DEPARTMENT OF BUSINESS AND INDUSTRIAL

MANAGEMENT

TERM ASSIGNMENT 2014-15

MANAGERIAL ACCOUNTING

FYMBA- SEM-I

SECTION-A

TOPIC: CASH FLOW FROM OPERATIONS

BY,

16: CHAWLA DIVYA

23: GANDHI SANI

44: LAPSIWALA MANSI

47: MAKWANA KALPESH

57: MODI NANCY

SUBMITTED ON -6TH DECEMBER, 2014

SUBMITTED TO – DR. NAMRTA KHATRI

BASIC OF CASH FLOW:-

Meaning:-

It shows the amount of cash generated and used by a company in a given period.

It is calculated by adding noncash charges (exp: depreciation) to net income after

taxes.

Cash flow can be attributed to a specific project, or to a business as a whole.

OBJECTIVES OF CASH FLOW STATEMENT

The objectives of cash flow statement are:

1) To ascertain the sources from activities (i.e., operating/investing/financing

activities) from which cash and cash equivalents were generated by an

enterprise.

2) To ascertain the uses by activities (i.e., operating/investing/financing activities)

for which cash and cash equivalents were used by an enterprise.

3) To ascertain the net change in cash or cash equivalents indicating the difference

between sources and uses from or by the three activities between the dates of

two Balance Sheets.

4) To tell how much cash come in during period, how much cash went out and what

the net cash flow was during the period.

5) To explain causes for changes in cash balance.

6) To identify financial needs and help in forecasting future cash flows.

CLASSIFICATION OF CASH FLOW:-

There are mainly three types of activities included into cash flow statement:

1. Operating Activities

2. Investing Activities

3. Financing Activities

1. Operating Activities:

Operating activities are the principal revenue producing activities of the

enterprise and other activities that are not investing or financing activities.

Operating activities include the production, sales and delivery of the company's

product as well as collecting payment from its customers. This could include

purchasing raw materials, building inventory, advertising, and shipping the

product.

Generally, changes made in cash, accounts receivable, depreciation, inventory

and accounts payable are reflected in cash from operations.

Cash flow is calculated by making certain adjustments to net income by adding

or subtracting differences in revenue, expenses and credit transactions

(appearing on the balance sheet and income statement) resulting from

transactions that occur from one period to the next. These adjustments are made

because non-cash items are calculated into net income (income statement) and

total assets and liabilities (balance sheet). So, because not all transactions

involve actual cash items, many items have to be re-evaluated when calculating

cash flow from operations.

For example, depreciation is not really a cash expense; it is an amount that is

deducted from the total value of an asset that has previously been accounted for.

That is why it is added back into net sales for calculating cash flow. The only time

income from an asset is accounted for in CFS calculations is when the asset is

sold.

Changes in accounts receivable on the balance sheet from one accounting period

to the next must also be reflected in cash flow. If accounts receivable decreases,

this implies that more cash has entered the company from customers paying off

their credit accounts - the amount by which AR has decreased is then added to

net sales. If accounts receivable increase from one accounting period to the next,

the amount of the increase must be deducted from net sales because, although

the amounts represented in AR are revenue, they are not cash.

2. Investing Activities:

Investing activities are the acquisition and disposal of long-term assets and other

investments not included in cash equivalents. These activities include

transactions involving purchase and sale of long term productive assets like

machinery, land, etc., which are not held for resale.

Changes in equipment, assets or investments relate to cash from investing.

Usually cash changes from investing are a "cash out" item, because cash is used

to buy new equipment, buildings or short-term assets such as marketable

securities. However, when a company divests of an asset, the transaction is

considered "cash in" for calculating cash from investing.

Operating Activities

Cash Inflows

cash sales

cash recieved from the debtors

cash receieved from commision and fees

Royalty

In Case of financial companies

Cash received for Interest and Dividends

Sale of Securities

Cash Outflows

Cash purchase

Payment to creditors

Cash operating expenses

Payment of Wages

Income Tax

In Case of financial companies

Cash paid for interest

Purchase of Securities

3. Financing activities

Financing activities are the activities that result in change in the size and

composition of the owner’s capital (including preference share capital in the case of

a company) and borrowing of the enterprise. Changes in debt, loans

or dividends are accounted for in cash from financing. Changes in cash from

financing are "cash in" when capital is raised, and they're "cash out" when dividends

are paid. Thus, if a company issues a bond to the public, the company receives cash

financing; however, when interest is paid to bondholders, the company is reducing

its cash.

The separate disclosure of cash flows arising from financing activities is important

because it is useful in predicting the claims on future cash flows by the providers of

funds.

Investing Activities

Cash Inflows

Sale of Fixed Assets

Sale of Investments

Interest received

Dividends received

Cash Outflows

Purchase of Fixed Assets

Purchase of Investments

Methods of calculating Operating Income

1. Direct Method: Reports operating cash flows as sources, uses of cash

2. Indirect Method: Reports operating cash by adjusting accrual net income to

cash flows.

Direct Method

The cash inflows and cash outflows are directly reported on the statement of cash

flows.

For instance, if cash received from customers as the cash effect of sales activities,

and cash paid to suppliers as the cash effect of cost of goods sold.

Income statement items that have no cash effect are simply not reported. Such as

depreciation expenses, gains and losses on the sale of assets , etc.

The direct method of presenting the statement of cash flows presents the specific

cash flows associated with items that affect cash flow. Items that typically do so

include:

Financing Activities

Cash Inflows

Issue of shares in Cash

Issue of Debentures in cash

Proceeds from Long-term borrowings

Cash Outflows

Payment of Loans

Redemption of preference shares

Cash Buy-back of Equity shares

Payment of Dividend

Payment of Interest

o Cash collected from customers

o Interest and dividends received

o Cash paid to employees

o Cash paid to suppliers

o Interest paid

o Income taxes paid

Performa:-

Particulars Amount

Cash Receipts from Customers xxx

Cash Paid to suppliers and employees Xxx

Cash generated from Operations Xxx

Income Tax Paid Xxx

Cash Flow before Extra-ordinary Items Xxx

Extra-ordinary items Xxx

Net Cash from Operating Activities (Direct Method) Xxx

Indirect Method

While preparing the Cash Flow Statement as per the Indirect Method, the Net

Profit/Loss for the period is used as the base and then adjustments are made for

items that affected the Income Statement but did not affect the Cash.

While preparing the Cash Flow Statement as per the Indirect Method, Non Cash

and Non Operating charges in the Income Statement are added back to the Net

Profits while Non-Cash & Non-Operating Credits are deducted to calculate the

Operating Profit before Capital Changes. The Indirect Method of preparing of

Cash Flow Statement is a partial conversion of accrual basis profit to Cash basis

profit. Further, necessary adjustments are made for Increase/Decrease

in Current Assets and Current Liabilities to obtain Net Cash Flows from

Operating Activities as per the Indirect Method.

Format of Cash Flows from Operating Activities – Indirect Method

Particulars Amount

Net Profit before Tax and Extra-ordinary items Xxx

Adjustments for

- Depreciation Xxx

- Foreign Exchange Xxx

- Investments Xxx

- Gain or Loss on Sale of Fixed Assets Xxx

- Interest Dividend Xxx

Operating Profit before Working Capital Changes Xxx

Adjustments for

- Trade and Other Receivables Xxx

- Inventories Xxx

- Trade Payable Xxx

Cash generated from Operations Xxx

- Interest Paid (xxx)

- Direct Taxes (xxx)

Cash before Extra-Ordinary Items Xxx

Deferred Revenue Xxx

Net Cash Flow from Operating Activities (Indirect Method) Xxx

Manipulation FROM cash flow (operations)

Reasons for Cash Flow Manipulation

1. Cash flow is often considered to be one of the cleaner figures in the financial

statements. (WorldCom, however, has proved that this isn't true.)

2. Companies benefit from strong cash flow in the same way that an athlete

benefits from stronger muscles - a strong cash flow means being more attractive

and getting a stronger rating. After all, companies that have to use financing to

raise capital, be it debt or equity, can't keep it up without exhausting

themselves.

3. The corporate muscle that would receive the cash flow accounting injection

is operating cash flow (OCF). It is found in the cash flow statement, which comes

after the income statement and balance sheet.

How the Manipulation Is Done?

1) Dishonesty in Accounts Payable

Companies can bulk up their statements simply by changing the way they deal with

the accounting recognition of their outstanding payments, or their accounts payable.

For Example

When a company has written a check and sent it to make an outstanding payment,

the company should deduct its accounts payable. While the "check is in the mail",

however, a cash-manipulating company will not deduct the accounts payable with

complete honesty and claim the amount in the operating cash flow (OCF) as cash on

hand.

2) Non-Operating Cash

A subtler steroid is the inclusion of cash raised from operations that are not related

to the core operations of the company.

Non-operating cash is usually money from securities trading, or money borrowed

to finance securities trading, which has nothing to do with business. Short-term

investments are usually made to protect the value of excess cash before the

company is ready and able to put the cash to work in the business's operations. It

may happen that these short-term investments make money, but it's not money

generated from the power of the business's core operations.

Therefore, because cash flow is a metric that measures a company's health, the cash

from unrelated operations should be dealt with separately. Including it would only

distort the true cash flow performance of the company's business activities. GAAP

requires these non-operating cash flows to be disclosed explicitly. And you can

analyze how well a company does simply by looking at the corporate cash flow

numbers in the cash flow statement.

3) Questionable Capitalization of Expenses

Also a subtle form of doping, we have the questionable capitalization of expenses.

For Example

A company has to spend money to make products. The costs of production come out

of net income and therefore operating cash flow. Instead of taking the hit of an

expense all at once, companies capitalize the expense, creating an asset on the

balance sheet, in order to spread the expense out over time - meaning the company

can write off the costs gradually. This type of transaction is still recorded as a

negative cash flow on the cash flow statement, but it is important to note that when

it is recorded it is classified as a deduction from cash flow from investing

activities (not from operating cash flow).

Certain types of expenditures - such as purchases of long-term manufacturing

equipment - do warrant capitalization because they are a kind of investing activity.

The capitalization is questionable if the expenses are regular production expenses,

which are part of the operating cash flow performance of the company. If the regular

operating expenses are capitalized, they are recorded not as regular production

expenses but as negative cash flows from investment activities. While it is true that

the total of these figures operating cash flow and investing cash flow - remain the

same, the operating cash flow seems more muscular than that of companies that

deducted their expenses in a timely fashion.

Basically, companies engaging in this practice of capitalizing operating expenses are

merely juggling an expense out of one column and into another for the purpose of

being perceived as a company with strong core operating cash flow. But when a

company capitalizes expenses, it can't hide the truth forever. Today's expenses will

show up in tomorrow's financial statements, at which time the stock will suffer the

consequences.

4) Stretching Out Payables

The simplest thing that companies can do to improve reported operating cash flow

is to slow down the rate of payments to their vendors.

Extending out vendors used to be interpreted as a sign that a company was

beginning to struggle with its cash generation. Companies now “spin” this as a

prudent cash-management strategy. Another consequence of this policy is to boost

the reported growth in cash flows from operations. In other words, reported

operating cash flows can be improved due solely to a change in policy to slow the

payment rate to vendors. If analysts or investors expect the current period

improvement to continue, they may be mistaken; vendors will eventually put

increasing pressure on the company to pay more timely. Therefore, any benefit may

be unsustainable or, at minimum, any year-over-year improvement in operating

cash flow may be unsustainable.

The extension of payables can be identified by monitoring day’s sales in payables

(DSP).

This metric is calculated as the end-of-period accounts-payable balance divided by

the cost of goods sold and multiplied by the number of days in the period.

As DSP grow, operating cash flows are boosted.

For Example

General Electric Corporation began stretching out its payables in 2001 and therefore

received boosts to operating cash flow. however, that while the company received a

significant benefit to cash flows from operations in 2001, that benefit began to slow

in subsequent periods, indicating that GE will probably be unable to continue to fuel

growth in operating cash flow using this method. Interestingly, GE modified some

executive compensation agreements to include cash flow from operations as a

metric on which management is evaluated.

5) Financing of Payables

A more complicated version of stretching out payables is the financing of payables.

This occurs when a company uses a third-party financial institution to pay the

vendor in the current period, with the company then paying back the bank in a

subsequent period.

For Example

An arrangement between Delphi Corporation and General Electric Capital

Corporation shows how seemingly innocuous ventures can affect operating cash

flows. The arrangement allowed Delphi to finance its accounts payable through GE

Capital. Specifically, GE Capital would pay Delphi’s accounts payable each quarter. In

return, Delphi would reimburse GE Capital the following quarter and pay a fee for

the service.

This agreement provided Delphi with a means to change the timing of its operating

cash flows. In the first quarter of the venture, Delphi did not have to expend any

cash with respect to accounts payable to vendors. The impact to operating cash

flows can be seen in Delphi’s accounting for the agreement with GE Capital. After GE

Capital paid the amounts due from Delphi to its vendors, Delphi reclassified these

items from accounts payable to short-term loans due to GE Capital. Delphi did this in

a quarter in which cash flows were seasonally strong and it had access to the

accounts-receivable securitization facilities. The reclassification resulted in a

decrease to operating cash flow in that quarter, and an increase in financing cash

flows. In the subsequent quarter, when Delphi paid GE Capital, the cash outflow was

accounted for as a financing activity because it was a repayment of a loan. Normally,

cash expenditures for accounts payable are included in operating activities.

Therefore, because of the arrangement, Delphi was able to manage the timing of

reported operating cash flows each period because the timing and extent of the

vendor financing (and offsetting receivables securitizations) was at the discretion of

company management.

Another example shows that the accounting profession has been slow to adapt to

these types of transactions. During 2004, three companies in the same industry—

AutoZone, Pep Boys, and Advance Auto Parts—all financed payments to vendors

through a third-party financial institution. In other words, similar to Delphi above,

the financial institution paid the vendors on behalf of the respective automotive

company. Subsequently, the company paid back the bank, thereby slowing down its

rate of payment to the vendors and boosting its operating cash flow. While each of

these auto parts companies used a similar process for financing payables, each

reflected it differently on its cash flow statement. Interestingly, two of these

companies had the same auditor. This disparity in accounting treatment made

analysts’ comparisons of free cash flow yields for each of these companies

irrelevant.

6) Selling Accounts Receivable/ Securitizations of Receivables

Another way a company might increase operating cash flow is by selling off

its accounts receivable. This is also called securitizing.

The agency buying the accounts receivable pays the company a certain amount of

money, and the company passes off to this agency the entitlement to receive the

money that customers owe. The company therefore secures the cash from their

outstanding receivables sooner than the customers pay for it. The time between

sales and collection is shortened, but the company actually receives less money than

if it had just waited for the customers to pay. So, it really doesn't make sense for the

company to sell its receivables just to receive the cash a little sooner - unless it is

having cash troubles, and has a reason to cover up a negative performance in the

operating cash flow column.

7) Tax Benefits from Stock Options

Most companies currently follow Accounting Principles Board (APB) Opinion 25,

which generally allows companies to avoid recording stock options as an expense

when granted. Current IRS rules do not allow a company to take a deduction on its

tax return when options are granted. At the time the stock option is exercised,

however, the company is permitted to take a deduction on its tax return for that

year reflecting the difference between the strike price and the market price of the

option. On the external financial statements reported to investors, that deduction

reduces (debits) taxes payable on the balance sheet, with the corresponding credit

going to increase the equity section (additional paid-in-capital).

A question developed over how to classify this tax benefit (reduction of the taxes

payable) on the cash flow statement. Some companies had been including it as an

add back to net income in the operating section of the cash flow statement; others

included it as a financing activity. FASB’s Emerging Issues Task Force (EITF) Issue

00-15, released in July 2000, specifically indicated that a reduction in taxes payable

should, if significant, be shown as a separate line item on the cash flow statement in

the operating section (i.e., as a source of cash). [SFAS 123(R), Share-Based Payment,

which requires options to be expensed, also relegates the excess tax benefit to the

financing section of the cash flow statement. SFAS 123(R) takes effect for fiscal years

beginning after June 15, 2005.] If the company does not disclose the tax benefit in

the operating section or in the statement of changes in stockholders equity, then

EITF 00-15 provided that the company should disclose any material amounts in the

notes to the financial statements. The tax benefit is sometimes disclosed only in the

annual statement of stockholders equity, rather than as a separate line item in the

operating section of the cash flow statement for investors to analyze.

To the extent that operating cash flow is affected by a growing impact from the tax

benefit on stock options, an investor should question whether the reported

operating cash flow growth is in fact sustainable and is indicative of improved

operations. In fact, the boost to operating cash flow is often greatest in a period

when the stock price has increased. In other words, when the sto ck is performing

well, more stock options are exercised, resulting in a higher tax benefit, which is

included as a source of operating cash flow, implying improving growth of operating

cash flow. Because companies in the technology sector use stock options to a higher

degree, these entities may require more-careful scrutiny. (This is an issue, however,

only when a company has taxable income and the taxes that it would have paid are

avoided by this tax benefit. If a company has a loss, there is no boost to o perating

cash flow.) Analysts and investors should thoroughly review the cash flow

statement, the stockholders equity statement, and the notes to the financial

statements to glean the volume of options exercised during the period, and the

related tax benefit included as a source of operating cash flow.

8) Stock Buybacks to Offset Dilution

A second issue related to stock options that affects reported cash flows is the

buyback of company stock. A large number of companies have, in recent periods,

been buying back their own stock on the open market. In a majority of cases, this

activity is due to stock-option activity. Specifically, as stock prices generally

increased in 2003, many of those who held stock options exercised those relatively

cheap options. If companies did nothing to offset the larger number of outstanding

shares that existed as a result of the growing number of in-the-money options,

earnings per share would be negatively affected. Management of such companies

therefore face a choice: They can allow earnings per share to be diluted by the

growing share count or they can buy back company stock to offset that dilution.

From an accounting standpoint, the impact of options on the income statement is

usually minimal, as discussed above. On the cash flow statement, the tax benefit of

option exercises is a source of operating cash flow, benefiting those companies

whose option exercises grow. Cash expended by a company for the buyback of

corporate stock, however, is considered a financing activity on the cash flow

statement. Consequently, as option exercises grow, so does the boost to operating

cash flows for the tax benefit, but the outflows for stock buybacks to offset dilution

of earnings are recorded in the financing section of the cash flow statement.

Interestingly, as a company’s stock price rises, more options are generally exercised

and the company must buy back more stock at the ever-higher market prices. In

some cases, the entire amount of cash flow generated by operations in recent

periods could be expended to buy back company stock to offset the dilution from in-

the-money options. Therefore, when analyzing the true earnings power of a

company as measured by cash flows, it is important to consider the cash expended

to buy back stock to offset dilution. This cash outflow should be subtracted from the

operating cash flow in order to calculate the true free cash flow the company

generated in the period in question.

9) Other Means

Many other means exist by which companies can influence the timing or the

magnitude of reported free cash flows. Increasing the use of capital lease

transactions as a way to acquire fixed assets obfuscates free cash flow because

capital expenditures may be understated on a year-over-year basis. The accounting

for outstanding checks and financing receivables are additional examples. In fact,

General Motors and others have restated prior years’ reported cash flow results in

order to reflect the SEC’s increased scrutiny of finance receivables. The restatement

amounted to a downward revision of almost half of the reported operating cash

flow.

Some companies have pointed analysts toward different metrics, such as operating

cash flows, which are believed to be a more transparent indicator of a company’s

performance. The quality of a company’s cash flows must be assessed, as highly

motivated and intelligent management teams have created new ways to obfuscate

the true picture of a company’s operations. Auditors must be aware of the new focus

by users of financial statements on operating cash flows, and adjust their work

accordingly in order to provide the most value to the public.

How to Detect these Frauds:

Key methods (These should be part of your process for analyzing companies!):

1. Track Days’ Payables Outstanding, Days’ Sales Outstanding and Days’ in

Inventory over time and note apparent shifts in payment policies. These three items

are used to calculate the Cash Conversion Cycle, which is an important metric for

many businesses and should be calculated and tracked.

2. Track the different line items on the Statement of Cash Flows over time, and note big

swings. It may help to adjust for swings to get a clearer picture of the free cash flow

that the company generates in a sustainable manner.

3. Watch for swings in soft liabilities like “other payables” that might indicate the

company is pushing tax payments or payroll forward.

4. Watch for new disclosures about Prepayments (“due to an increase in customer

prepayments”) related to the discussion of Accounts Receivable increases (in the

notes to the Statement of Cash Flows).

5. Watch for disclosures about offering discounted terms for early payment. This will

also affect the gross margin, as these discounts would affect COGS, so you might

uncover this shenanigan by investigating changes in the gross margin.

Summary

Whether it is the world of sports or the world of finance, people will always find

some way to cheat; only a paralyzing amount of regulation can ever remove all

opportunities for dishonest competition and business requires reasonable

amounts of operating freedom to function effectively. Not every athlete is cycling

anabolic steroids, just as many companies are honest on their financial

statements. That said, the existence of steroids and dishonest accounting

methods mean that we have to treat every gold medalist and every company's

financial statement with the proper amount of scrutiny before we accept them.

Bibliography

1. http://www.investopedia.com/exam-guide/cfa-level-

1/financial-statements/cash-flow-direct.asp

2. http://www.accountingtools.com/cash-flows-direct-method

3. http://accountingexplained.com/financial/statements/cash-

flow-operating-activities-direct-method