the information needed to analyze this decision? No,
not entirely. The external profit report (income statement)
doesn™t include enough information about how operating
expenses would react to the sales volume increase and the
sales revenue increase.


External Income Statement for New Example
Figure 3.1 presents the external income statement for the
most recent year for a new business example. This external
profit performance report has been prepared according to
generally accepted accounting principles (GAAP) regarding
the format and disclosure standards for this key financial
statement. Be warned, however, that every business is a little
different when it comes to details in their income statements.

Terminology differs somewhat from business to business. For
instance, some companies prefer the term gross profit instead
of gross margin in their external income statements (sales
revenue minus cost-of-goods-sold expense). Many businesses
report two or more classes of operating expenses below the
gross margin line instead of just one amount for all selling and
administrative expenses as shown in Figure 3.1. For instance,
a business may disclose the amount of its research and devel-
opment expense for the year as separate from all its other
operating expenses. Nevertheless, the example shown in



Sales revenue $39,661,250
Cost-of-goods-sold expense $24,960,750
Gross margin $14,700,500
Selling and administrative expenses $11,466,135

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