Financial AccountingA Decision-Making Approach, 2nd Edition

King, Lembke, and Smith

John Wiley & Sons, Inc.

Prepared byDr. Denise English,

Boise State University

*

After reading Chapter 3, you should be able to:

1. Describe the elements of cash flow and the importance of cash flow information.

2. Explain the importance of forecasting future cash flows.

3. Explain what is meant by the cash cycle and describe some important aspects of cash management.

4. Explain why internal control over cash is important and describe some aspects of good cash control.

5. Describe how cash flows are reported.

6. Demonstrate the effects of interest on cash flow and explain what is meant by the time value of money and why it is important.

7. Compute future values and present values of expected cash flows and use these computations for decision making.

CHAPTER THREE

UNDERSTANDINGCASH FLOWS

Got Cash?

Cash flows are receipts or payments of cash.

They arise from three basic types of activity:1) Operating cash flows relate to primary operations, such as

receipts from customers and payments to suppliers.

2) Investing cash flows relate to the company’s investments in the assets it needs to operate, such as purchasing and disposing of equipment used in operations.

3) Financing cash flows relate to the company’s acquiring the cash needed to be able to operate and invest, such as borrowing long-term monies, issuing shares of ownership, and distributing dividends to shareholders.

Got Cash?

Five aspects of cash flow are important:

1) Where is cash coming from (source) or where is it going to (use), and why (purpose)?

2) How much is the cash inflow or outflow?

3) Is the cash flow recurring?

4) When will the cash flow occur?

5) Will the cash flow affect some other cash flow?

Business Cash Flows

InflowRecurring

InflowInfrequent

InflowInfrequent

OutflowRecurring

OutflowInfrequent

OutflowInfrequent

Cash Pool

Operations(sales)

Investing(sell old truck)

Financing(bank loan)

Operations(expenses)

Investing(buy new truck)

Financing(repay loan)

EXHIBIT 3-1

“To Coin a Phrase . . .”

Cash Forecasts:

estimates of the amounts and timing of future cash flows.

Solvency:

an entity’s ability to pay its debts when due.

Liquidity:

an entity’s ability to have cash available when needed.

Forecasting Cash Inflows

1) Revenue forecasts– consider trends in customer preferences, economy,

cyclical and seasonal factors, competition, technology

2) Cash generated from Sales– including cash collected from accounts receivable

3) Nonrevenue cash inflows– contingencies such as lawsuits pending– disposals of assets– borrowings

Forecasts of Cash Outflows

1) Understand level of operations and cost structure concepts of the organization.

2) Recurring cash outflows

--for a level of operations assumed, what fixed andvariable costs are incurred?

3) Infrequently recurring cash outflows

--replacement of old equipment--repayment of borrowings--uninsured losses--litigation losses

Evaluating Cash Management

Cash management focuses on the way in which cash is employed within an organization

Because of the time value of money, – available cash should be employed as much as

possible.– Cash collections should occur as quickly as possible.– Cash payments should not be paid out until necessary.

Because of its desirability, proper safeguards must be in place to protect cash.

The Cash Cycle EXHIBIT 3-5

IOUCash

InventoryReceivables

The Cash Cycle

For a typical merchandising company:1) invests cash in inventory

2) sells goods to customers

3) receives customers’ promises to pay

4) (later) collects customers’ payments.

How long is the cash cycle for:

- a hot dog stand?

- a home construction company?

- a manufacturer of airplanes?

IOU

Efficient Employment of Cash and Credit

1) Be aware of expected cash needs and flows. Keep only enough necessary cash available.

2) Invest excess cash in marketable securities or other investments easily convertible to cash.

3) Use credit carefully; exchange high-rate interest for low-rate interest and use interest-free debt when possible.

4) Borrow funds by utilizing lines of credit, only when related fees are less than the interest or investment revenues that would be lost by having excess cash available.

Internal Control Over Cash

Risks:

1) Cash is highly desirable.

2) Cash is easy to hide.

3) Cash is easy to convert to personal use.

4) Cash doesn’t grow on trees.

Internal Controls over Cash

Controls:

1) Provide physical safeguards over cash

- deposit cash receipts daily- keep cash on hand at a minimum and under lock and key

- make someone accountable for cash on hand

2) Separate duties related to handling and accounting for cash

- separate custody of and accounting for cash- separate cash receipts and cash payments responsibilities

- cash-handling employees should be bonded

Internal Controls over Cash (continued)

Controls (continued):3) Require appropriate documentation and authorization

- make payments by check (except for very small expenses)

- separate authorizing, preparing, signing, and mailing checks

- prepare a list of daily cash receipts (or cash register record)

- reconcile cash receipts list with bank deposit daily

- never make cash payments from cash receipts

4) Reconcile all bank accounts regularly- performed by someone independent of cash handling and cash accounting

5) Audit all cash balances and related records.

The Cash Flow Statement

The Cash Flow Statement is one of four required financial statements. It helps answer questions such as:

-- Are the major sources and uses of cash consistent with the competition?

-- Do the company’s operations generate sufficient cash to sustain the company on a long-run basis?

-- What are the major uses of the company’s cash, and what does this imply for future cash needs?

-- Are the company’s sources of cash sufficient to provide cash to pay off maturing debt and provide cash distributions to owners?

Cash Flow Sources and Uses

Nature of Activity Type of Cash Flow Source/Use

Operations Collections from customers SourceInterest income SourcePayments to suppliers UsePayment of wages UsePayment of rent UsePayment of interest Use

Investing Purchase of building UsePurchase of equipment UseInvestment in securities UseSale of old equipment SourceSale of investment securities Source

Financing Investment by owners SourceLoans from bank SourceDistribution of profits to owners UseRepayment of loan Use

Decisions and the Timing of Cash Flows

Would you rather have $1,000 now or a year from now? The time value of money plays a central role in both

personal and business decisions. Interest reflects the cost of money. It is the “rent” paid

for the temporary use of money. The rate expressing the time value of money is also

known as the discount rate.

?

Determining Future Values

The way in which a sum of money grows as it earns interest can be expressed using the following notation:

pv = a present value or current sum of money

fv = a future value or an amount at some time in the future

r = the relevant interest rate (or discount rate)

i = an amount of interest; equal to r times the amount on which interest is being earned

n = the number of periods during which an amount earns interest

Determining Future Values

$1,000 set aside to save for a nice vacation after graduation would accumulate at the end of one year as follows:

$1,050 = $1,000 + ($1,000 x .05)

$1,050 = $1,000 + $50

where:

pv = $1,000

r = 5%

i = $50 (or pv x r)

n = 1 year

Determining Future Values

With i equal to (pv x r ), then:

fv = fv + (pv x r )

fv = pv x (1+r )

Using our savings account example:

fv = $1,000 x (1+.05) = $1,050

To determine an amount at the end of the 2nd year, multiply the amount at the end of the first year by ( 1 + r ):

fv = pv (1 + r ) ( 1 + r )

Restated, this is:

fv = pv ( 1 + r ) 2

Determining Future Values

For each additional year that the original amount and the earned interest remains in the savings account, it grows by r and is equal to the amount at the beginning of the year multiplied by ( 1 + r ). If the original amount earns interest for n periods, the future amount is:

fv = pv ( 1 + r )n

Determining Future Values

The Role of Compounding

Compounding: the process of computing interest in future periods on both the principal and the previously computed interest.

Interest is stated on an annual basis unless otherwise indicated.

The stated (nominal) rate of interest does not consider compounding.

The effective (yield) takes into account the effect of compounding (APR or APY).

Determining Present Values

If a future value can be determined as:

fv = pv (1 + r )n

The present value of a known future amount can be determined by dividing both sides of the equation by (1 + r )n and deriving:

pv = fv / (1 + r )n

Determining Present Values

If we wanted to know what to invest today in order to accumulate $10,000 (fv) at the end of 3 years (n), at an annual interest rate of 5 percent (r), we would use the formula:

pv = fv / (1 + r )n

Or,

?? = $10,000 / (1 + .05)3 = $8,638.

Multiple Cash Payments/Receipts

A series of payments is just a single payment made a number of times.

Each single payment can be analyzed individually using standard present and future value concepts, and the results summed.

When all payments in a series of cash flows are the same and are made at equal intervals, the stream of payments is called an annuity.

Future Value of Multiple Payments

Joe wants to know how much he’ll have in 4 years if he sets aside $4,000 at the end of each year while earning 6% on his money. (Hint: sum the individual future values.)

First payment $4,000 x (1.06)3 = $ 4,764Second payment $4,000 x (1.06)2 = $ 4,494Third payment $4,000 x (1.06)1 = $ 4,240Fourth payment $4,000 x 1 = $ 4,000

----------- Total $ 17,498

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Present Value of Multiple Payments

Irma’s grandfather writes her a check today to fund her college tuition of four $10,000 tuition payments each year starting one year from today. How much should the check be, assuming 4% interest? (Hint: sum the individual present values.)

First tuition payment $10,000 / (1.04)1 = $ 9,615 Second tuition payment $10,000 / (1.04)2 = $ 9,246 Third tuition payment $10,000 / (1.04)3 = $ 8,890 Fourth tuition payment $10,000 / (1.04)4 = $ 8,548

------------ Total $ 36,299

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Present Value of Multiple Payments

If Irma expected her tuition to increase at the rate of 10 percent per year instead of remaining constant, what should be the amount of the check? (Hint: again sum the individual present values.)

First tuition payment$10,000 / (1.04)1 = $ 9,615 Second tuition payment $11,000 / (1.04)2 = $ 10,170 Third tuition payment $12,100 / (1.04)3 = $ 10,757 Fourth tuition payment $13,310 / (1.04)4 = $ 11,377

------------Total $ 41,919

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Using Present and Future Values

Appendix B provides four tables to facilitate present and future value computations. These tables simply summarize the computations used earlier and incorporate the results. Those four tables are:

1. Future value of a single amount2. Present value of a single amount3. Future value of an annuity (multiple equal payments)4. Present value of an annuity (multiple equal payments)

Which table to use?

Are you trying to find:A current amount--use a present value table

A future amount--use a future value table

Are you dealing with:A single payment--use a single amount table

Multiple equal payments--use an annuity table

If multiple payments are unequal:Treat each payment as a single payment and sum the results.

Present value of a single amount

You need $12,000 to go on an around the world cruise in 5 years and want to know how much to set aside now at 4 percent interest. You could calculate:

pv = $12,000 / (1.04)5 = $9,863.

Or, use Table 2 in Appendix B for the present value of a single amount factor (1 / (1+r)n) where n = 5 and r = 4%:

pv = $12,000 x .82193 = $9,863.

Future value of a single amount

If you deposited $9,863 in the bank today for your cruise, how much would you have at the end of five years (it should be $12,000!)? You could compute:

fv = $9,863 x (1.04)5 = $12,000.

Or, use Table 1 in Appendix B for the future value of a single amount factor (1+r)n where n = 5 and r = 4%:

fv = $9,863 x 1.21665 = $12,000.

Present Value of Multiple Payments

Congratulations! You won the National Publishers’ lottery of $10 million dollars to be paid out in 25 equal annual installments. National Publishers needs to know how much to deposit to pay your prize.Their bank guarantees a rate of 5%. Using Table 4 in Appendix B, extract the factor for 25 payments at 5 percent and compute the present value as follows:

($10,000,000 / 25) x 14.09394 = $5,367,576.

Equal Payments Plus a Lump Sum

National Publishers’ informs you that the payout will be $200,000 a year for 24 years, starting one year from today, and the balance of $5,200,000 to be paid at the end of the 25th year. How much must National Publishers’ set aside now if their bank guarantees 5%?

Present value of the annuity: $200,000 x 13.79864 = $ 2,759,728 Present value of the lump sum: $5,200,000 x .29530 = $ 1,535,560 ---------------- Total present value $ 4,295,288

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Decisions and the Time Value of Money

Managers use time-value-of-money techniques when making investment decisions such as major purchases of new plants and equipment.

Investors and Creditors use time-value-of-money techniques to assess the amounts, timing, and likelihood of future cash flows associated with their investment or loan.

The usefulness of time-value-of-money techniques depends on being able to accurately forecast cash flows and determining the appropriate interest rate to use.

Appendix 3-1

Periodic bank reconciliations are an important internal control over cash.

The purpose of a bank reconciliation is to determine why there is a difference between the bank statement cash balance and the balance of cash in the accounting records.

Once differences are identified, eachone can be dealt with appropriately.

Reconciliation of Bank Accounts

Understanding a Bank Reconciliation

Items that might cause differences between the bank balance and the balance in the accounting records:

1) Checks outstanding--checks written and recorded in the accounting records which have not yet cleared the bank.

2) Deposits in transit--deposits made at the bank (perhaps after business hours) which have been recorded in the accounting records but have not yet been recorded by the bank.

3) Bank charges--Bank fees often deducted automatically that have been recorded by the bank but have not yet been recorded in the company’s accounting records.

Understanding a Bank Reconciliation (cont’d)

Items that might cause differences between the bank balance and the balance in the accounting records (continued):

4) Automatic deposits or withdrawals--amounts collected from customers or paid to vendors and suppliers automatically each month that have been recorded by the bank but not yet recorded in the accounting records.

5) NSF checks--customers checks deposited by the business for which payment has been refused by the issuer’s bank because of insufficient funds in that account. The checks are returned to the depositor and the amounts deducted from its account.

Understanding a Bank Reconciliation (continued)

Items that might cause differences between the bank balance and the balance in the accounting records (continued):

6) Errors--the bank could erroneously pay a check on another customer’s account or fail to record a deposit correctly. The company could also record a deposit or payment incorrectly in their own records.

7) Fraud or misappropriation of funds--discrepancies in deposits and altered or unrecorded checks could surface while comparing the accounting records with the bank statement.

Preparing a Bank Reconciliation

1) Examine the bank statement to identify items such as bank charges, automatic collections and payments, and NSF checks.

2) Determine which checks have been issued and are still outstanding.

3) Determine the amount of any deposits in transit.

4) Determine any unexplained differences.

5) Compare individual items on the bank statement with the accounting records to explain any remaining differences.

Bank Reconciliation Format

Balance per bank

+ Deposits in transit

- Outstanding checks

+/- Errors made by the bank

-----------------------------

Correct cash balance =

=================

Balance per accounting records:

+ Automatic deposits

- Automatic payments

- Bank service charges/fees

- NSF checks previously deposited

+/- Errors made by the company

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Correct cash balance

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Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

Copyright © 2001 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.

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