Financial Decision Making 8 questions 4 papers

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rounding (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A mathema�cal decision made to use less-exact (but easier-to-use) numbers.

short-term debt (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

All debt payments that must be made in the next 12 months.

specific iden�fica�on method (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A way of calcula�ng inventory values by adding up the value of each product in inventory (based on the purchase and sold details of each).

straight-line deprecia�on method (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A way to value inventory. The company determines an asset's life span and then divides the cost of that asset by the number of years it will have a useful life to the company.

treasury stock (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Stock that has been bought back by the company from stockholders.

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3 The Income Statement

© Rudyanto Wijaya/iStock/Thinkstock

Learning Objec�ves

A�er reading this chapter, you should be able to:

1. Examine the elements of an income statement. 2. Describe the accounts that make up an income statement. 3. Describe the different types of profit shown on an income statement. 4. Explore the elements of the statement of shareholders' equity. 5. Examine and create a common-sized income statement.

Introduc�on Successful business owners and department managers o�en look forward to reading an income statement (also some�mes called a statement of earnings, statement of income, statement of opera�ons, or profit and loss [P&L] statement) because it tells them just how much of a profit they have made in any given accoun�ng period. The statement could be for a month, a quarter, a year, or some other �me period that the manager deems necessary. Most businesses develop monthly, quarterly, and annual income statements.

For business owners or managers who are struggling to meet sales goals, the income statement is o�en no cause for celebra�on—and may even be a source of dread, if it reveals that the company is opera�ng at a loss.

Regardless of whether a business is successful or struggling, the income statement is always extremely important because it discloses the "bo�om line," or net profit/loss. However, the more important parts of the statement are how the company got to that number during the period being reported.

In this chapter, we discuss how the numbers are crunched to get to the bo�om line, and explore the cri�cal rules of accoun�ng that impact when those numbers can be reported on the income statement. As in previous chapters, we will be following Best General Company throughout this chapter and addressing decisions the budget commi�ee and managers might make based on the document being discussed.

Before we get to the income statement numbers, let's review the key elements of an income statement, discuss the dates that appear at the top, and explore possible formats.

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The income statement presents the "bo�om line" showing a company's profit or loss.

3.1 The Sec�ons of an Income Statement In addi�on to other informa�on, every income statement includes the following four key sec�ons:

1. Sales or Revenues: how much revenue the company brought in by selling its products or services. 2. Cost of Goods or Services Sold: how much the company spent to purchase or produce the products or services it sold. 3. Expenses: how much the company spent to keep the doors of the business open. Essen�ally, this includes all expenses except those spent specifically on the

cost of goods or services sold. 4. Net Profit or Loss: the "bo�om line" that tells whether the company made a profit or operated at a loss.

Let's use the annual income statement of Best General Company (Figure 3.1) to explore how these key sec�ons typically appear. Note that the income statement in Figure 3.1 shows three periods. This enables the business owner or manager to quickly see trends over �me.

Figure 3.1: Best General Company income statement

In Figure 3.1, the Revenue sec�on is only one line item. An internal report that a company manager sees could include more detail in this sec�on. For example, the first line might be called Gross Revenues, with addi�onal informa�on provided about sales discounts and returns. The manager would therefore have more informa�on about what was subtracted to get to the net revenue figure shown as the first line of the public statements. We discuss this informa�on in greater detail in the Revenue sec�on below.

The Cost of Goods Sold sec�on is also only one line item. Again, an internal report that a Best General Company manager sees could include more detail about the costs incurred to purchase or produce the goods sold. We discuss this informa�on in greater detail in the Cost of Goods Sold sec�on below.

For major corpora�ons, the Expenses sec�on is some�mes divided into Opera�ng Expenses and Non-Opera�ng Expenses. The simpler example shown in Figure 3.1 does not include a dis�nct non-opera�ng expenses sec�on; it lists the non-opera�ng income and expenses as Other Income and Other Expenses.

The Expenses sec�on enables managers to know what expenses were incurred as part of the opera�ons of the business and what expenses were incurred that were not from opera�ons. We discuss this informa�on in greater detail below.

The Net Profit sec�on in Figure 3.1 is only one line, but many companies present profits at various stages, such as earnings before taxes and interest (EBIT) or earnings before taxes, interest, deprecia�on, and amor�za�on (EBITDA). We discuss why companies view profits in several different ways below.

Our budget commi�ee would be able to discern the following key trends from the income statement shown in Figure 3.1, each of which would need to be further explored:

Revenue is decreasing. Note how revenues were $120,000 in 2011 but dropped to $100,000 by 2013. The budget commi�ee would want to find out why revenue is on a downward trend. They would need a more detailed internal report to find out if there are fewer products being sold, or if a greater number of

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This singe-step format income statement shows one sec�on for revenues and one sec�on for expenses.

discounts are being offered to sell those products. They may find other reasons for the decrease as they get more detail. They would use this informa�on to prepare a realis�c budget projec�on for the next year. Cost of Goods Sold is also on a downward trend, from $84,000 in 2011 to $73,000 in 2013. That may be good news if the company has found a way to reduce the costs of buying its goods, or it could just be that fewer goods needed to be bought because products purchased or manufactured in previous years were sold in the current year. The budget commi�ee may discover other reasons as they look at the details behind the numbers. These details also will be needed to project the Cost of Goods Sold for next year's budget. Opera�ng Expenses are on an upward trend, from $20,500 to $22,500. Increases in salaries or some other factor could be driving that increase. The budget commi�ee would need to see more details from the accounts that make up that line item to know why there is an upward trend.

Now we will take a closer look at the key rules for the presenta�on of an income statement. We will then explore the various types of profits one might measure when looking at an income statement. Finally, we will explore the rules that accountants must follow when preparing these financial statements.

Report Timing

Unlike the balance sheet, which is a snapshot in �me, the income statement shows the performance of a business over a longer period. The "as of" date on the balance sheet will be the same as the period ended date on the income statement. If the company operates on a calendar year basis, the phrase "Year Ended" will appear in the heading, at the top of the statement; if it operates on another 12-month period, the phrase will read as "Fiscal Year Ended." If the statements are issued monthly or quarterly, the phrasing will read as "Month" or "Quarter" Ended. Whatever phrase shown at the top will be followed by the ending date of the period.

Remember, when a manager compares results from one year to the next in the same company, or compares one company to another, it is important to examine the same opera�ng period. For example, if one company's statement shows "Year Ended, December 31, 2013" and another company shows "Fiscal Year Ended, January 31, 2013," the manager needs to develop a spreadsheet that will enable him to calculate results for the same months. He can do this by ge�ng a copy of the quarterly reports, where month-by-month data are usually shown.

Suppose the manager works for a retail company that is highly dependent on holiday sales, and he wants to see how well his company did versus a compe�tor for the fourth quarter of the year. His company reports the fourth quarter using the months of November, December, and January. His compe�tor reports the fourth quarter using October, November, and December. (For many retail companies, October is a much slower month than January, because people use holiday gi� cards to make purchases or exchange gi�s a�er the first of the year). The manager would not be comparing apples to apples without adjus�ng the numbers to be sure he is looking at the results for the same three months. He would need to use a report that shows month-by-month results, if available, so he could prepare a spreadsheet with the same three months for each company before doing his analysis.

It is generally a good idea to do the comparison with a company that uses the same �me period. Luckily, companies in the same industry o�en report using the same �me periods.

Format Op�ons

Companies can format informa�on on the income statement in either a single-step or mul�-step presenta�on. Both statements provide the same informa�on, but the mul�-step format uses various summary totals to make it easier to find the key profit totals, such as gross profit or opera�ng profit, which we discuss below. Most companies use the mul�-step format because it is easier to read and analyze.

Single-Step Format

The single-step format groups all data into two categories: revenues and expenses (see Figure 3.2). Revenue includes income from sales, interest income, and gains from sale of equipment. In addi�on to income raised from regular opera�ons, a company will also include income from one-�me transac�ons, such as the sale of a building or piece of major equipment. Other types of revenue may also be possible. This varies by type of business.

All types of expenses are grouped in the second category. This can be a very long list. Common expenses include adver�sing, salaries, administra�ve expenses, insurance expenses, vehicle expenses, office supplies, and so on. Gains or losses would also be shown, such as the loss from the sale of equipment or other assets.

The benefit of using a single-step format is that it is simpler to prepare. The limita�on of the single-step format is that it does not indicate whether the company is actually making a profit from its opera�ons; to determine this, we must reorder the informa�on into a mul�-step format.

Figure 3.2: Single-step format income statement

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Compare the groupings of items to the single-step format of Figure 3.2. The mul�-step format provides the opera�ng income (or opera�ng profit), which is the amount of profit a�er costs of goods sold and opera�ng expenses have been subtracted.

Mul�-Step Format

Income statements created using the mul�-step format divide the statement into several groupings and provide cri�cal subtotals to facilitate analysis of the informa�on (see Figure 3.3). Even though they include essen�ally the same informa�on, the addi�onal groupings of the mul�-step format help the reader quickly view the key profit lines:

Gross Profit: This shows the profit made from sales minus the costs of buying or manufacturing the products or services sold. Opera�ng Profit: This shows the profit from the actual opera�ons of the company. Profit Before Income Tax Expense: This shows the income before taxes and interest are subtracted. Net Profit (or Loss): This shows the bo�om line—whether the company made a profit or experienced a loss.

Many companies add addi�onal profit lines, such as Earnings Before Interest, Taxes, Deprecia�on, and Amor�za�on (EBITDA).

Figure 3.3: Mul�-step format income statement

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When looking at the bo�om line on the single-step format in Figure 3.2, Best General Company appeared to be making a profit of $4,400 on $10,000 of sales. But a closer look with the mul�-step format in Figure 3.3 reveals that the business is not profi�ng on its opera�ons. Opera�ng profit was just $400. Using the single-step format in Figure 3.2 gave the impression that the business was profitable, but most of the profits came from a one-�me sale of equipment. It is therefore cri�cal to calculate the opera�ng income, even if all you have is a single-step income statement. To do that, remove from the net profit all items not included in opera�ons (minus interest income $500; minus gain on sale of equipment $5,000; plus deprecia�on expense $600; plus income tax expense $700; and plus interest expense $200) or reformat the single-step income statement into a mul�-step format.

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To help readers navigate their income statement, IBM divides revenue into three line items: services, sales, and financing.

3.2 Building Blocks of the Income Statement Now we will take a closer look at the numbers on the income statement and explore how an income statement is created. We will start with Revenues, which are not always as simple as a total of the sales made. Then we will take a closer look at Cost of Goods or Services Sold. Finally we will explore the Expenses sec�on of the income statement.

Revenues

For some types of businesses, such as retail stores or restaurants, recognizing revenue can be a rela�vely simple process. A manager adds up all the receipts for the day and enters total revenue earned. However, that's not the case for many other types of businesses, especially when sales and services involve construc�on, installa�on, or training. Sales for many types of consul�ng businesses also don't usually get fully recognized on the day the contract is signed. Revenue is only earned when the job is completed or a contract deadline is met.

For example, a construc�on company that contracts to build a major project may earn its revenue over a number of years based on various deadlines set in the contract. A company like IBM that provides complex systems earns its revenue at various stages of comple�on—a�er installa�on, a�er training is completed, and at the end of a service period. Note, when looking at IBM's income statement in Figure 3.4, its revenue is split into three line items: Services, Sales, and Financing.

Figure 3.4: Top por�on of IBM's 2012 income statement

Source: IBM. (2013). 2012 annual report. Retrieved from h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf (h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf)

We'll take a closer look at how IBM actually recognizes these three different line items, which can all be part of one contract, when we review the notes to financial statements later in the chapter. First, let's examine the basic rules of revenue recogni�on.

Revenue Recogni�on

As explained in Chapter 2, the first rule in accrual accoun�ng is that revenue is recognized when it is earned. Note that this is not true of companies that use cash-basis accoun�ng, in which cash revenue is recognized when cash is received. However, all major companies that must file financial statements with the Securi�es and Exchange Commission (SEC) use accrual accoun�ng. Most smaller companies use it, too, even if they do not report to the SEC, because it more accurately matches revenue earned to expenses at the �me in which the transac�ons occur. Thus, in this book, we focus on the rules of accrual accoun�ng. The key ques�on that must be answered before recognizing revenue, then, is: Has the money been earned?

The following are some common scenarios in which addi�onal informa�on, beyond the sale of a product, might be required in order to determine revenue recogni�on:

Price Nego�a�ons: Suppose a company is in the middle of nego�a�ng the price for a product and service. It is the end of the month and the salesperson wants credit for the sale, but there are s�ll some details to be worked out before there is a final price. Revenue cannot be recognized un�l a final price is set, the contract has been signed, and the customer has accepted the product or service. Distribu�on Issues: Suppose the buyer of the product does not pay for the merchandise un�l it is sold to a third party, such as a retailer. This is common when an intermediary is involved in the distribu�on of the product. The company selling the product cannot recognize the revenue un�l the retailer pays for the product. Sending out the product to a third-party distributor means the revenue cannot be recognized un�l the product reaches the end customer who will remit payment. The determining factor is who actually has �tle (ownership) of the product and the provisions under which the product can be returned to the manufacturer. Service/Installa�on/Training Issues: Revenue is recognized when the service, installa�on, or training is complete and accepted by the customer. Some�mes a company is paid for a product in full before the revenue is earned. This would be shown as Prepaid Revenue, which is shown as a liability account on the balance sheet. This account may also be called Unearned Revenue or Deferred Revenue. For example, IBM not only sells its products, it also installs the systems, trains its customers, and services the systems. In some cases, IBM provides financing so the customer can buy the system as well. Revenues from a major sale will not be recognized un�l the related terms have been met. For example, IBM may be paid in full for the equipment when installa�on is complete, but it will not recognize the revenue for training and servicing un�l the terms of that part of the contract are met. Revenue from financing will be recognized as payments are made. Shipping Issues: Goods are shipped FOB (Free on Board) des�na�on, whereas other �mes they are shipped FOB shipping point.

When goods are shipped FOB des�na�on, the buyer does not own and pay for the shipment un�l it is received. In this case, the revenue is not recognized un�l the buyer receives it. If the shipment is stolen or lost, the buyer is not responsible for paying for the goods. On the other hand, if the shipment is sent FOB shipping point, it is assumed the buyer takes �tle on the day they are shipped and revenue can be recognized upon shipment. In this case, if the shipment is lost or stolen, the buyer is responsible for the loss.

Selling Within the Corpora�on: Some�mes sales are made between the parent company and a subsidiary company. In this case, the sale would not be recognized as revenue but instead would be considered a transfer of assets. Buyback Agreements: Some�mes a company agrees to buy back its inventory at some point in the future. If the buyback covers all costs of the inventory plus holding costs, this does not cons�tute a sale and the revenue is not recognized. This type of arrangement can be common in the financial services industry where financial products are sold with a promise to buy them back with interest.

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As illustrated in these scenarios, revenue recogni�on can be a complex ques�on in certain types of businesses. A manager for a company with complex revenue issues may want to ask her accoun�ng liaison to explain the revenue recogni�on rules under which their company operates.

Changes are being contemplated to simplify revenue recogni�on, as discussed in "The New World of Financial Oversight."

New World of Financial Report Oversight

As U.S. regulators try to converge U.S. rules with interna�onal financial repor�ng rules, one of the major projects involves improving revenue repor�ng. Right now, there are many different requirements for specific transac�ons and industries, such as so�ware, real estate, and construc�on contrac�ng. Today there are over 200 specialized and industry-specific revenue recogni�on requirements under U.S. GAAP.

Regulators are expected to issue revenue recogni�on guidance in 2014 that will improve the ability to respond to revenue recogni�on changes more quickly and increase comparability among industries. The goal will be to improve disclosures to users of financial statements so they can be�er compare and contrast the numbers.

Read more about the revenue recogni�on project spearheaded by the U.S. Financial Accoun�ng Standards Board and the interna�onal regulators here (h�p://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=900000011146) .

Task Box 3.1: Recognizing Revenue

Analyzing Industry Compe�tors, Part B

Review the revenue recogni�on schemes for the two companies you chose to research in Chapter 2 (see Task Box 2.9 (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/sec2.3#task2.9) ). The informa�on is most likely located in the first of the Notes to the Financial Statements, o�en called "Significant Accoun�ng Policies" or "Accoun�ng Methods." Be prepared to discuss the way revenue is earned and recognized for each of the companies, and how it might be different for each.

Sales Adjustments

The recogni�on of revenue is not the only factor that comes into play when calcula�ng net sales. Sales are adjusted for a number of reasons. In most cases, a company's external financial reports will not show any detail of how much sales were adjusted. Companies prefer to keep these details confiden�al and report them only on internal reports.

Within a company, managers who are responsible for producing revenue will get a more detailed report that shows the accounts used to calculate Net Revenue shown on the income statement. Managers will only find details about these adjustments on these internal financial reports. These adjustments can have a major impact on a company's net revenue figures and reduce the net revenue reported. Anything that reduces revenues will ul�mately reduce profits.

Revenue-producing managers want to keep a close watch on the adjustments to be sure they are accurate. Also, if any of the revenue adjustments show an increasing trend, managers want to determine the reason for the increase.

Companies make three common adjustments to their gross sales or revenue totals:

1. Volume discounts: Companies use this incen�ve to offer major retailers a reduced price if they buy in large numbers. For example, a company may offer its widgets at $50 each if fewer than 1,000 units are ordered. However, it may cut the price to $45 when 1,001 to 5,000 units are ordered and further reduce the price to $40 for orders over 5,000 units. That's why big box retailers, such as Walmart and Target, can o�en offer lower prices: They can take advantage of volume discounts. Volume discounts reduce the gross sales for the seller but likely increase total sales volume.

2. Returns: Every company that produces tangible goods can expect that some items will be returned by buyers. Returns reduce the gross sales for the company. Accoun�ng will track returns (usually accompanied by a credit memo) in a separate account and watch the trends for returns. If the trend goes up sharply, it can indicate that there is a problem with a product. Management will use this report to follow those trends and start an inves�ga�on if the numbers jump drama�cally.

3. Allowances: Allowances are liabili�es for a company. For example, a gi� card is an allowance that people pay for up front but take no merchandise. These allowances must be monitored because at some point, someone will likely use that gi� card and take some product, which would increase the costs of goods sold at a later date. Rebates are another type of allowance that people may or may not cash in. Companies will reduce their gross sales to account for these future liabili�es.

Sales Adjustments at IBM and 3M

A sales manager can find out some informa�on about how compe�tors are recognizing revenue. This research can help the sales manager discover new revenue opportuni�es or new methods for recognizing revenue that she may want to discuss with her accoun�ng and finance staff if she believes this will improve the company's revenue and profits.

Note 1 in 3M's Notes to the Financial Statements indicates that 3M reduces income for distributor incen�ves that include rebates and free goods, primarily at the �me of sale. It says in the notes, "These sales incen�ves are accounted for in accordance with ASC 605 Revenue Recogni�on [a GAAP standard]. The es�mated

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reduc�ons of revenue for rebates are based on the sales terms, historical experience, trend analysis and projected market condi�ons in the various markets serviced."

Remember, 3M is a manufacturer that distributes most of its product through intermediaries, which then sell the products to the retailers, which ul�mately sell the products to the customer. So its incen�ves are based primarily on ways to encourage volume sales. Note that 3M reduces revenues for rebates. These rebates are offered to encourage sales, but not all rebates are redeemed. Consumer Reports indicates that 70 percent of consumers actually send in the request for rebates. Companies do not use general sta�s�cs such as these, however; instead they develop a percentage of rebates used based on historical company data (Consumer Reports Magazine, 2009).

Most of IBM's sales are directly to the businesses it serves. Thus, the reduc�ons to revenue discussed in Note A are very different. IBM indicates it reduces revenues for client returns, stock rota�on (moving older products to the front so they are sold first), price protec�on (agreements to maintain a set price over a specific period of �me), rebates, and other similar allowances based on "historical results taking into considera�on the type of client, the type of transac�on and the specifics of each arrangement."

Neither company provides exact details about how much these adjustments total in the Notes to the Financial Statements. Companies usually closely guard the details about costs and sales reduc�ons, because they don't want to give their compe�tors informa�on to use against them. This is why managers with direct responsibility for the revenue involved are o�en the only ones allowed to access this informa�on.

Task Box 3.2: Handling Revenue Reduc�ons

Analyzing Industry Compe�tors, Part C

Read the Notes to the Financial Statements to find out how the companies you've chosen to research handle their revenue reduc�ons. Do the two companies handle them in the same way or differently? What are the similari�es and differences?

Now let's take a closer look at cost of goods or services sold.

Cost of Goods or Services Sold

Every company, even a consul�ng company that offers only services, incurs costs for what it sells. In a service-based company, the costs may include those related to bidding on a project. For example, an architectural or engineering firm likely incurs staff costs and equipment costs in order to prepare a bid for a specific project. Those costs would be costs of services sold. Once the company wins the project, it may hire staff to work on that project with no other responsibili�es in that company. These staff costs would be charged against that project's gross profit. Essen�ally, cost of goods or services sold includes any expenses that can be directly charged against the produc�on of that product or service.

Adver�sing, for example, is considered an expense rather than a cost because it would be difficult to determine exactly which ad drove a customer to buy which product. Most adver�sing is much broader than one par�cular product or service. Tracking and figuring that out is not worth the staff �me involved, so adver�sing becomes an expense rather than a cost and is not included in Cost of Goods Sold.

Another factor that can impact the Cost of Goods Sold line is the inventory valua�on method used. In Chapter 2, we discussed LIFO vs. FIFO vs. Average Cos�ng. Below is a summary of the calcula�ons we completed in that chapter:

LIFO FIFO Average cos�ng

Beginning Inventory $400.00 $400.00 $400.00

Cost of Goods Sold $3,250.00 $2,962.50 $3,063.50

Ending Inventory $650.00 $937.50 $835.50

Clearly, the Cost of Goods Sold number usually is the highest when using the LIFO inventory value method; prices in most industries gradually increase because of infla�on. This is not true in all industries, and, in some cases, the older inventory can be more expensive, as in the computer field, where costs some�mes go down for products.

When a higher value is used for cost of goods sold, then the company's profits will be reduced. In the example above, company profits would be $287.50 ($3,250 – 2,962.50) less using LIFO rather than FIFO. If prices were going down, then FIFO would likely be the higher cost of goods sold number. Average cos�ng always evens out the price differences.

In a manufacturing company like 3M, costs include anything spent to produce a product. This includes the purchase of raw materials, the labor costs to make the product, and the cost involved in storing raw materials un�l they are needed. In addi�on, the costs of the machinery and tools for product produc�on are also allocated to Cost of Goods Sold.

Other types of businesses determine their Costs of Goods or Services Sold based on the purchases of products they made in order to sell their products or services.

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Companies like IBM must analyze a number of factors to determine when to recognize costs.

Franziska Kraufmann/picture-alliance/dpa/Associated Press

Financial report readers can see how complicated it is for a service company, such as IBM, to determine its costs of goods sold by reading Note A in IBM's Notes to the Financial Statements. That note states, for example, that "Recurring opera�ng costs for services contracts, including costs related to bid and proposal ac�vi�es, are recognized as incurred."

IBM tracks its costs on service contracts, including bid and proposal ac�vi�es, and recognizes them when incurred. Since it can take months to actually win a proposal, IBM indicates that it reports opera�ng costs periodically throughout the bidding process. (The rest of this note can be found in the "World of Business," which discusses other difficult decisions regarding the recogni�on of costs.)

World of Business

Recognizing Costs of Goods and Services Sold

Determining when a company should recognize costs is not always easy. Discover the complexi�es to be considered in this excerpt from IBM's 2012 Notes to the Financial Statement, regarding the recogni�on of costs:

"For fixed-price design and build contracts, the costs of external hardware and so�ware accounted for under the POC [percentage-of-comple�on] method are deferred and recognized based on the labor costs incurred to date, as a percentage of the total es�mated labor costs to fulfill the contract. Certain eligible, nonrecurring costs incurred in the ini�al phases of outsourcing contracts are deferred and subsequently amor�zed. These costs consist of transi�on and setup costs related to the installa�on of systems and processes and are amor�zed on a straight-line basis over the expected period of benefit, not to exceed the term of the contract. Addi�onally, fixed assets associated with outsourcing contracts are capitalized and depreciated on a straight-line basis over the expected useful life of the asset. If an asset is contract specific, then the deprecia�on period is the shorter of the useful life of the asset or the contract term. Amounts paid to clients in excess of the fair value of acquired assets used in outsourcing arrangements are deferred and amor�zed on a straight-line basis as a reduc�on of revenue over the expected period of benefit not to exceed the term of the contract. The company performs periodic reviews to assess the recoverability of deferred contract transi�on and setup costs. This review is done by comparing the es�mated minimum remaining undiscounted cash flows of a contract to the unamor�zed contract costs. If such minimum undiscounted cash flows are not sufficient to recover the unamor�zed costs, an impairment loss is recognized."

Consider This:

1. Does your company have a complex set of rules for recognizing costs? 2. Must you differen�ate costs between services and goods in your company?

Source: IBM. (2013). 2012 annual report. Retrieved from h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf (h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf)

IBM's Notes to the Financial Statements demonstrate that the company must analyze a number of moving parts to determine its costs of goods sold.

For service contracts: It must calculate opera�ng costs for service contracts and costs related to bid and proposal ac�vi�es. For fixed-price design contracts: It must calculate costs of external hardware and so�ware based on the percentage of comple�on. The total es�mated labor costs to fulfill the contract are calculated; then a percentage of those costs are allocated each period to determine Costs of Goods Sold. The company also calculates transi�on and setup costs related to the installa�on of the systems and processes. Fixed assets are capitalized and depreciated on a straight-line basis over the expected useful life of the asset.

In addi�on to a sec�on on service costs, IBM includes a sec�on regarding so�ware costs and how they are calculated. Research and development becomes a cri�cal part of calcula�ng these costs. Hardware costs are not discussed in detail in the note, but these are either calculated as manufacturing costs (if IBM produces the product) or purchased costs (if IBM purchases the product from another company).

Similar to how it separates Revenues, IBM differen�ates its costs by services, sales, and financing on its income statement, as shown in Figure 3.4.

Gross Profit

The gross profit number is cri�cal for determining how much profit a company is making from the actual sale of its goods or services before considering the opera�ng expenses. If the company's gross profit is not high enough to cover opera�ng expenses, managers must take ac�ons to fix the problem as soon as it is recognized.

There are essen�ally four ways managers can fix the problem:

1. Managers can recommend that the company increase its prices, if the market will bear it without the company losing too many sales. Sales and marke�ng managers will need to research compe�tors' pricing to determine if this is an op�on. If compe�tors are charging the same or lower prices, this op�on will likely decrease sales.

2. Managers can look for opportuni�es to expand sales into new markets. This will likely mean the company will incur addi�onal sales and marke�ng expenses, so it needs to carefully analyze the impact of this choice. Sales and marke�ng managers will need to assess opportuni�es for expansion and their costs. They will then prepare a report for upper management.

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The opera�ng expenses of a company are shown in the expense sec�on of the income statement.

3. Financial and purchasing managers can find a way to decrease costs. They can do this by finding other suppliers with whom they can nego�ate a lower price. Another way to reduce costs may be to take advantage of volume discounts when ordering materials. Managers in a manufacturing company may be able to find other ways to reduce manufacturing costs.

4. Managers can recommend that the company lower its prices to increase sales. This may seem counterintui�ve, but if the company can reduce its costs by purchasing or manufacturing at greater volumes, lowering the price to increase sales could improve the gross profit.

These are the types of decisions companies must make at least yearly, and usually more o�en, a�er evalua�ng periodic financial reports. If managers or execu�ves see gross profit trends moving lower, it is an indica�on that the company needs to make changes to maintain profitability in the long term.

Opera�ng Expenses

Recall that companies provide few details about their expenses on public financial reports because companies prefer to reveal as li�le informa�on as possible on their public reports, because they know their compe�tors will read them. Now we will take a closer look at the Expense sec�on of the income statement for the Best General Company, as shown in Figure 3.5.

Figure 3.5: Expense sec�on of the income statement for Best General Company

Selling, General, and Administra�ve Expenses

The Selling, General, and Administra�ve Expenses line item reflects all expenses the company incurs in selling its products or services (including sales commissions and adver�sing), as well as the expenses it incurs in running all its administra�ve and sales offices. All salaries and wages, insurance costs, professional fees, rents, office supplies, and other similar types of expenses are also included in this number.

If the company operates retail stores, it will include the expenses of running those stores here as well, such as store rents, inventory warehousing, sales associates wages, and u�li�es. However, recall that because a retail store sells many products, companies cannot match the expenses of opera�ng a retail store to the costs of one product sold. Therefore, retail store opera�ons are considered an expense rather than a cost of goods sold.

Note in Figure 3.5 that the Best General Company is experiencing an increase in these expenses. They have increased by $2,000 over the last three years. The budget commi�ee would need to review the accounts that are used to calculate that number to determine where the increases occurred. They would need to determine if there is a way to control these rising expenses by reviewing the accounts where expenses are increasing and determining if there is a way to cut some of these expenses in the next year's budget.

Research and Development

The Research and Development (R&D) line shows the total spent on inves�ga�ng the viability and u�lity of future products. When comparing two companies in a similar industry, this can be a cri�cal number. For example, if one company is spending a great deal more on R&D than the other, it might be seeking to develop more new products or improve the ones it currently sells. A company that is not spending on R&D, or is spending very li�le, may be too interested in the short-term bo�om line and not inves�ng enough money in the future growth of the company.

Best General Company incurred the same level of expenses in each of the three years shown on the income statement. The budget commi�ee may determine that R&D needs to be increased to enable the company to research new products. They may recommend that the execu�ves form a commi�ee to review this op�on and develop a plan for the R&D team.

Task Box 3.3: Comparing Research and Development Spending

Analyzing Industry Compe�tors, Part D

Calculate the amount spent on R&D at the two companies you've chosen to inves�gate. Are they spending roughly equal amounts? If not, why not? Hint: You may find some discussion of R&D in the Management's Discussion and Analysis sec�on of the annual report.

Other Income and Other Expenses

The Other Income line item is usually a catchall sec�on where a company includes income that is not earned from opera�ons. For example, if a company sells a building, a major piece of equipment, or some other asset, the income from that sale is shown here. Generally, items shown are one-�me income.

The same is true for the Other Expenses line item. Generally, these are one-�me rather than recurring expenses that do not involve the day-to-day opera�ons of the company. Figure 3.6 shows the Other Income and Other Expenses sec�on of the Best General Company income statement.

Figure 3.6: Other income and other expenses sec�on of the income statement for Best General Company

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Income and expenses that are not directly related to company opera�ons are shown in the other income and expenses sec�on of the income statement.

Deprecia�on and Amor�za�on Expenses

In Chapter 2, we discussed the calcula�on of deprecia�on and amor�za�on for the purposes of por�oning the cost of buying the asset over the life of the asset to be�er match the expenses with the revenue earned from using those assets. For example, these long-term assets can include buildings, equipment, and other assets held for more than one year. Each year, the amount of deprecia�on or amor�za�on to be added to the accumulated deprecia�on line item on the balance sheet is offset by a deprecia�on or amor�za�on expense. This expense line item is included on the income statement to show the expenses incurred for that year.

Net Income

As we've discussed, net income (loss) is the "bo�om line." This number allows an employee to quickly determine whether a company has made a profit or incurred a loss.

Exploring a li�le of what is behind the numbers on the income statement reveals that there is a great deal to find out about the numbers that lead to the bo�om line. Someone who looks only at the bo�om line misses a lot of crucial informa�on needed to assess whether a company is profitable.

Let's take a closer look at how a manager can determine whether the business is earning a profit.

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The gross profit sec�on shows income a�er the cost of goods sold are subtracted.

3.3 Profit Types The most important lines on any income statement are the lines that show whether the company made a profit. There are three key profit line items that enable managers to quickly determine a company's profitability using the mul�-step income statement format. These three profit line items are shown in bold on Figure 3.3. Each of these profit line items provides a different type of informa�on.

1. Gross Profit: Shows whether the company made a profit from selling its products or services before considering the expenses of opera�ng the company. The line is shown in the top sec�on with Revenues minus Cost of Goods Sold.

2. Opera�ng Profit: Shows whether the company made a profit a�er all opera�ng expenses are subtracted. The line is shown below the Expense sec�on. 3. Net Profit (Loss): Shows whether the company made a profit a�er all opera�ng and non-opera�ng expenses are subtracted. This is the bo�om line of the

income statement.

Using that informa�on, we can test a company's profitability with three ra�os:

1. Gross Profit Margin: This indicates how well the company is doing a�er taking into considera�on the cost of goods or services sold. 2. Opera�ng Profit Margin: This indicates how well the company is doing a�er taking into considera�on the opera�ng expenses. 3. Net Profit Margin: This indicates how well the company is doing a�er taking into considera�on all opera�ng and non-opera�ng costs.

We will now demonstrate how to calculate these margins and what they mean for managers trying to determine whether their company is profitable.

Gross Profit Margin

First we will calculate the gross profit margin using the Revenue sec�on of the income statement for Best General Company, shown in Figure 3.7.

Figure 3.7: Gross profit sec�on of the income statement for Best General Company

The gross profit margin for each of the three years can be calculated by dividing the Gross Profit by the Revenue. The following shows the gross profit margin for each of the three years.

Gross Profit Margin= Gross Profit Revenues

2013 2012 2011

Gross Profit Margin $27,000 $100,000 =27.0% $32,000 $120,000 =29.1% $36,000 $110,000 =30.0%

Note that the gross profit margin gives the managers of Best General Company a way to quickly see that the company's profit is dropping on the goods it is selling. This is a bad sign for the company. The managers would need to ask accoun�ng for the details of the accounts used to calculate the Revenue and Cost of Goods line items to determine what is driving this downward trend. Some key accounts to review would be:

Revenue: Managers would need to determine whether revenue was going up or down. Sales Discounts: Did the company offer more discounts in 2011 than it did in 2013? If more discounts are being offered, managers would need to find out why this is happening. Sales Returns: Are more products being returned? If so, managers would need to determine whether a quality control problem exists or if something else is driving the returns. Purchases: Is the company paying more for the products, which in turn is increasing the Cost of Goods Sold? If this is the case, managers may seek to find a new supplier, adjust profit expecta�ons, or consider raising prices to cover addi�onal costs. They could consider buying increased volumes to take advantage of volume discounts.

In addi�on, the managers of Best General Company may want to compare the gross margin of the company to the gross margin for the industry to see how well the company is doing compared to its compe�tors. If the gross margins are significantly lower, more research would be needed to determine what the company can do to improve its performance.

The marke�ng and sales manager would want to compare Best General's revenue results to those of its compe�tors. The purchasing manager may want to take a closer look at the company's Costs of Goods Sold compared to its compe�tors. All managers may want to review the key compe�tors' annual reports to find out how they are doing and possibly discover informa�on that could be used to develop recommenda�ons for improving the results of the Best General Company. For example, in reading the details in the annual reports of one company, the marke�ng manager may read informa�on that gives her an idea for a new product line or new marke�ng campaign.

Task Box 3.4: Calcula�ng Gross Profit Margin

Analyzing Industry Compe�tors, Part E

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The opera�ng profit sec�on of the income statement shows profit a�er all opera�ng expenses have been subtracted.

Expenses not directly related to the company opera�ons are shown in the non-opera�ng expenses sec�on of the income statement.

Calculate the gross profit margin for the last five years for the companies you have chosen to research. Is gross profit going up or down? Are sales going up or down? Are costs going up or down? Determine from these numbers whether the companies are improving their profitability. Why did you come to that conclusion?

Opera�ng Profit Margin

The managers would next want to determine whether the company is s�ll making a profit a�er subtrac�ng all its opera�ng expenses. The opera�ng profit margin indicates how much profit a company is making a�er taking all opera�ng expenses into considera�on. Figure 3.8 shows the Expenses sec�on, followed by the Opera�ng Profit line, for Best General Company.

Figure 3.8: Expenses and opera�ng profit sec�on of the income statement for Best General Company

To calculate the opera�ng profit margin, divide the opera�ng profit by revenues shown in Figure 3.8. The results are shown in the table below.

Operating Profit Margin= Operating Profit Revenues

2013 2012 2011

Opera�ng Profit Margin $4,500 $100,000 =4.5% $10,500 $110,000 =9.5% $15,500 $120,000 =12.9%

The Best General budget commi�ee members can quickly see that the downward trend is even more significant when opera�ng expenses are considered. The company was making an opera�ng profit of 12.9% in 2011, and it is now down by more than half, to 4.5%. The managers would want to take a closer look at expenses to see which expenses are increasing and ask for more detail from the accounts that are used to calculate those line items. The key line item that shows increasing expenses is the Selling, General, and Administra�ve Expenses line item in Figure 3.8. Many accounts are used to calculate that line item, including selling expenses, office expenses, salaries expense, insurance expenses, and so on.

The Best General budget commi�ee should ask to see a detailed report of all the accounts that are used to calculate Selling, General, and Administra�ve Expenses and inves�gate which ones are contribu�ng to the increase in these expenses.

It is important for a company to maintain a high opera�ng profit margin. This gives the company more price flexibility during an economic downturn. Why? Because with higher opera�ng profit margins, the company has the op�on to cut prices if needed to a�ract more business. It therefore has the flexibility needed to be compe��ve no ma�er how bad an economic downturn may be. Net profit may go down, but the company will have no trouble staying in business.

Net Profit Margin

The third key profit test is net profit margin, which looks at how well the company has done overall, considering both opera�ng and non-opera�ng ac�vi�es. Non- opera�ng ac�vi�es can be as simple as interest income or expense, or they can be much more significant, such as the expenses related to the discon�nua�on of a product line or the closure of a plant. Figure 3.9 shows the non-opera�ng expenses and the net profit for Best General Company.

Figure 3.9: Non-opera�ng expenses and net profit sec�on of the income statement for Best General Company

To calculate the net profit margin, divide the net profit by revenues. The results for Best General Company are shown in the table below.

Net Profit Margin= Net Profit Revenues

2013 2012 2011

Net Profit Margin $3,550 $100,000 =3.6% $8,200 $110,000 =7.5% $13,000 $120,000 =10.8%

The budget commi�ee of Best General Company can see the company is barely making a profit of 3.5%. If the Other Income of $2,500 from non-opera�ng sources were not available, the net profit would be only $1,050, or just above 1%. Any drop in revenues could mean the company would show a net loss rather than a net profit.

Clearly, Best General Company needs to make some major changes to improve its profitability. In addi�on to reviewing the key accounts as discussed above, the budget commi�ee members may also want to compare Best General Company's results with other companies in the same industry. They can do this by researching key industry sta�s�cs. Chapter 6 discusses analyzing financial results in more depth.

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Task Box 3.5: Industry Benchmarks

One way to compare a company's results to industry sta�s�cs is by using the website BizStats.com. There you can search for industry financial benchmark reports and get industry profitability risk data as well as industry sta�s�cs. To see how IBM is doing, for example, you can use BizStats.com to find industry profit and loss benchmarks as follows:

1. Select the company structure: Corpora�on (for IBM) 2. Input annual sales: $104,507,000,000 (no commas when entering on the website) 3. Pick industry: Professional-Scien�fic-Technical Services 4. Pick specific industry: Computer systems design and related services

You will then get industry income-expense statement benchmarks, as well as industry balance sheet benchmarks. The gross profit margin benchmark in this industry category is 72.67%. IBM is not a perfect match for this industry, since it also manufactures and sells hardware.

Therefore, you might also want to find the benchmarks for computer manufacturing. However, when it comes to the bo�om line, IBM is doing much be�er than others in this industry. This industry's net profit benchmark is 9.21%, whereas IBM's is 15.9%.

You can also examine IBM's results on the manufacturing side using BizStats.com:

1. Select the company structure: Corpora�on (for IBM) 2. Input annual sales: $104,507,000,000 3. Pick industry: Manufacturing 4. Pick specific industry: Computer and electronic product manufacturing 5. Pick specific industry once more: Computers and peripheral equipment

In the manufacturing industry segment, the gross profit margin is much lower than in the services industry. The gross profit margin is 38.91%. Remember that Cost of Goods Sold will always be much higher for a company that is manufacturing its products than for a service industry that has much lower cost of services sold. The net profit for the manufacturing sector is just 8.98%. IBM far exceeds the net profit here, as well.

Prac�ce using Bizstats.com by finding the benchmarks for your company or a company in which you are interested. How do those companies compare to others in their industry sectors?

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Details of the claims owners have against the assets of the company are shown in the statement of shareholders' equity.

3.4 The Elements of a Statement of Shareholders' Equity At the bo�om of the income statement or on another page, a statement of shareholders' equity is shown. This statement indicates how shareholders were affected by the company's results for the year. It also indicates other changes that might impact claims owners have against the company, such as the issuance of new stock or the buyback of stock already on the market. The first line is always the balance in each of the accounts that make up shareholders' equity:

Common Stock and Addi�onal Paid-in Capital, Retained Earnings, Treasury Stock, Accumulated Other Comprehensive Income (Loss), and Non-controlling Interests.

The bo�om line of this statement is Total Equity. Figure 3.10 shows the statement of shareholders' equity for Best General Company.

Note that the net earnings from the income statement match the retained earnings on the statement of shareholders' equity. Net earnings not paid out in dividends to the shareholders are held as retained earnings. The retained earnings total is an historical account that tracks all money reinvested into the business over the years.

Figure 3.10: Best General Company statement of shareholders' equity

The statement of shareholders' equity for Best General Company is rela�vely simple. On a major corpora�on's, however, there will be line items not shown here. Let's review the line items that can appear on a statement of shareholders' equity and what they show.

Common Stock and Addi�onal Paid-In Capital

Public and private corpora�ons divide the ownership of the company using shares of stock. Most of these shares are called common stock. Common shareholders can par�cipate in the elec�on of a board of directors and can vote on company policy. Most common shareholders in a major corpora�on own such a small share in the company that their vote holds li�le weight. The common shareholders of a small company o�en own a significant por�on of the common stock of the company, o�en have a role on the Board of Directors, and possibly hold a posi�on in upper management.

When common stock is first set up, a share value called "par value" is established. When the stock is first sold to investors, any money collected above the par value is listed as "addi�onal paid-in capital." So if a stock has a par value of $10 and 100 shares are sold for $20 each, the value of the common stock shown on the statement of shareholders' equity would be $1,000 and the value of paid-in capital would be $1,000.

Best General Company, when formed, set its par value at $10 per share for a total of $20,000 in common stock. Since it is a small company, it was not sold on the stock market. Its shareholders are the partners who started the company. Their propor�on of ownership is based on the number of shares each partner owns. For example, if Partner A owns 500 shares, it means he invested $5,000 (500 x $10 per share) in the company to buy those shares.

This sec�on of a statement of shareholders' equity can get very complex for a large corpora�on, especially if it issues stock at different prices. Another line item may show stock-based compensa�on. This reflects stock that was awarded to employees as part of their compensa�on plan.

Other Line Items

Some companies will have addi�onal line items. For example, if there is preferred stock issued, there will be a line item detailing the value of the preferred stock, similar to the line item for common stock. We discussed preferred stock in Chapter 2.

We also discussed treasury stock in Chapter 2. Any transac�ons involving the buying back of stock or reissuing of stock will be detailed in a line item on this statement.

Non-Controlling Interests

Some�mes there is a line item called Non-Controlling Interests. This line item shows ownership held in companies in which the holding company has no controlling interest. A company generally must hold between 5% and 10% of another company before it can push for a seat on the board and obtain some control.

Let's now turn our a�en�on to how we can use the informa�on on the income statement to analyze some basic trends for a company using a common-sized income statement.

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With each line item shown as a percentage, a common-sized income statement allows readers to easily iden�fy trends within a company and also to compare large and small companies.

3.5 Crea�ng a Common-Sized Income Statement The common-sized income statement enables users to analyze the key line items that lead to profit or loss from a different perspec�ve by calcula�ng each number on the income statement as a percentage. It allows for an easier comparison between two or more companies of varying sizes in the same industry. It is also useful for managers to quickly iden�fy trends from year to year.

The common-sized income statement may be presented with both dollar figures and percentages for each line item, or, when it displays a number of years on one page, it may be presented with just percentages. The percentages allow for a quick assessment of the trends of each line item when looking at several years on one report. All items are shown as a percentage of Net Revenue or Net Sales. Note that because this statement is not required by the government, it does not need to be prepared according to a par�cular set of rules.

Task Box 3.6: Preparing a Common-Sized Income Statement

To prepare a common-sized income statement, start an Excel worksheet. Copy the informa�on from the income statement into the Excel worksheet. Then develop a formula to divide each line item by Net Sales or Net Revenue. To make things easier, download our template (h�ps://ne.edgecastcdn.net/0004BA/constella�on/Ar�culate/OMM622/Financial_Decision_Making_Template.xlsx) that uses the mul�-step format with the formulas already developed for the percentage columns.

Figure 3.11 shows a common-sized income statement for Best General Company prepared using the downloadable mul�-step template. To use the template, we separated expenses and other income. We also moved interest expenses to the Other Expenses category.

Figure 3.11: A common-sized income statement for Best General Company

Figure 3.11 clearly illustrates that Best General Company is showing a downward trend in profitability. The three key factors include:

1. A downward trend in Revenues. 2. An upward trend in Cost of Goods Sold. 3. An upward trend in Selling, General, and Administra�ve Expenses.

Review the discussion in each of the profit analysis sec�ons above to consider the tasks that managers may engage in when confronted with these trends.

Task Box 3.7: Calcula�ng a Common-Sized Income Statement

Analyzing Industry Compe�tors, Part F

Use the downloadable template (h�ps://ne.edgecastcdn.net/0004BA/constella�on/Ar�culate/OMM622/Financial_Decision_Making_Template.xlsx) to calculate the common-sized income statement for the companies you have chosen. What trends do you no�ce a�er crea�ng a common-sized income statement for your companies?

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Summary and Resources

Chapter Summary

In this chapter, we illuminated the numbers on the income statement to take a closer look at how companies develop this statement.

We reviewed the rules related to statement �ming and forma�ng and how these rules impact the way the statement is presented. We examined the key sec�ons of an income statement and explored how the numbers are developed for the income statement. This included rules related to how revenue is recognized and how costs or expenses are determined. Some companies, such as retail companies and restaurants, simply recognize revenue at the �me the good or service is sold. Other companies must determine when the revenue is actually earned. We explored the costs of producing or purchasing products or services to be sold and looked at the expenses incurred to operate a business and how those differ from costs incurred to sell products. Next we discussed the three key profit line items that enable managers to quickly determine how well the company is doing. We also discussed key details managers may want to review if they see problems in the numbers to determine where the problems are in the company's opera�ons. We briefly reviewed the statement of shareholders' equity, where the ownership of the company is detailed. We then explored a tool that makes it easier to analyze an income statement called the common-sized income statement. This tool helps managers to spot trends in the income statement by comparing results period to period. It also gives managers a way to compare the company results to those of compe�tors, even if the compe�tors are a different size.

Takeaways for Chapter 3

Managers must review the trends of the various line items in an income statement from period to period to determine how well the company is doing and to iden�fy areas where the company is doing well, as well as find areas where improvement is needed. Managers should compare their company results to those of their compe�tors to test how well the company is doing. Companies do not operate in a vacuum. Using the common-sized income statement a manager can compare his company to a company of any size. Managers should be aware of the accounts that are used to calculate the line items on the income statement, so if they see a problema�c trend they know what detail to request from accoun�ng in order to fix a problem. Also this detail can help managers spot a posi�ve trend upon which they may want to build.

Discussion Ques�ons

1. What are the key factors a manager should consider when reviewing gross profit trends? 2. What are the key factors a manager should consider when reviewing opera�ng profit trends? 3. What are the key factors a manager should consider when reviewing net profit trends? 4. Why is it important to compare a company's results period to period? 5. Why do you think it is important to use a common-sized income statement to compare compe��ve companies?

Further Reading/Resources

BizStats.com (h�p://www.bizstats.com/)

3M 2012 Annual Report (h�p://media.corporate-ir.net/media_files/irol/80/80574/Annual_Report_2012.pdf)

IBM 2012 Annual Report (h�p://www.ibm.com/annualreport/2012/bin/assets/2012_ibm_annual.pdf)

InvestorWords.com (h�p://www.investorwords.com/ )

Key Terms

Click on each key term to see the defini�on.

allowances (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

An account used to track a discount or rebate given to the customer.

common-sized income statement (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Document that enables users to analyze the key line items that lead to profit or loss from a different perspec�ve by calcula�ng each number on the income statement as a percentage.

cost of goods or services sold (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The costs directly associated to produce the products or services to be sold by the business.

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EBITDA (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

A profit line seen on some companies' income statements that shows earnings before interest, taxes, deprecia�on, and amor�za�on.

expenses (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The money spent on opera�ng the business.

gross profit (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Profit a�er the cost of goods sold is subtracted.

gross profit margin (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Percentage of profit a�er the cost of goods sold is subtracted.

net profit margin (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The percentage of net profit.

net profit (or loss) (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The bo�om line of an income statement that shows whether the business experienced a gain or a loss.

opera�ng profit (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Profit from the opera�ons of the company.

opera�ng profit margin (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The percentage of profit a�er subtrac�ng opera�ng expenses.

Profit Before Income Tax Expensed (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Income before taxes and interest are subtracted.

returns (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Products returned by purchasers.

revenue (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The total income from the sales of products or services.

sales (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

The revenue earned from selling products or services.

volume discounts (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/cover/books/AUOMM622.14.1/sec�ons/c

Discounts offered when a significant volume of merchandise is purchased at the same �me or over a promised period of �me. The volume is nego�ated between buyer and seller.

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4 Elements of a Statement of Cash Flows

© Eldad Carin/iStock/Thinkstock

Learning Objec�ves

A�er reading this chapter, you should be able to:

1. Explain how a statement of cash flows is calculated. 2. Discuss how cash is used for company opera�ons. 3. Explore how cash is used for company investment opportuni�es. 4. Assess how cash is raised or spent from financing ac�vi�es. 5. Explain how to analyze a statement of cash flows.

Introduc�on In Chapter 3, we examined the income statement, which indicates a company's financial results based only on the revenue it earns, with the bo�om line showing whether the company made a profit. However, because accrual accoun�ng allows companies to recognize sales on the date of comple�on, even if cash has not yet changed hands (review Chapter 3 for more informa�on on revenue recogni�on), a company can show profitability on the income statement but s�ll be cash poor. The statement that looks at how cash flows into and out of the business is the statement of cash flows.

In this chapter, we will explain how the statement of cash flows is calculated and explore how informa�on is used from the balance sheet and income statement to prepare this statement. The Best General Company budget commi�ee would likely review this statement to determine if there are flow issues that need to be addressed.

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This statement shows the flow of cash into and out of the company.

This sec�on of the statement of cash flows shows how cash flowed into and out of the business from opera�ng ac�vi�es. More detail about cash from customers and cash paid to suppliers is shown in the direct method of this statement.

This sec�on of the statement of cash flows shows how cash flowed into and out of the business from opera�ng ac�vi�es. The indirect method does not show detail about cash from customers or cash paid out to suppliers and vendors.

4.1 What Is a Statement of Cash Flows? The most common reason cash on hand is lower than profit from opera�ons is that a company's customers have not yet paid their outstanding bills. Another common reason is that more inventory was purchased than the company was able to sell.

Managers need to review the inflow and ou�low of cash shown on the statement of cash flows to determine whether there is a cash flow problem. The bo�om line of the statement of cash flows shows managers whether the company actually increased or decreased the cash on hand from all its ac�vi�es during the repor�ng period.

The statement of cash flows also indicates how a company is ge�ng and using its cash. Like the income statement, the statement of cash flows shows the opera�ng results throughout the period being reported. However, as noted, it also details how cash flowed into and out of the company from other ac�vi�es, such as inves�ng, which could include the purchase or sale of long-term assets, and financing, which could include taking on a new loan or issuing stock.

The statement of cash flows details the flow of cash from three types of financial ac�vi�es:

1. Opera�ng Ac�vi�es: This sec�on provides a manager with informa�on about the company's cash through the sales of its products or services. It also indicates how the company used cash to pay for needed goods or services to operate the business.

2. Inves�ng Ac�vi�es: This sec�on provides a manager with details about the company's investments. It indicates whether the company used cash to purchase securi�es, or raised cash by selling securi�es or other long-term assets, such as a building or a division. It also provides details about cash spent on capital investments, such as upgrades to major assets held, which can include upgrades to a factory or renova�on of a building.

3. Financing Ac�vi�es: This sec�on provides a manager with informa�on about transac�ons that raised cash through adding long-term debt or issuing new stock. It includes informa�on about cash used to pay down debt or buy back stock. The payment of dividends is also found here.

Figure 4.1 shows the statement of cash flows for the year 2013 for Best General Company. To comply with SEC rules, companies normally show three years of results on the statement of cash flows.

Figure 4.1: Statement of cash flows for Best General Company

Possible Formats

The statement of cash flows can be organized into either the direct format or indirect format. The difference between these is the amount of detail provided. They both provide the same conclusion about how much cash was added to the business or deducted from it, but they offer different details about how cash flowed into and out of the business:

Direct Method: This method groups major classes of cash receipts and cash payments separately. For example, cash from customers is grouped separately from cash received on interest-earning savings accounts, or from dividends paid on stock. Major groupings of cash payments include cash paid to buy inventory, cash disbursed to pay salaries, cash paid for taxes, and cash paid to cover interest on loans. This method is preferred by the Financial Accoun�ng Standards Board (FASB) because research studies have shown that the addi�onal informa�on is useful for making decisions. The direct method improves the ability of financial report readers to predict future opera�ng cash flows and earnings (Broome, 2004; Orpurt & Zang, 2009). Indirect Method: This method focuses on differences between net income and net cash flow from opera�ons, and is used by most companies. The Securi�es and Exchange Commission (SEC) only requires the detail provided by the indirect method.

Differences between these methods can be seen only in the Opera�ng Ac�vi�es sec�on of the statement of cash flows, which is always the first sec�on of the statement. Figure 4.2 provides a sample of the direct method as might be used by Best General Company, whereas Figure 4.3 shows the indirect method. As shown in Figure 4.2, the direct method provides a good deal of informa�on, such as cash received from customers or cash paid to suppliers and employees. That detail cannot be found on the balance sheet or income statement.

Meanwhile, as shown in Figure 4.3, the statement using the indirect method makes no men�on of cash from sales or cash paid to buy supplies. It also does not show cash paid for salaries or the amount of cash gleaned in income tax refunds. What is shown are the results from various calcula�ons using the income statement and balance sheet.

Figure 4.2: Opera�ng ac�vi�es—direct method

Figure 4.3: Opera�ng ac�vi�es—indirect method

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This worksheet shows the changes in the values of assets, liabili�es, and equity from one year to the next.

Companies o�en prefer the indirect method because of the limited amount of informa�on it provides—this is an advantage when it comes to thwar�ng compe�tors' ability to mine significant details from the company's public statements. We will focus on this method in this chapter, since almost all companies use it, and managers are most likely to see it when reading financial reports.

How the Statement of Cash Flows Is Calculated

A statement that uses the indirect method starts with net income from the income statement. Adjustments are then made for line items in which cash was used. At the bo�om of each of the three sec�ons (Opera�ng, Inves�ng, Financing) is a line item that shows cash provided by or used for line items in that sec�on, as shown in Figure 4.1.

In order to compile a statement of cash flows using the indirect method, all a manager needs is two years' worth of balance sheets and income statements. The manager then develops a cash flow worksheet, similar to the one in Figure 4.4.

The line items included in this worksheet are line items from the balance sheet. This worksheet is used to determine the change in value of each of these items on the balance sheet. For example, Cash and Cash Equivalents went down by $1,100, while Accounts Receivable increased in value by $600.

In addi�on to these line items, the manager would also need the Net Income line item from the income statement, as well as Deprecia�on Expenses and Income Tax Expenses. If a company used cash for one-�me inves�ng ac�vi�es (such as the purchase of new property, plant, or equipment) or financing ac�vi�es (such as taking on a new loan obliga�on or issuing new stock), that informa�on also would be needed to calculate net cash on hand at the end of the period. For this simple example, we did not include these more complex transac�ons.

Once the manager completes the worksheet, he or she will see that some accounts went up in value from year to year, while others went down. How these changes affect cash will vary depending on the type of account.

When an asset account increases in value, it means there was an ou�low of cash. For example, the Accounts Receivable account increased in value by $600. That means that there was an increase in the amount due from customers who have not yet paid their bills. Therefore, the cash not yet received from customers will reduce cash received from opera�ng ac�vi�es by $600. Sales were reported as revenue, but the cash was not collected. Accounts Receivable will be shown as a nega�ve number on the statement of cash flows, as can be seen in Figure 4.3, to reflect the reduc�on in cash received in the current year.

Figure 4.4: Cash flow worksheet for Best General Company

Cash used to pay bills, as indicated in the Accounts Payable line under Liabili�es in Figure 4.4, decreased in value by $500. That means cash was used to pay bills incurred in the previous accoun�ng period. This, too, reflects an ou�low of addi�onal cash, and that number will appear as a nega�ve number in the Opera�ng Ac�vi�es sec�on of the statement of cash flows, as shown in Figure 4.3.

How can a manager predict if a number will be a nega�ve or posi�ve number on the statement of cash flows? Table 4.1 can be a helpful guide for managers who need to make that determina�on.

Table 4.1: Effect of inflows and ou�lows of cash by account type

Inflow of cash Ou�low of cash

Decrease in an asset account Increase in an asset account

Increase in a liability account Decrease in a liability account

Increase in an equity account Decrease in an equity account

An inflow of cash will show as a posi�ve number on the statement of cash flows, which means the company received addi�onal cash. An ou�low of cash will show as a nega�ve number on the statement of cash flows, which means the company received less or spent more cash.

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4.2 Opera�ng Ac�vi�es The Opera�ng Ac�vi�es sec�on of the statement of cash flows that uses the indirect method includes two parts. The adjustment part of this sec�on shows adjustments to cash on hand for expenses that do not require the use of cash, such as deprecia�on. The remainder of that sec�on shows the changes needed to reflect cash on hand a�er the addi�ons and subtrac�ons for balance sheet account changes from one period to another. Figure 4.3 shows increase or decrease in Accounts Receivable, Inventories, Accounts Payable, and Accrued Liabili�es.

We will start with the adjustments based on the income statement.

Adjustments

The adjustments are changes to cash flow based on items on the income statement that do not require the use of cash, such as deprecia�on and amor�za�on or deferred income taxes.

Deprecia�on and Amor�za�on

The first line item in the adjustment sec�on of the Opera�ng Ac�vi�es is usually Deprecia�on or Deprecia�on and Amor�za�on (see Chapter 2 for a review of these concepts). Best General Company reported $2,400 in deprecia�on expenses.

Deprecia�on expenses do not involve the use of cash; rather, they indicate the gradual reduc�on in the value of an asset to match expenses with revenue. The cash only changes hands when the asset is ini�ally purchased. When an asset is bought using a loan, then cash also changes hands when the debt based on the asset is paid. Debt payoffs are shown in the financing ac�vi�es sec�on of the statement of cash flows.

Because deprecia�on expenses do not require the cash, the number is added back in to show an increase in cash on hand. Managers then know that there is more cash available with this adjustment. Deprecia�on does lower the net income, as shown in a line item on the income statement.

Deferred Income Taxes

Another line item in the Opera�ng Ac�vi�es sec�on of the statement of cash flows is Deferred Income Taxes. These are tax expenses that were incurred, but cash was not yet used to pay them. According to GAAP rules, a company must match expenses to the year incurred, even if cash is not paid out, so income tax expenses would be reported on the income statement even if cash was not yet paid to the government. Best General Company showed no deferred taxes on its financial statements.

Accounts Receivable

As we discussed above, the difference in the value for Accounts Receivable shown on the balance sheet between the current year and the previous year indicates whether customers have added to the amounts owed the company or decreased the amounts owed the company. If the number shows an increase, more customers owe money to the company and less cash was received from sales made with store credit. If the number shows a decrease, customers paid down accounts receivable from the prior year, plus paid addi�onal cash for new credit sales.

On the statement of cash flows in Figure 4.3, we see that Best General Company shows an increase of $600 in the value of its accounts receivable. This means the company has less cash on hand. The $600 must be subtracted from net income to discover how much cash is actually available to the company. Managers must be aware there is less cash available, and they may need to adjust spending or find a source of cash, such as a line of credit, when wai�ng for cash to be paid by customers.

In order to improve cash on hand, managers may need to consider incen�ves for earlier cash payment from customers. They may also want to ask the accoun�ng department for an aging schedule (discussed in Chapter 2) to find out which customers are behind on paying their invoices, and possibly cut off those customers from new purchases un�l their previous charges are paid.

Inventories

The Inventories line in the Opera�ng Ac�vi�es sec�on on the statement of cash flows shows whether more or less cash was used to buy inventory. If the balance sheet indicates that a company's inventory decreased from the previous year, this means that some of the inventory was bought in the previous year. Thus, some of the sales involved inventories that were paid for in a previous year. This will result in an increase in cash on hand.

If the opposite is true, and the balance sheet indicates that inventories increased, this means that more money was spent on inventory, which was not sold. In this case, cash on hand would be decreased because it was used to buy inventory that is s�ll on the books.

For example, Best General Company's inventory at the end of 2012 was $38,000, and it increased to $40,000 at the end of 2013. That means $2,000 of cash was used for addi�onal inventory not sold, which reduces the cash on hand. The Cost of Goods Sold item on the income statement only includes the cost of inventory sold, so the cash on hand must be reduced to show the addi�onal purchase of inventory. The cash spent for that addi�onal inventory is shown by the difference between the current year and the previous year on the balance sheet.

Best General's managers need to determine why more inventory was bought that could not be sold in 2013 than in 2012. They would need to determine whether this was caused by a downturn in the economy, a lack of customer interest in some of the inventory on hand, a reduc�on in the number of customers, or some other reason.

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Another possibility for why the cash spent on inventory increased is that the purchase price of the inventory went up. That, too, would need to be inves�gated by managers. They would need to determine whether a new vendor should be found to reduce costs, or whether the company needs to consider raising prices to maintain the profit margins. If managers determine that they must consider an increase in prices, the marke�ng and sales team would need to weigh in on what impact an increase in price may have on future sales.

Accounts Payable

The Accounts Payable line item reflects what is in the Accounts Payable account, which tracks invoices that have not yet been paid. This means that cash will need to be paid out in a future accoun�ng period.

An increase in the Accounts Payable number over the previous year indicates that there is more cash on hand. Bills will need to be paid during the next accoun�ng period, but cash has been held back un�l they are due. The expenses that were incurred when these invoices were received by the company were shown as expenses on the income statement in order to match expenses with revenues earned in the same period. This means the income statement showed less profit, even though cash was not used to pay these expenses.

For example, the Accounts Payable line item for Best General Company decreased by $500 from $9,400 in 2012 to $8,900 in 2013, as shown in Figure 4.4. This means that an addi�onal $500 in cash was used in 2013 to pay invoices for expenses that were incurred in 2012. This reduced the cash on hand by $500, so this reduces the amount of cash on hand that was generated from 2013 net income.

Managers might want to ask for detail about the invoices not yet paid. If the value of Accounts Payable increases from the previous year, it could be a sign the company is having difficulty making payments. Invoices not yet paid will impact cash available during the next accoun�ng period, when those invoices must be paid.

Other Assets or Other Liabili�es

Any items not shown on an individual line item on the balance sheet or income statement will be found in line items called Other Non-Current Assets or Other Non- Current Liabili�es. Accrued Liabili�es (as seen in Figure 4.1) and Income Taxes Payable are two of the line items that would normally fall under Other Liabili�es. When calcula�ng how much cash is on hand, cash flow changes follow the same guidelines as individual items, as shown in Table 4.1.

A decrease in the Other Assets line item from the previous year to the current year will mean that addi�onal cash flowed into the business and would be added to net income. An increase in Other Liabili�es would also increase cash on hand, so that difference would be added to net income. In both cases, the cash on hand would be increased.

Ou�lows of cash, which means the amount of cash on hand is reduced, would be seen when there is an increase in an Other Assets account or a decrease in an Other Liabili�es account. In both cases, this would mean that the cash on hand would be decreased.

Bo�om Line: Net Cash Provided by Opera�ng Ac�vi�es

The bo�om line of the Opera�ng Ac�vi�es sec�on shows how much cash the company generated or spent from its opera�ng ac�vi�es. When looking at the bo�om line of the Opera�ng Ac�vi�es sec�on for Best General Company (Figure 4.1), we find that the total of cash on hand from opera�ng ac�vi�es is $3,450. This means the company generated just $3,450 from its opera�ons.

Managers should take a closer look at the numbers to see what is draining the company's cash. If Accounts Receivable has gone up drama�cally, it might mean that customers are slowing their payments. Another cri�cal number to review is Inventories. If inventories are increasing, cash is being used to buy and store those inventories that are not selling. This could mean sales are slowing or there could be another cause.

Managers must take a closer look at the transac�ons involving inventory to determine what is causing the problem. Wherever there are significant differences from year to year, managers should inves�gate the reasons by asking for detailed reports from their accoun�ng liaison so they can review the transac�ons used to generate the line items on the financial statements.

A competent manager would also want to inves�gate the line items that indicate reduced cash available to find out what can be done to improve the cash flow and limit or eliminate the drain on cash. The Opera�ng Ac�vi�es sec�on of the statement of cash flows is useful to determine which numbers account for the drain. This can be a cri�cal factor in the company's ability to con�nue opera�ons and pay its vendors, suppliers, and employees. If opera�ons do not generate enough cash, a company could be headed for disaster.

If cash flows increases, then discovering why this happened and what can be done to con�nue improving the genera�on of cash from the ac�vi�es involved is also an important step for the manager. Anything that can be done to expand ac�vi�es that generate more revenue or more cash will help the company's net income and cash on hand.

Task Box 4.1: Inves�ga�ng Opera�ng Ac�vi�es

Analyzing Industry Compe�tors, Part G

Review the Opera�ng Ac�vi�es sec�ons of the statements of cash flows for the two companies you chose to inves�gate in Chapter 2 (see Task Box 2.9 (h�p://content.thuzelearning.com/books/AUOMM622.14.1/sec�ons/sec2.3#task2.9) ). Answer the following ques�ons:

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1. What have been the primary line items that increased cash on hand? 2. What have been the primary line items that decreased cash on hand? 3. Which company do you think did a be�er job of genera�ng cash from its opera�ons? Why?

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This sec�on shows the cash ac�vi�es from the inves�ng sec�on of the company.

4.3 Inves�ng Ac�vi�es The Inves�ng Ac�vi�es sec�on of the statement of cash flows looks at what cash has been used to make improvements to the company's opera�ons or to grow the company. In some cases, this sec�on will show cash provided by inves�ng ac�vi�es, such as the sale of long-term assets. Line items found in this sec�on can include:

Purchase or sale of property, plant, and equipment Mergers or acquisi�ons Major improvements to exis�ng buildings Major upgrades to exis�ng factories and equipment Purchase or sale of marketable securi�es

Figure 4.5 shows the Inves�ng Ac�vi�es sec�on of the Best General Company statement of cash flows. Since the company's revenues are falling, it would not likely have the resources to spend on new inves�ng ac�vi�es. For this reason there were no major purchases or improvements in the current year.

Figure 4.5: Inves�ng ac�vi�es sec�on of the Best General Company statement of cash flows

Property, Plant, and Equipment

Property, Plant, and Equipment is o�en the first line item in the Inves�ng Ac�vi�es sec�on of the statement of cash flows. Best General Company shows no changes to its Property, Plant, and Equipment.

Changes in this sec�on would show the use of cash to buy new property, plant, or equipment. If the company sells property, plant, or equipment it already owns, the cash generated by the sale of these assets would be shown in this sec�on of the statement of cash flows as a posi�ve figure. For example, if Best General Company decides to invest money in a new store, the cash used for that investment would be shown in this sec�on of the statement as a nega�ve figure.

Managers likely would already be aware of major sales or purchases of property, plant, and equipment prior to the prepara�on of this statement, but they may not know the full cash impact un�l they see it listed here.

Investment in Assets

O�en, the next line that could be found in the Inves�ng Ac�vi�es sec�on is Investment in Assets, which is different from the Property, Plant, and Equipment account in that it shows the detail of other investment ac�vi�es to grow the company. For example, the company may invest cash for research and development of a new product line.

This can be cri�cal informa�on that reveals what types of investments a company is making to grow its business or expand into new business areas. Explana�ons for these expenditures would be found in the management's discussion and analysis, or in the notes to the financial statements. The company's investor rela�ons office can also provide more details about a line item on the company's financial statement. Best General Company does not show any investment in assets.

Marketable Securi�es

Like individual investors, companies do not want to sit on significant amounts of cash that are not earning a return, so they some�mes buy and sell marketable securi�es throughout the year. Generally, these transac�ons involve placing cash in a financial instrument that will provide a be�er return than a low-interest savings account.

Best General Company does not indicate investments in marketable securi�es, but many companies will show cash being held in marketable securi�es. Usually the financial management team will manage these investment ac�vi�es and be certain that cash is available for opera�ng ac�vi�es when needed.

Acquisi�ons and Disposi�ons

Some companies decide to grow their business by acquiring another company already opera�ng in the industry in which they want to expand. Other companies may decide they no longer want to con�nue opera�ons in a par�cular part of their business and decide to sell that part to another company. Occasionally, a company may sell off a major segment of its opera�ons to streamline the company. This could result in more cash taken in than laid out.

Acquisi�ons are purchases of another company. Disposi�ons are sales of a por�on of the assets of a company, such as the sale of a division or a factory.

When a company acquires another company, it usually uses cash as part of that purchase agreement. The value of other assets may also be impacted by an acquisi�on or disposi�on. For example, details about changes to other assets—such as inventory; marketable securi�es; property, plant, and equipment; intangible assets; and goodwill—are located in the notes to the financial statements. The notes also contain details regarding liabili�es acquired, such as accounts payable, other debt, and deferred taxes.

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Reading the details about acquisi�ons and dives�tures can provide insight into changes the company is making that might affect future opera�ons. Considering what the company is selling and what the company is buying can be par�cularly informa�ve. Reading through management's discussion and analysis of these en��es can provide addi�onal clues as to how the acquisi�ons will fit into the company's long-term plans.

The primary reason to review this sec�on of the statement of cash flows is to see how the company is managing its cash to buy, sell, or upgrade its assets. If the company shows significant cash expenditure in this sec�on, it indicates plans have been carried out to expand opera�ons or to make improvements to company opera�ons.

An important ques�on managers should seek to answer when reviewing this sec�on is whether the company is using most of its cash for investments to keep exis�ng factories opera�ng or whether it is using the cash to upgrade its assets in order to keep up with technology. Best General Company does not indicate any acquisi�ons or disposi�ons.

Task Box 4.2: Inves�ng Ac�vi�es

Analyzing Industry Compe�tors, Part H

Review the Inves�ng Ac�vi�es sec�ons for the two companies you have chosen to analyze. Answer these ques�ons:

1. Which company is using more cash to upgrade its facili�es? What types of upgrades is each company doing? 2. Is either company using cash to merge or acquire other companies? How are they using their cash for this purpose? 3. Is either company buying or selling marketable securi�es? Is this a significant por�on of their use of cash? Explain. 4. Is either company acquiring new businesses? Is either company selling por�ons of its business? How do you think these changes will affect the

company's opera�ons and its profitability in the future? Do you think these changes are good or bad for the company?

The Bo�om Line: Inves�ng Ac�vi�es

The bo�om line of the Inves�ng Ac�vi�es sec�on of the statement of cash flows shows the total amount of cash used for inves�ng ac�vi�es, and it will read "net cash used in inves�ng ac�vi�es." Some companies may have taken in more cash than they used. In that case, the bo�om line would be "net cash provided by inves�ng ac�vi�es."

However, if a manager sees a posi�ve number in this sec�on, it warrants a closer look. A company that sells off assets because it's having difficulty paying its bills is not enjoying strong performance. One sure sign that the company is having financial difficulty would be a nega�ve cash ou�low from opera�ons and a posi�ve cash inflow from inves�ng ac�vi�es. This would likely mean the company is not ge�ng enough cash from its opera�ons and is selling off assets to con�nue to exist. Once the company is out of assets to sell, it will likely go bankrupt.

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This sec�on of the statement of cash flows shows the inflow and ou�low of cash from the company's financing ac�vi�es.

4.4 Financing Ac�vi�es When a company needs a major influx of cash to expand opera�ons or fund its current opera�ons and it can't secure enough from opera�ng ac�vi�es, it will seek to raise money from outside sources. This might involve issuing stock to raise money from new investors or taking out a loan. Companies can also sell bonds, which are another form of debt, to raise cash. Any cash raised or invested related to these types of funding ac�vi�es can be found in the Financing Ac�vi�es sec�on of the statement of cash flows.

Figure 4.6 shows Best General Company's Financing Ac�vi�es sec�on of the statement of cash flows. This sec�on would show the proceeds from any new debt issued. It would also show short-term borrowings followed by repurchases of stock that has already been sold on the market, if the company made any of those transac�ons. Best General did not issue debt or repurchase stock, and reduced long-term debt and other non-current liabili�es. No dividends were paid to shareholders. Let's take a closer look at each of these types of transac�ons.

Figure 4.6: Financing ac�vi�es sec�on of the statement of cash flows for Best General Company

Common Stock Transac�ons

Common stock transac�ons can include cash raised from the issuance of new stock or cash used to buy back stock from investors. Best General Company showed no changes in cash from the sale or purchase of stock.

Managers would want to be aware of major new cash raised from new investors or a cash ou�low to buy back common stock held by investors. Both types of transac�ons will impact the cash available for ongoing opera�ons.

If the managers have significant holdings of common stock, such as through an employee compensa�on program, the value of their holdings will be impacted by common stock transac�ons. A new stock issue would increase the number of shares among which the profits must be split, which could lower the value of the stock held by managers. A buyback of stock being held by investors would decrease the number of shares among which profits must be split, which could raise the value of the stock held by managers.

Short-Term Borrowings

Companies also raise cash throughout the year using lines of credit and other types of short-term borrowings or loans. These types of short-term loans are for 90 days or less. Since cash is raised and cash is used throughout the year, the number found on the statement of cash flows is the net of these borrowings. Best General Company shows no change in the amount of its short-term loans.

Long-Term Debt

When companies need cash for periods of more than 12 months, such as a mortgage for the purchase of new property or a loan for the purchase of new equipment, cash raised from this new debt can be seen on this line item. Some�mes cash is raised by the issuance of new bonds, which will also be shown in the long-term debt sec�on of the statement of cash flows. Details about this new debt can o�en be found in the notes to the financial statement.

Cash Dividends Paid

Some companies pay out a por�on of their profits in cash to their shareholders. This payout of cash is called dividends. Best General Company did not pay out any cash dividends in the opera�ng period reported. See "New World of Financial Report Oversight" in this chapter for differences between U.S. and interna�onal companies' repor�ng of cash dividends paid.

New World of Financial Report Oversight

Cash dividends can appear in different sec�ons of the statement of cash flows, depending on whether a company is based in the United States or abroad. The U.S. GAAP require dividends paid out to shareholders be shown in the Financing Ac�vi�es sec�on of the statement of cash flows. Dividends received from the company's investments (such as stock owned in another company) are shown in the opera�ng ac�vi�es sec�on of the statement of cash flows.

The Interna�onal Financial Repor�ng Standards (IFRS) rules allow companies to show dividends in either the opera�ng ac�vi�es sec�on or the financing ac�vi�es sec�on, as long as the way they are shown is consistent as either opera�ng or financial ac�vi�es.

There is no �me frame for when the U.S. rules will converge with the interna�onal rules, but when reading financial statements from non-U.S. companies, look carefully for informa�on about dividends in both the opera�ng ac�vi�es and financial ac�vi�es sec�ons of the statement of cash flows. If the company paid out dividends, this can be a significant difference to consider when comparing cash flows.

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WorldCom filed for the largest bankruptcy in U.S. history a�er senior execu�ves falsely reported inflated cash flows.

Suzanne Plunke�/Associated Press

Consider This:

1. Review a statement of cash flow for a non-U.S. company and one for a U.S. company. 2. Do you see any differences in how the statement is shown interna�onally?

The Bo�om Line: Financing Ac�vi�es

The bo�om line of the Financing Ac�vi�es sec�on of the statement of cash flows is shown as "net cash used in financing ac�vi�es" if more cash was used than taken in or as "net cash provided by financing ac�vi�es" if more cash was taken in than used.

O�en, an older, well-established company will use the cash raised to reduce debt or buy back stock on the market. A younger company may show that it raised more cash from issuing new stock or taking a new debt.

Managers should review this sec�on to determine how much cash was raised by borrowing addi�onal funds and how much was raised by taking on new debt. If the company is substan�ally increasing its debt, this could be explained by the purchase of new assets to grow the company or it could be a sign that the company is having problems raising enough cash for opera�ons. By reviewing this sec�on in conjunc�on with the Opera�ng Ac�vi�es sec�on and the Inves�ng Ac�vi�es sec�on, a manager should be able to determine how the company's cash is being raised and how it is being invested. (See "World of Business" for cases that show why all three sec�ons are important to analyze when considering the financial health of a company.)

Task Box 4.3: Financing Ac�vi�es

Analyzing Industry Compe�tors, Part I

Compare the Financing Ac�vi�es sec�ons of the statements of cash flows for the two companies you have chosen. Answer the following ques�ons:

1. Are your companies using cash or raising cash from their financing ac�vi�es? 2. If a company is raising cash, what informa�on can you find in the management's discussion and analysis about the plans for this cash? 3. Are the companies buying back stock or issuing stock? How do they plan to use this cash? 4. Are the companies taking on more debt or paying down debt? If they are taking on more debt, how does the company plan to use this cash?

World of Business

Cash and Bankruptcy: WorldCom and Lehman Brothers

The statement of cash flows used to be the key statement for judging financial performance. That changed in 2002 when it was discovered that American telecommunica�ons giant WorldCom had hid expenses and inflated its cash flow by $3.8 billion. To make it look like it was taking in more cash from opera�ons, the company moved day-to-day expenses into the category of capitalized expenses. By doing this, WorldCom showed the use of that cash in the

Inves�ng Ac�vi�es sec�on of its statement of cash flows, rather than in the Opera�ng Ac�vi�es sec�on. WorldCom also "capitalized" these expenses by wri�ng them off over several years. Ul�mately, in 2002, this manipula�on resulted in the largest corporate bankruptcy in the history of the United States up to that �me.

However, this record was beaten in 2008 by both banking giant Washington Mutual, which lost billions because of its mortgage financing ac�vi�es, and financial services firm Lehman Brothers. Interes�ngly, Lehman Brothers did not hide its cash flow problem. Instead, it showed net income increasing each year, even though cash from opera�ons kept decreasing. For example, in 2007, net income was $4.19 billion, while cash from opera�ons was a nega�ve $45.6 billion. The company survived during that period by borrowing more each year to cover its cash needs. The Financing Ac�vi�es sec�on of the cash flow statement included this informa�on. (Thapa, 2007)

The lesson: Managers should not review solely the results from the Opera�ng Ac�vi�es sec�on to determine a company's cash flow. Rather, they should always be sure to look at all three sec�ons of a company's statement of cash flows for changes in cash.

Consider This:

1. What would you do if you discovered that the company at which you are employed was not accurately repor�ng cash flow? 2. Should banks that manage people's money face more scru�ny in their cash flow repor�ng?

The Bo�om Line for Cash Flows

A summary of cash inflows and ou�lows is shown in the bo�om sec�on of the statement of cash flows. Figure 4.7 shows this summary for Best General Company.

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The bo�om lines of a statement of cash flows reveal whether there is an increase or decrease in cash, followed by addi�onal detail regarding cash paid for interest or taxes.

Figure 4.7: Bo�om lines of the statement of cash flows for Best General Company

O�en managers will focus on this bo�om line and not carefully review the changes to cash in each of the three sec�ons: opera�ons, inves�ng, and financing. Managers must pay a�en�on to key changes in each of three sec�ons and not just look for the bo�om line in order to make decisions about the company's cash flows for future opera�ons. As discussed in each sec�on above, different accounts impact the inflow and ou�low of cash. Managers need to review the details of those accounts to further analyze any cash flow opportuni�es or problems.

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The chart summarizes the key changes in cash inflows and ou�lows for Best General Company for the year ended 2013.

If the value of a company's inventory decreases, the company can show the loss in the non-cash transac�ons sec�on of the statement of cash flows.

Fuse/Thinkstock

4.5 Analyzing a Statement of Cash Flows We discussed many ways to analyze the informa�on on the statement of cash flows within each sec�on of the statement. Now we will take a look at a way to summarize the net cash inflows and ou�lows and determine how a company is raising and using most of its cash. This is similar to the common-sized balance sheet and income statement we discussed in previous chapters. We will collect all line items that generated cash in one sec�on of this analysis and collect all items that used cash in the second sec�on. Then we will determine the percentage of cash raised and used by each type of ac�vity.

Figure 4.8 shows the results for Best General Company using the template described above.

Figure 4.8: Percentage of cash inflows and ou�lows for 2013 for Best General Company

To determine the percentage of cash inflows, we divide the cash inflows for each line item by the total cash inflows. To determine the percentage of cash ou�lows, we divide the cash used for each line item by the total cash ou�lows. For example, to determine the percentage of cash ou�lows for Accounts Payable at Best General Company, look at Figure 4.8, where the company shows a $500 ou�low of cash for Accounts Payable. The total for net cash ou�lows was $7,650. To find the percentage, divide $500 by $7,650. The percentage of cash ou�lows for the Accounts Payable account is 6.5%.

The purpose of this analysis is to determine the primary sources of cash inflow and ou�low by type of account. In most cases, the line item for net cash from opera�ng ac�vi�es will be zero in the ou�lows sec�on, but occasionally, if the net cash from opera�ng ac�vi�es is a nega�ve number, that means opera�ng ac�vi�es contributed to the ou�low of cash. If that occurs, the inflows sec�on will show zero cash from opera�ons.

Best General Company showed an increase of $3,450 for net cash from opera�ng ac�vi�es, so we include that in the Inflows of Cash sec�on.

A manager looking at this analysis would see that cash was used for building up inventories and paying down debt. No cash was used to increase revenues, even though not enough cash was generated from sales to cover the company's opera�ng expenses. Best General Company's budget commi�ee would need to address this major problem as part of budget planning for the next year. What ac�vi�es should the commi�ee recommend to improve cash generated from revenues? (The downloadable template we have developed can make it easier to answer this ques�on.)

In addi�on to showing cash inflows and ou�lows, some transac�ons do not include cash. The World of Business gives examples of non-cash transac�ons.

Task Box 4.4: Analyze Cash Flow Trends

Analyzing Industry Compe�tors, Part J

Use the downloadable template to analyze the cash flows of the two companies you have chosen. Compare the use of cash and the cash flow trends and answer these ques�ons:

1. Do both companies have a posi�ve or nega�ve cash flow from opera�ons? If not, why do you think that is so? 2. What are the primary uses of cash for each of your companies? 3. What trends do you see in the use of cash?

World of Business

Repor�ng Non-Cash Transac�ons

Some�mes at the bo�om of a statement of cash flows, managers will see a sec�on called non-cash transac�ons. The types of informa�on that could be shown here include:

Net change in the fair value of investments. For example, if inventory dropped in value, this loss in value would be shown here. If the company made a significant dona�on of assets, the value of that dona�on would be shown here. If the company borrowed money using a capital lease purchase arrangement, that transac�on's value would be shown here. If the company exchanged non-cash assets or liabili�es for other non-cash assets or liabili�es, details about the exchange would be shown here. For example, the acquisi�on of a company o�en includes non-cash assets or liabili�es.