Professional Documents
Culture Documents
I. Introduction
Components and Relationships Between the Financial Statements
It is important to understand that the income statement, balance sheet and cash
flow statement are all interrelated.
The income statement is a description of how the assets and liabilities were utilized
in the stated accounting period. The cash flow statement explains cash inflows and
outflows, and will ultimately reveal the amount of cash the company has on hand;
this is reported in the balance sheet as well.
We will not explain the components of the balance sheet and the income statement
here since they were previously reviewed.
Figure 6.13: The Relationship between the Financial Statements
Though these items are typically not included in the statement of cash flow, they
can be found as footnotes to the financial statements.
Under
U.S. and ISA GAAP, the statement of cash flow can be presented by means of two
ways:
1. The indirect method
2. The direct method
The Indirect Method
The indirect method is preferred by most firms because is shows a reconciliation
from reported net income to cash provided by operations.
Calculating Cash flow from Operations
Here are the steps for calculating the cash flow from operations using the indirect
method:
1. Start with net income.
2. Add back non-cash expenses.
o
The following example illustrates a typical net cash flow from operating activities:
5,000
(50,00
0)
(45,00
0)
Here's the calculation of the cash flows from financing using the indirect method:
Cash collections are the principle components of CFO. These are the actual
cash received during the accounting period from customers. They are defined
as:
Formula 6.7
Cash payment for purchases make up the most important cash outflow
component in CFO. It is the actual cash dispersed for purchases from
suppliers during the accounting period. It is defined as:
Formula 6.8
for purchases = cost of goods sold + increase (or - decrease) in inventory + decrease (or - increase
for operating expenses = operating expenses + increase (or - decrease) in prepaid expenses + dec
rued liabilities
Cash interest is the interest paid to debt holders in cash. It is defined as:
Formula 6.10
interest expense - increase (or + decrease) interest payable + amortization of bond premium (or
Cash payment for income taxes is the actual cash paid in the form of
taxes. It is defined as:
Formula 6.11
w from investing and financing are computed the same way it was calculated under the indirect me
The diagram below demonstrates how net cash flow from operations is derived
using the direct method.
Formula 6.12
ow from operating activities - net capital expenditures (total capital expenditure - after-tax procee
The FCF measure gives investors an idea of a company's ability to pay down debt,
increase savings and increase shareholder value, and FCF is used for valuation
purposes.
Free Cash Flow to the Firm (FCFF)
Free cash flow to the firm is the cash available to all investors, both equity and debt
holders. It can be calculated using Net Income or Cash Flow from Operations (CFO).
The calculation of FCFF using CFO is similar to the calculation of FCF. Because FCFF
is the cash flow allocated to all investors including debt holders, the interest
expense which is cash available to debt holders must be added back. The amount of
interest expense that is available is the after-tax portion, which is shown as the
interest expense multiplied by 1-tax rate [Int x (1-tax rate)]. .
This makes the calculation of FCFF using CFO equal to:
FCFF = CFO + [Int x (1-tax rate)] FCInv
Where:
CFO = Cash Flow from Operations
Int = Interest Expense
FCInv = Fixed Capital Investment (total capital expenditures)
This formula is different for firm's that follow IFRS. Firm's that follow IFRS would not
add back interest since it is recorded as part of financing activities. However, since
IFRS allows dividends paid to be part of CFO, the dividends paid would have to be
added back.
The calculation using Net Income is similar to the one using CFO except that it
includes the items that differentiate Net Income from CFO. To arrive at the right
FCFF, working capital investments must be subtracted and non-cash charges must
be added back to produce the following formula:
FCFF = NI + NCC + [Int x (1-tax rate)] FCInv WCInv
Where:
NI = Net Income
NCC = Non-cash Charges (depreciation and amortization)
Int = Interest Expense
FCInv = Fixed Capital Investment (total capital expenditures)
WCInv = Working Capital Investments
Free Cash Flow to Equity (FCFE), the cash available to stockholders can be derived
from FCFF. FCFE equals FCFF minus the after-tax interest plus any cash from taking
on debt (Net Borrowing). The formula equals:
FCFE = FCFF - [Int x (1-tax rate)] + Net Borrowing
The Auditor
An audit is a process for testing the accuracy and completeness of information
presented in an organization's financial statements. This testing process enables an
independent Certified Public Accountant (CPA) to issue what is referred to as "an
opinion" on how fairly a company's financial statements represent its financial
position and whether it has complied with generally accepted accounting principles.
Note: Only independent auditors (CPAs) can produce audited financial statements. That is, the com
members,
staff and their relatives their relationship with the company compromises their independence.
The audit report is addressed to the board of directors as the trustees of the
organization. The report usually includes the following:
the financial statements, including the balance sheet, income statement and
statement of cash flows
In addition to the materials included in the audit report, the auditor often prepares
what is called a "management letter" or "management report" to the board of
directors. This report cites areas in the organization's internal accounting control
system that the auditor evaluates as weak.
What Does the Auditor Do?
The auditor will request information from individuals and institutions to confirm:
bank balances
contribution amounts
contractual obligations
physical assets
board minutes
interview key personnel and read the procedures manual, if one exists, to
determine whether the organization's internal accounting control system is
adequate
The auditor usually spends several days at the organization's office looking over
records and checking for completeness.
Auditor Responsibility
Auditors are not expected to guarantee that 100% of the transactions are recorded
correctly. They are required only to express an opinion as to whether the financial
statements, taken as a whole, give a fair representation of the organization's
financial picture. In addition, audits are not intended to discover embezzlements or
other illegal acts. Therefore, a "clean" or unqualified opinion should not be
interpreted as assurance that such problems do not exist.
The standard auditor's opinion contains three parts and states that:
the preparation of the financial statements are the responsibility of management,
and that the auditor has performed an independent review.
Generally accepted auditing procedures were followed, providing reasonable
assurance that the statements do not contain any material errors.
The auditor is satisfied that the statements were prepared in accordance with
accepted accounting procedures and that any assumptions or estimates used are
reasonable.
An unqualified opinion indicates that the auditor believes that the statements are
free from any material errors or omissions
The Qualified Opinion
A qualified opinion is issued when the accountant believes the financial statements
are, in a limited way, not in accordance with generally accepted accounting
principles. A qualified option may be issued if the auditor has concerns about the
going-concern assumption of the company, the valuation of certain items on the
balance sheet or some unreported pending contingent liabilities.
An adverse opinion is issued if the statements are not presented fairly or do not
conform to generally accepted accounting procedures.
Internal Controls
Under U.S. GAAP, the auditor must provide its judgment about the company's
internal controls, or the processes the company uses to ensure accurate financial
statements.
Under the Sarbanes-Oxley act, management is supposed to make a statement
about its internal controls including the following:
A statement declaring that the financial statements are presented fairly;
A statement declaring that management is responsible for maintaining and
executing effectual internal controls;
A description of the internal control system and how it is evaluated;
An analysis of how effective the internal controls have been over the last year;
A statement declaring that the auditors have review management's report on its
internal controls