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.

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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.
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3. Financing activities

Financing activities are the activities that result in change in the size
and composition of the owners 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.

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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:

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:-

Amoun
Particulars
t

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

Xxx
Method)
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

Xxx
Method)

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 days 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 Delphis 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 Delphis
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 industryAutoZone, 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.
FASBs 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 stock 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 operating
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 companys 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 SECs 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 companys performance. The quality of a companys cash
flows must be assessed, as highly motivated and intelligent
 management teams have created new ways to obfuscate the true
picture of a companys 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/statement
s/cash-flow-operating-activities-direct-method