Chapter 9 ipa | Cash, Capital, and Income prs Set Aarne tliat EG od | CHAPTER OBJECTIVES | After studying this chapter, you will be able to: Derive entity cash flows from a cash flow statement. Contrast different definitions of income. Compute the market-based income of an enterprise. CHAPTER OVERVIEW Objective of Cash Flow Information The primary objective of accounting, according to the FASB, is to provide investors and others with information useful for assessing the amount, timing, and uncertainty of prospective cash flows. These cash flows are assumed to form the basis for estimating the market value of debt, equity, and other financial instruments issued by the firm. Presentation and Prediction Given the importance of cash flows, the FASB mandated the presentation of a cash flow statement in annual reports. The statement falls into three sections: operations, investments, and financing. The last of these corresponds broadly to what this chapter defines as entity cash flow. Income Measurement Income may be defined as an increase in well-being. In the case of an enterprise, this may be operationalized as entity cash flow plus the change in value of the enterprise. Different definitions of value lead to various definitions of income.266 Chapter 9 4 Capital and income are two of the most basic concepts in Account; | Both are ultimately dependent on underlying cash flows. In the final "8 ysis, therefore, cash flows into and out of a business enterprise aya’? | most fundamental events upon which accounting measurements ano Me and upon which investors and creditors are assumed to tase they a ions. : “accountants tend to equate the term capital with the book value oft holdings of common shareholders. Likewise, they tend to equate the tem, income with the net income accruing to common shareholders. This chap. ter broadens that usage to the way in which those terms are more com. monly used by economists. Capital, broadly defined as in this chapter, the value of all the monies lent to an enterprise. This includes all loans, preferred stock, all common stock, and any other financial instruments that the enterprise may have issued. We will speak of all these financial instruments as equity—the holdings of common shareholders are termed owners’ equity. By analogy, the term income will refer in this chapter tp the amount earned by all equity holders, that is, the holders of both owners’ equity and liabilities. This is sometimes termed entity income to distinguish it from the concept of net income, which is that income acer. ing to the holders of owners’ equity. Stated otherwise, entity income is earnings before interest expense is deducted from net income. Cash attains its significance in the relationship between capital and income because it represents purchasing power that can be transferred readily in an exchange economy to any individuals or organizations for their own specific needs in acquiring goods and services desired by them and available in the economy. By far the most significant method of transferring cash (claims for purchasing power) is the bank check, ot other means of instructing a bank to transfer bank credit from one individ- ual or organization to another. Currency and coins represent merely a small fraction of the total means of transferring cash to and from a busi- ness firm. With only a very few exceptions, business firms acquire rights to goods and services in order to produce other goods and services for sale 0 customers, with the intent of distributing interest and dividends to long- term investors. Very seldom do stockholders receive benefits from the firm in a form other than cash. Most accounting measurements, therefore, are based upon past Present, or expected flows of cash. Revenues are generally measured i terms of the net cash expected to be received from the sale of goods services. Expenses are generally measured in terms of the cash paid, expected to be paid, for goods and services used by the firm, Accruals Tepresent the allocation to the current period of expected future ¢@® receipts or cash disbursements for services. Deferrals represent the allo cation to current and future periods of past cash receipts and cash dis" bursements for goods and services.Cash, Capital, and Income 267 eh of changes in expected cash Income and balance sheet i usually proposed, and ea ene cy Sra ety batle are measurements of firm efficiency 2 Hie ef asis that they Provide useful tion of future firm activity and dividend payments Bancsec cnn predic: ate and inherent biases created b the cas or al ae of the deliber. historical transaction prices, there is some doubt at oedionss wees ing’ methods.are’adequate to repart the to eat that traditional account- today. One way of avoiding some of these bisa hagas coas Teporting of cash flows, supplemented by ‘other informe 6 ee ate classifications to permit users of financial statements 10 € ake their own predictions regarding the future. Historical cash flow tari os ee SS ea a relevant information, either as SUE 0 ional financial reports, for investors and creditors in their evaluation of the firm and in their predictions of expected dividend payments. Although few advocate the complete replacement of the traditional income statement and balance sheet by a cash flow statement, many suggest a preference for certain procedures on the basis of their avoidance of allocations to several periods that appear to be arbitrary in nature. Others have a preference for income flows on the basis of their approxi- mation of cash flows. For example, the use of direct costing of invento- ries, the flow through method of treating interperiod tax differences (non- allocation), and the tax reduction method of handling the investment tax credit have all been advocated in the past, at least in part, because they are more closely related to the actual cash flows. Still others use cash flows to argue against some of the stances taken by the FASB. For in- stance, General Motors controller Eugene Flegm argues that one of the reasons for “‘the rejection of current value theories by managerial accoun- tants is. . . its subjective, non-cash orientation.” He goes on to say: The creation of “‘paper profits or losses" through the saeco determination of the sales or liquidation value of a company’s net assefs at diferent points in time, unrelated to realized cash, would leave management with “Pro out perhaps the cash to pay dividends or to reinvest eve that value is unimportant; belit A managers poy not be permitted to dominate Flegm is not saying that hat values shoul merely that they believe t268 Chapter 9 the computation of income, which they believe should be More clos, i ealized cash. E Winithe issuance of SFAS 95, the disclosure of cash flow informa, to investors was mandated by the FASB. This chapter develops a they ical framework within which the provision of cash flow information canbe seen to fall logically and naturally.-The first part of the chapter lays out the reasons for disclosure. The second and third sections discuss Potential uses of disclosure, including the use of cash in the computation of income, THE OBJECTIVE OF CASH FLOW INFORMATION SFAC I noted that the primary objective of accounting is to enable share. holders and others to form expectations regarding future cash flows. In the words of the FASB: Financial reporting should provide information to help present and potential investors and creditors and other users in assessing the amounts, timing, and uncertainty of prospective cash receipts from dividends or interest and the Proceeds from the sale, redemption, or maturity of securities or loans.? This objective derives from a normative discounted cash flow valuation model—essentially the same model used in capital budgeting. Those who lend money to an enterprise, whether they are holders of common stock or preferred stock, or creditors, do so in the expectation of getting a return on their money that is not less than the market rate of interest for an investment with equivalent risk. Stated otherwise, the present value of the cash flow stream that is expected to be generated by the investment should not be less than the cash that is to be invested, that is, the net present value should be greater than zero. We can write this algebraically, using the following notation: CF; = cash flow in year j r= market rate of interest (assumed constant) Vo = present value of the investment at time 0, the start 1 = cost of the Proposed investment at the start A potential investor will lend money only if. Vo=I @ where v= > GS @ matCash, Capital, and Income 269 Restating Sauations (1) and (2) in words, investors will not place their s Project unless the discounted present value of expected cash flows is at least as great as the cost of the investment. __ The key issue now becomes what information should be provided to investors and creditors to enable them to establish the expected value of their own investments so that they might make correct investment deci- sions. The ideal is the future cash flows that will accrue to each individual. But future cash flows cannot be projected with certainty, and providing individual statements is not cost effective. So the typical surrogate is to provide information about past cash flows of the enterprise as a whole (ENCF)). These past cash flows serve as a basis for forecasting future cash flows. Each individual is then free to estimate his or her own share of the total entity cash flow. As the FASB noted: The prospects for those cash receipts [i.e., the cash received by individuals] are affected by an enterprise's ability to generate enough cash to meet its obliga- tions when due and its other cash operating needs, to reinvest in operations, and to pay cash dividends. . . . Thus, financial reporting should provide infor- mation to help investors, creditors, and others assess the amounts, timing, and uncertainty of prospective net cash inflow to the related enterprise.? Rewriting equation (2) at the enterprise level yields: = ENCE; exSwEte, Mm 2 en ® where TV; = total value of the enterprise at time j ENCE, = entity cash flow expected in period j Thus, a major reason for the provision of historical cash flow statements at the enterprise level is to permit shareholders, both major and minor, and creditors to value the enterprise as a going concern. This value may then be fed into the investment model of individual investors and credi- tors. As the expectations of investors and creditors regarding the enter- prise’s future change, so one can expect their estimates of the value of the enterprise to change. : The relationship between the entity cash flow of an enterprise and the corresponding cash flows remitted to investors and creditors can be ex- pressed in the form of a cash flow identity. Entity Cash flows Cash flows to Cash flows to cash = to and from + and from majority + and from minority flows lenders shareholders shareholdersoe is identity for each period j as: ae + SHCF; + MICF,; writ ‘One may Te ner = ECF where, LCF = Lender cash flows (net) F = Lender (CF = Majority shareholder cash flows (net) SH CF = Minority shareholder cash flows (net) MIC the cash generated by the enterprise is id entically Inother i net cash flows of each of the participants in the ~ 1 ine Combining equations (3) and (4) yields: a ; & LCF; & SHCF; ie = MICE, 2, oa =2aen* AaeH Zaire 6 i hole is identically , the value of the enterprise as a Who! nay iron ‘the holdings of the lenders, the majority shareholders, ang the minority shareholders. mH a Present Values and Market Values In situations where companies are traded, the market establishes a price at which investors and creditors may sell and buy their rights to their expected cash flows. For instance, investors may trade their shares on stock exchanges; creditors may trade their holdings in markets for debt such as the bond market. The prices of these stocks, bonds, and other financial instruments are readily available for public companies on a daily basis in the financial press. If an investment were worth more than its cost, the investor would eam more than the market rate of interest over the life of the investment. The rate earned is often termed the internal rate of return, or the effective rate. In the case of investments made in securities on the major financial markets, such as the purchase of shares on the NYSE, considerations of market efficiency suggest that competition between investors will fort eee investments in these markets to the risk agus! efficient market hyeotienes vaue is equal to cost, Stated otherwise, 'ypothesis requires that at all times: Vo=1 © I , peed the price of the investment is at all times equal 0 . expected futra ete, °xPected cash flows, That is to say, knowledst shares in Bee cash flows is what permits the market to set prise® i ‘Ompany. This is true for all the various financial holdingsCash, Capital, and Income 27. the cot and so any such as bank notes, mort; e§ mp: 7 , gages, bonds, ee onds, common stock, pre- say that: - When equation 6) holds, we ney hea TV; = TMv, where 0 TMV; = the total market value of the firm In words, the discounted value of fu ture t the market value of the firm established by arpre tans ows eaual to ed by arm’s- i therefore rewrite the identity in equation (5) as jen teding, We may TMV) = MV“ + MV“) + Mv", 8) or Total market Market Market — Market value value of = value + value + of minority enterprise of debt of equity interests This result sheds further light on why the provision of information about future cash flows is so important. Estimates of the amount and timing of future cash flows are the critical ingredients in the pricing model. Estimates of risk are essential to establishing the appropriate market rate at which to discount the flows. The more effective the financial disclo- sure, the more accurate are the expectations that are formed about the amounts and timing of future cash flows. The more accurate the expecta- tions, the more efficient is the pricing of the investment. Inefficiently priced securities that reflect overly optimistic expectations will cause wealth losses to investors when the expected cash flows fail to material- ize. Net Income as a Predictor of Cash. Accounting net income is fre- quently claimed to be an indication of the ability of the firm to pay divi- dends. And, indeed, where management elects to base their dividends strictly on a fixed fraction of net income, then projected net income is all an investor needs to estimate a future dividend. However, the dividend decision must take into consideration many other factors, such as the availability of cash; the opportunities and objectives of the a _ Tespect to capital growth and expansion; and the police of i Spat regarding external financing, as well as the ability of the firm ee outside funds, But one of the great deficiencies of ros ee biaeea a predictor of future dividends is that it may be consi sain aa o because of the inability in many cases to obtain a eee alleen expenses with revenues, and because of the arbitrary i ve dividends procedures. The use of cash flows as @ predictor of Seer e ie aie therefore, avoids the biases of reported net income, excep!“ ipts and disburseme! nts ash receipts an ene, ain that the timing of certain by management. inanci ‘bili Liquidity, Solvency, and Financial Flexibility I, flow information has emphasizeg fc i ditors predict i help investors and cre s cash, Se ne foie of dividends and interest ang pe f principal, and to evaluate probable risk. formation Tepardiny meat ° Pea Prancial flexibility helps in meeting these goals by pemnit solvency and Mtrions of the probabilities of future returns, rather i ting pervictions of expected values. The probabilities of insolvency ang just predi hand and a very high return on the other a bankruptcy on the one | ae i ant in the evaluation of total risk. — ' toe aairal objective in the presentation of data regarding cash flows is to permit an evaluation of liquidity and firm solvency. Liquidity is the relative ability to convert assets into cash. sometimes referred 10 as the nearness of assets to cash. It also refers to the relationship between a firm's short-term liabilities and its cash and near-cash items. Solvency isa broader term referring to the ability of a firm to obtain cash, or have cash available, for whatever purpose the business requires. More specifically, solvency is the ability of a firm to pay its debts when they become due, Financial flexibility is the ability of a firm to obtain cash on short notice in order to meet unforeseen contingencies, or to take advantage of favorable opportunities. All three concepts are related. but financial flexibility isa broader concept than solvency, and solvency is broader than liquidity. The importance of solvency is that it is necessary for firm continuity. Insolvency may lead to bankruptcy, forced liquidation, and the loss of claims by both stockholders and creditors. However, even in the absence of. bankruptcy, insolvency may lead to a restructuring of debt and equily claims, resulting in a loss to both stockholders and creditors. But solvency itself is not necessary to cause losses to stockholders and sredhorssthe mere threat of insolvency may cause the equity and credit ae ieee a reduction in the market price of shares and cert: pape mess and an increase in the costs of additional borrowing a “uty. “he reason for the reaction of market prices to a threat insolvency is that it creates an increase in risk—the risk of complete Partial loss of equity or credit clai becouse Since liquidity refers to asset chee ccteriet iscussit re sentation of liquidity information ia nites e iscussion OL : ‘ : ‘0 found in Chapter 13.* It is Thus far, the discussion of cash rovision of informat fkely to be distributed *S. ee the section on classification in Chapter 13.Cash, Capital, and Income 273 oot for ee to note that liquidity information is part of the information meee evaluate solvency and financial flexibility. These broader conecott quire not only information regarding the ability to convert gai ts into cash, but also information regarding the commitments expectations relating to future cash receipts and disbursements. CHECKPOINTS 1. What is the primary objective of accounting? 2. What are the objectives of providing cash flow information to users of financial statements? 3, Define entity cash flow. 4, Under what circumstances are present values likely to equal market values? 5. Distinguish the terms liquidity, solvency, and financial flexibility. THE PRESENTATION AND PREDICTION OF CASH FLOW INFORMATION* As already noted, the primary objective of accounting is to present data that will: 1. Help the investor or creditor predict the amount of cash likely to be distributed in the future in the form of dividends or interest and in the form of liquidation distributions or repayment of principal. 2. Aid in the evaluation of risk. The term risk, in this context, includes both the expected variability of future returns and the probability of insolvency or bankruptcy. Data that will enable users to form pre tions of cash by the firm are key, therefore. However, the cash distribu- tion decisions of the firm each period are based on many complex factors. In particular, what portion of that cash flow will go to servicing sharehold- ere and what to servicing creditors will depend on debt financing policies represented, perhaps, by a target debt-to-equity ratio. Taken as a whole, though, cash distribution in the long run must reflect cash flow generating therefore, may be able to obtain assis- dictions about expected distribu- capacity. Investors and creditors, y rant tance in the prediction of future dividend levels if they have information regarding the following types of flows: Professor Gerald Law- «This section has benefited considerably from conversations with son.™m Chapter 9 e basic current operations of the enterpyi 2 ‘h flows unrelated to current operations ing or occasional cas! r eration 2 Ee eneal orter unexpected events of the desire to maintain q fe aris in the future. i t for the firm in the . at 7 3 ast ed from their sale when not needed for future operations, eoninee rot from, or repaid to, bondholers and stockholder ” part of firm financing. : : peer Payments of interest and dividends to investors with priority claims such as preferred stockholders. These five requirements, together with the tax implications of each, form the basis for the format of cash flow statements seen in practice today. This format includes the following three sections: Cash flows relating to th we 1. A statement of operating receipts and payments. 2. A statement of financing activities. 3. A statement of investing activities. These three sections have now been mandated by SFAS 95, An exam- ple of the format that the FASB prefers appears in Exhibit 9-1. This format is not without its critics. Many firms still appear to prefer an indirect format that begins with net income and adds back adjustments to income to convert it to operating cash. The authors believe this ap- proach conceals more than it reveals and would prefer it be discarded, Others prefer to place several items in the FASB’s format in other classifi- cations. In particular, some prefer to treat interest paid as part of invest- ing activities and dividends received as part of investing activities rather than part of operating activities. The FASB acknowledged that different classifications might be desired, and required that sufficient detail be pro- vided within the statement to permit users to make their own rearrange- ments. There is some dispute also about the nature of cash equivalents which should be used. The FASB suggested these be limited to short-term, highly liquid investments with a maturity limit of three months. By con- trast, the Accounting Standards Committee of the Canadian Institute of Chartered Accountants defines cash equivalents more broadly as short- term investments less short-term borrowings.‘ The Board acknowledged that any choice was arbitrary, and suggested that whatever definition is used in the statement of cash flows be consistent with that in the balance sheet—and that management disclose the nature of its choice. ey eee ee such as the purchase of oe ae tH pie vac have appeared in cash flow and funds flow ae A ease ie 7 is based on the assumption that cash flows in a Saw tc out to purchase land. The FASB has suggested th 1ow be disclosed in a footnote on grounds that doingE ‘HIBIT 9-1 Statement of Cash Flow: Cash, Capital, and Income 218 COMPANY M CONSOLIDATED STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 19X1 Increase (Decrease) in Cash and Cash Equivalents Cash flows from operating activities: Cash received from customers : 7 $13,850 Cash paid to suppliers and employees (12,000) Dividend received from affiliate "20 Interest received 55 Interest paid (net of amount capitalized) (220) Income taxes paid G25) Insurance proceeds received 15 Cash paid to settle lawsuit for patent infringement 30) Net cash provided by operating activities $1,365 Cash flows from investing activities: Proceeds from sale of facility 600 Payment received on note for sale of plant 150 Capital expenditures (1,000) Payment for purchase of Company S, net of cash acquired _(925) Net cash used in investing activities (1,175) Cash flows from financing activities: Net borrowings under line-of-credit agreement 300 Principal payments under capital lease obligation (125) Proceeds from issuance of long-term debt 400 Proceeds from issuance of common stock 500 Dividends paid (200) Net cash provided by financing activities 875 Net increase in cash and cash equivalents 1,065 Cash and cash equivalents at beginning of year _ 600 $1,665 Cash and cash equivalents at end of year otherwise is confusing. By contrast, Canadian standard: is ion i itself. The precise positionin: inclusion in the statement itself. pl ; findings of the efficient market theory. is probably moot given the Entity Cash Flow bottom line in SFAS 95 is the change in cas! tt terprise, otherwise known as the cl holdings of the en! s still require their g of the disclosure hand cash equivalent ange in liquidity. In276 Chapter 9 this case, it is $1,065. Such changes are primarily due to SPeculatig precautionary motives and may be thought of as investments in the f cial security of the firm. Entity cash flow, the number we seg is ing generated by the enterprise through operations. less the cash ioe - invested in the disposal and acquisition of property, less the cash ii or in (withdrawn from) the security of the enterprise, that is, the ing Sted (decrease) in liquidity. Using the FASB’s illustration in Exhibit 9-1, sa has: Net cash provided by operating activities = $1,365 Net cash used in invested activities = $1,175 Net cash used in increasing liquidity = $1,065 Entity cash flow, defined as operating cash less cash invested less in. crease in liquidity is, therefore, $(875) = $1.365 — 1,175 — 1,065, This cash flow is distributed among two groups of users in this particu. lar example. It goes to shareholders and to debtholders. One may write: SHCF; = $300 (= $500 — 200) LCF; = $575 (= $300 — 125 + 400) In other words, the cash generated from operations of $1,365 less the cash spent on investments of $1,175, less the increase in liquidity of $1,065 equals the cash inflow from creditors of $575, plus the cash inflow from shareholders of $300. In short: $1,365 — 1,175 — 1,065 = (300) + (575) Both sides represent entity cash; the left focuses on the cash generated, the right on the cash distributed.* As noted above, some cash flow theorists believe that a few of the items in the FASB’s formulation of cash flows should be reclassified. In particu- lar, they would treat interest and dividends received from affiliates as pat of investments, and interest paid as part of the lender cash flow stream. They, therefore, would revise the numbers in the following manner: Original $1,365 — 1,175 — 1,065 = (300) + (575) Dividend received (20) 20 Interest received (55) 55 Interest paid 220 220 Revised $1,510 — 1,100 — 1,065 = (300) + (355) * Note that the sign on the right is reversed to match the sign on the left.Cash, Capital, and Income 277 In words, under t formulation, cash from Operations excludes inter- > this f i ir : i €st Paid of $220, interest Teceived of $55, ivi cash distributions is that many cash flows, including dividends, are inter- Dividends to common stockholders can be looked on as that amount available after the above expected flows are predicted. However, as indi- should also be given to the needs of the firm for holding cash or increasing its cash holdings. In addition to the knowledge of past cash flows, the investor should have information regarding the philosophy, or attitudes, of the firm regarding the payment of dividends, and regarding the invest- ment. or reinvestment, of cash available, or obtainable by additional fi- nancing. In faking predictions regarding future cash flows from operations, it is important to start with historical information classified according to the behavioral characteristics of the cash flow requirements, For example, ideally the various types of cash flows relating to operations would be classified according to major product groups or product categories, so that predictions could be made regarding future demand for the products and regarding special cost relationships related to specific product Frou. Geographic distribution of source and sales of products may oe e Bil nificant, particularly where foreign countries are Eitan, ci ze ideally, classifications of cash flows would permit a eae fe oe in future cash flows that are related to other known or pre Dyan ables. Much of this detail is not currently available in reporte Cone citcihin hoi ne cue detect. For instance, commit ted cash flows should be classified separately from a EOF exeiinler Vaal east aba for tn lane See yeaeereiooened In consast dalia erating cash flows for the last five years, § PI Pena ce chice markels or may give some indication of the rate of growth of end278 Chapter 9 i ws that can be expected in the future « the level of pense aaa share has been changing over tint oral the oatl difficult of cash requirements to predict is that nee; fatal expenditures. Depreciation. as sence eas for Meagy,, ing income. is not relevant for this purpose t PCAs lee ements are Not necessarily related to either the cost of the items ean e A the past, to periodic allocations of this cost. Although capital expenditure Patterns in the past may provide some guide to the future, expectations of manage. ment regarding its plans and opportunities can greatly assist this predic. tion. The desirability of disclosing such expectations was underlineg by the FASB which wrote: Management knows more about the enterprise and its affairs than investors, creditors, or other “‘outsiders’’ and can often increase the usefulness of finan. cial information by identifying certain transactions, other events, and circum. stances that affect the enterprise and explaining their financial impact. More. over, financial reporting often provides information that depends on, or is affected by, management’s estimates and judgment.® Discussions of such information are now a required feature of the section in the annual report labeled Management's Discussion and Analysis.’ Future capital expenditure will typically be a function of the age struc- ture of existing assets and the need (if any) to create additional capacity to accommodate the operating cash flows that are expected to grow in the future. In attempting to predict a sequence of future capital expenditures, a distinction between replacement and growth capital expenditures can be made. Replacement expenditures are principally a function of the age structure and expected useful service lives of existing assets, that is, the existing asset stock will cause particular replacement cycles. Growth ex- penditures are a function of anticipated sales volume growth, including that of new or contemplated products, and the degree of utilization of existing capacity. Thus, the greater the amount of idle capacity, the more distant is the need for additional capacity for any given expected rate of sales volume growth. The use of historical cash flow information to make predictions regard- ing future dividends is, therefore, a complex Process. However, as recent empirical studies have shown, the reliability of making predictions that take cash flow information into account is greater than predictions made from historical income data alone. Because of the increase in predictabil- ity, the presentation of historical cash flow information in external final cial reports has been mandated. * * The reverse is also true, Conventions beyond that contained in cash flows. Rel the most desirable. al net income appears to have information content leasing both cash and income numbers is, therefore,Cash, Capital, and Income 299 Lon 1. What classifications does cash flow statement? 2. Define shareholder cash flows, Zi Define lender cash flows. . List three factors that are helpful in predicting investing cash flows. s the FASB use in its suggested format for a INCOME MEASUREMENT Accountants frequently refer to two economic concepts based on real- world observations as logical starting points for a definition of a concept of accounting income. These two economic concepts are the change in well-being and the maximization of profit under specified conditions of market structure, product demand, and input costs. These concepts are implicit in the FASB’s assertions that: Comprehensive income i the change in equity ofa business enterprise during a period... . The test of success (or failure) of the operations of an enterprise is the extent to which the cash returned exceeds (or is less than) the cash spent (invested) over the long run." The former is the concept of capital maintenance, and the latter is a form of the profit maximization concept. Economists have attempted to refine these concepts as saying something about real-world observations, even though they disagree among themselves regarding their significance. However, economists have not been very helpful in solving the measure- ment problems surrounding these concepts. As a result, accountants have chosen to apply precise rules for income measurement regardless of how close they may come to measuring the economists’ concepts. This section explores the various concepts of capital maintenance and the alternative methods that have been suggested for their measurement. Practical and conceptual limitations are also presented. In particular, this section dem- onstrates how the measurement of income relates to the provision of information regarding cash flows. Capital versus Income i ist Irving Fisher, capital is a e language of the American economist ‘ i of ‘wealth at an instant of time." Income is a flow of services rush sock Capital is the embodiment of future services. and income is the enjoyment of these services over a specific period of time. With theseChapter 9 sible to confuse the two term; definitions, it goes inthe re2erv0r ‘at any one time, and the other Se relates to the a flowing out of the reservoir during a Period of time eters oe Orne terms are related to a business enterprise, however, take on slightly different meanings. In the above destin, income is aererived from the use of capital; however, a business enter pose of its own enjoyment. Its purpose is : provide a flow of wealth for the benefit ofits owners. Whereas capi)? still thought of as the stock of weaith that can provide future Services income is thought of as the ee of wealth or service in excess of iy" aintain a constant capital. Sima broadened still further in the enterprise concept he income. Now, capital consists of all monies provided by external partes to the enterprise, that is, it includes share capital and debt capital. Income is then the income accruing to all providers of monies to the firm, thats, includes interest accruing to creditors and earnings accruing to minority enjoyms does not exist for the pul shareholders. es Care should be taken here to distinguish the term comprehensive in. come from the term entity income as used in this chapter. The former refers to the income accruing to common shareholders only and was introduced by the FASB to cover some items such as prior period adjust- ments which, although reported as a change in retained earnings, might better be considered as part of income in this period. Comprehensive income is comprehensive only with respect to common shareholders. The term entity income refers to the income accruing to the enterprise as a whole. It includes interest income, minority shareholder income, income to preferred shareholders—and comprehensive income to common ma- jority shareholders. Regardless of the precise definition, the concern throughout is to distin- guish income, sometimes referred to as a return on capital, from a retum of capital. The distinction is important for two reasons. First, changes in the capital of the enterprise may affect the amount of future flows to residual equity holders (such as the holders of common stock) and thus the value of their equity at any point in time. Second, changes in enter prise capital may affect the relationships among the various equity hold ers, including the holders of debt and preferred stock. Holders of equity are interested not only in how much they can expect to receive from the enterprise during the following period, but also in the net changes in the ability of the enterprise to provide future flows. Inves" oe ce nee is focused not only on the ability of the oa ae . s, but in many cases on its growth potential. The wight to these fi langes is even more important when the ownership ese future flows are transferred frequently during the life of | She te early period of the railroad industry in the ue 5 incommon for promoters to pay huge dividends ©!Cash, Capital, and Income 281 capital during the early life of the fi ievi i true income ef the rd le firm. Investors, believing this to be the a ‘m, paid high prices for the stock, only to find later ey to pay dividends in the future was being eroded because of ige early dividends. Equity requires that both buyers and sellers of common stock have adequate information to make expectations regarding the Current and future dividends of the firm. _ With the separation of ownership and control in most large corpora- tions, accounting also has the responsibility to report on the stewardship of the management group entrusted with the proper use of the invested capital. A proper distinction between income and changes in capital is one of the means of determining the extent to which management has carried out the function of operating the enterprise for the benefit of the owners. The concept of wealth maintenance is also important to bondholders, preferred stockholders, and the providers of short-term credit. All of these equity holders are interested in the probability of repayment at some future date. The prospect of repayment is greater if the total in- vested capital of the enterprise is maintained at a constant level or permit- ted to increase. The prospect of repayment is less if the capital is dimin- ished, either through losses, or by the payment of dividends in excess of earnings. The creditors cannot always be protected against losses, but if they are properly notified, they may be able to protect their position before it is too late. To a certain extent, creditors are protected legally, and often contractually, from the impairment of invested capital by the payment of dividends in excess of earnings. The various classes of equity holders are also interested in the return on their investment, whether it be contractual (as interest on debt) or depen- dent on earnings (as dividends on preferred and common stock). Since invested capital reflects, in part, the ability of the firm to continue the payment of a return to equity holders in the future, changes in the amount of invested capital are vital in decisions regarding the future flow of this return to any class of equity holders. The concepts of capital and income, however, are not clearly formu- lated. Capital can be defined in terms of the current monetary unit or a monetary unit of constant value; in physical terms; in terms of capacity to produce goods and services; or in terms of the future expectations regard- ing future flows to stockholders. The measurement difficulties in separat- ing capital and income are even greater. These conceptual and measure- ment difficulties are discussed in the following section. The Wealth Maintenance Concepts of Income ‘The Scottish economist Adam Smith was the first to define income as that amount that can be consumed without encroaching upon capital. English economist and Nobel prizewinner Sir John Hicks elaborated upon this by282 Chapter 9 the amount that a person can consume ting F d be as well off at the end of that time as at the eB a period of time an‘ ome, according to Smith and Hicks, ;.&" . atively, ine isy a sisted He ‘ntenance of well-offness. but before consum, si surplus . of the firm were valued at $80,9 For example bay ee coo ar the beginning. income would be Saat end Ore at capital transactions and the pay ment of dividends, Tada, dial capital stock in the amount of $11,000 had been sold and if ¢ dends in the amount of $8,000 had been paid during the period, the income would have been $1,000. In other words: saying that income is ivi. et Income = ($8,000 — $11,000) + ($80,000 — $76,000) Algebraically, where W represents well-offness: ING, = CF; + (W; ~ Wii) 3 The nature of income to emerge from this formulation depends on the definition one gives to W; and how one measures it. A variety of options has been proposed. None has received universal acceptance. This lack of acceptance reflects a lack of agreement as to the precise meaning of the term well-offness. A fundamental problem is whether. and to what extent, to include psychic benefits in the definition. One may be wealthy but in poor health; alternatively, one may be “‘rich"’ in one’s children. Organiza- tions, of course, do not suffer either psychic joys or sorrows. The lack of applicability of psychic benefits to organizations and the difficulty of ap- plication to individuals have caused most authors to limit the concept of well-offness to tangible wealth. Several methods of valuing this wealth include: 1. Valuation of the firm by using input values (either historical or current Cost) for nonmonetary assets and adding the present cash value of monetary assets and subtracting liabilities. 2. The aggregation of the selling prices of the several assets of the firm less the summation of the liabilities. . Capitalization of the expected future net stream of cash or services #9 be received over the life of the firm. 4. Valuation of the firm on the basis of the current stock market pris’ applied to the total stock outstanding. ine assume for argument’s sake that the general value tained A jen! of well-offness dui and expressed in money terms. The measure™ ring peri i arias in Chal ter 12 on inflation, © Pet14S Of price-level changes is discussed in: CASH, Capital, and Income 283 idual versus Entity Inco: a Rees attention | the indiduat Cae rate fincome in eauation ® rely aoting that ‘aN extend it to the enterprise NI of majority ae = (Dividends — Capital ibuti * Change in majority shereholog eats = SHCF;+A MASEW, NI of minority shareholders _ = ividends — capital contributions) + Change in minority shareholder wealth = MICF, + A MIsHW, (i) NI of debt holders or lenders = (Interest — new borrowings + re , payments) + Change in debt-holder wealth , = LCE +ALW, (12) These three income streams combine to form the total income of the enterprise (defined on a before interest, before minority shareholder ba- sis.) In other words, one may write entity income (ENINC) as ENINC; = SHCF; + 4 MASHW; + MICE; + A MISHW, (13) + LCE, + A LW, But the three cash flow terms on the right combine to form entity cash flows so we may rewrite equation (13) as ENING; = ENCF; + 4 [MASHW; + MISHW; + LW) (14) This can be rewritten as: 15 ENING, = ENCF) + 4 ENW; (15) where ENW = wealth of all investors and creditors in the entity. i n the left As already noted, the exact nature of the income term 01 : is measured on the depends on the way in which the entity wealth (EN ey independent of ight. However, entity cash flows (ENCF) are comp ross all formulations the way in which wealth is measured and constant ae oes income form- of income. This universality of entity cash flows # ision of cash flow i i is i ce of the provisiOh. ac lations underlines once again the ae van enterprise: ‘This is particu: i 01 information to investors and credit ‘ategrated Bl lobal economy. larly true as the world moves toward an In!284 Chapter 9 Historical Input Prices concept of wealth maintenance similar to that accg umed i ilar to ae ‘of input prices in terms of either historical practice is the use current costs (less depré tion formulation of incot involves income to majority s NI = Dividends + A Retained earnings Pled jn sary). Thi £085 ciation where necessars). The wealth-mayint a me that is most familiar to readers in this Tey hareholders only: ard (1g), By including capital contributions one can convert this to read NI = (Dividends — Capital contributions) + A Net worth i = SHCF, + A NW; By adding interest expense, borrowings and lendings, and minority income to both sides, one can further expand this last equation to read Entity income = Net cash paid to lenders = Net cash paid to minority shareholders + Net cash paid to majority shareholders + Change in book value of holdings of lenders, minority shareholders, and ma- jority shareholders = LCF, + MICF) + SHCF;+ AENNW; (18) where ENNW = Entity net worth = Book value of owners’ equity plus debt —_(19) But the three cash flow terms on the right combine to form entity cash flows so we may rewrite equation (18) as: Entity income = ENCF; + A ENNW; 20) It should be emphasized that although this appears to have the same structure as other capital maintenance concepts, it is not subject to rea world interpretation because of its reliance on depreciation allocations and the accounting concept of realization.* In other words, the entity income derived here is simply an expansion of conventional accounting income. It does not include changes in wealth due to fluctuations in valve in the marketplace—except to the extent that these are recognized in writing down of inventory, for instance. The resulting income compul® ie of See Chapters 11 and 15 for further discussion of the lack of real-world interpretation these concepts.‘Cash, Capital, and Income 7285. tion is based o mn structural rulk because it i: Tules rather than reali is di: here income (epee described as nancial caval mamtensnce with tion ing the difference between beginning and ending valua- In the absenc: i ke mine te sai oe ea ae input prices (costs), are eaual of the period, expressed in terms of ena Sy (Gosts), are equal tothe total input prices of the assets at the adjusted for Period. Income is reflected in an increase in these values i saulte fe capil transactions and dividend payments. This income orodecs pe : e conversion of input prices into market values by the 7 sale and exchange. Cash and receivables are received in ex- jange for the assets valued at cost. Therefore, some of the asset values at the end of the period as well as some at the beginning (the monetary assets) are expressed in terms of market values (output prices). Current Input Prices When the inputs are expressed in terms of current values, the computa- tion of income is the same as with historical costs, but the income result- ing includes holding gains and losses arising from price changes—whether or not these holding gains and losses have been realized through sale or exchange. Algebraically, one has: Entity income (current input basis) = ENCF; + 4 ENCV; 1) where ENCV = Entity value in terms of current input prices. That is, the income will include gains and losses from the holding of assets as well as the normal operating profit." By expressing the asset values at the beginning of the period in terms of end-of-period input costs, come of these gains and losses can be eliminated; but, unless adjustmen’s sre made for changes in input values of costs incurred during the period, capital gains and losses will still be included. Maintenance of Constant Purchasing Power Economists often contend that income should be measured in real terms, rather than in nominal terms. Algebraically, they suggest: income (constant purchasing power basis) ti ae = ENCF; + 4 ENCPV; (22) where i ENCPV = Entity value in terms of constant purchasing power.286 Chapter 9 When changes in the general level of prices occur, the Measure, income by comparing capital values at different times in term, monetary unit at each time results in measurements that do not changes in real capital. Therefore, many suggestions have been the adjustment of of a constant purchasing powel Ment of S Of the TeDtesen, i Made capital values so that income can be measured in te, tn r or in terms of a constant value of the monetary unit. These suggestions and the problems involved in makin adjustments for changes in the purchasing power of money are discusseq at greater length in Chapter 12 on inflation. Current Cash Equivalents As another alternative to the capitalization of a firm, the firm’s capital can be defined as the sum of the money or cash equivalent of all assets less the sum of the money equivalent of the liabilities. In other words: Entity income (current cash equivalent basis) = ENCE, + 4 ENMVA; 3) where ENMVA = Entity value in terms of market value of individual assets. The current cash equivalent can be defined as the market selling price or realizable price of the assets held by the firm." This is the price that would be reached in an orderly liquidation. By computing the net assets computed in a similar fashion at the beginning of the period, and adjusting for capital transactions, the income for the period can be determined.” The value of the firm determined by the summation of market pricesis assumed to be relatively objective or verifiable, because these prices dé pend upon the expectations of others outside the firm. Note that these are opportunity cost values. They represent values for which the existing assets could be exchanged in the market. The value of the firm as @ whole would normally be greater than the sum of the market prices of the sP& cific assets, because if it were not, the owners of the firm would be better off by selling its assets in the market. This difference is due, in part, to the exclusion of goodwill and other intangibles that do not have market prices separate from tangible asset prices. However, it may also be due to the evaluations of expectations, the selections of discount factors, and the adjustments for risk, as well as costs involved in the sale and transfer of specific assets. In addition to the verifiability of current cash equivalents, the computa- tion of income by comparing changes in the market prices of assets liabilities has the advantage of providing a better basis for judging the alternatives open to management. But it provides @ limited basis eo the prediction of future changes because it does not disclose the nature ° the changes arising in prior periods.Capitalization Cash, Capital, and Income 287 ane a peauently Suggested measure of net assets from a theoretical aie ae capitalize the value of the expected cash distributions to seh TS by the firm during the remaining life of the enterprise, in- cluding the final amount expected to be paid at liquidation. This was the measure used at the start of this chapter to motivate the FASB’s insis- tence that the prediction of future cash flows is the primary objective of accounting and was captured in equation (2). If the investment is being made for a finite number of years, in the expectation not only of a return over these years, but also repayment of capital at the end, then equation (2) can be rewritten as: = 3 CF Vn Yo os a+y* 07 (24) For a single period, this can be rewritten as on vi "Gent Ttn (25) Reordering equation (25) yields V, = (1+ Vy - CF, (26) In words, the value of one’s investment can be expected to grow with the rate of interest, but decrease with the amount of cash that is con- sumed. Reordering this in accordance with our general definition of in- come, one finds that Income = CF, + (V; — Vo) = rVo (27) i individual can be computed by in other words, the ex ante income ofan indivi c ee the cash flow that the individual expects to receive from the any with the expected change in the value of that individual's hold- el where the values are established by discounting future expected cash flows. At the enterprise level we have:Chapter 9 Entity income = In other wo! nte by combining the enterprise's change in its total value. Bot! tions can be converted from h flows. : The income computed by this net income. As computed here, has been maintaine values are maintaine come. Accounting net income. A Numerical Example. following cash distributions ENC, + (TV1 ~ rds, the ex ante inc .d. Accounting i d. The former is sometimes termed econom income is at TV.) = TV enterprise ome of the en! can be com method is seldom the same as accou income is the excess after market y, net income is the excess after net t best an approximation of eco, ——- Year BWawne Cash Flow (net) $100 300 200 400 500 pected cash flow with the gy ted hh the individual and the enterprise fg te ex ante to ex post by focusing on Tea a ized ting boo} lie in. omic As an example, let us assume certainty and th during a life of five years for a firm: oo case of ee a appropriate discount rate would be the risk- (assumed to be 5 percent in this c: t ase) an value of the firm at the start would be $1,261. en A oie puted as follows: a ee of the firm as ant Beginning of First Year $100 x 0.9524 [(cs) ] 300 x 0.9070 {| 200 x 0.8638 [ 400 x 0.8227 [ 500 x 0.7835 [ ee Ua272 = 173 End of First Year $300 x 0.9524 [(74,) ] = $ 26 200 x 0.9070 (a) wae 400 x 0.8638 (4) eat 500 x 0.8227 (74) ] = _# x 08227 [(4)\ reCash, Capital, and Income 239 At the end of the first year the capitalized value of the remaining cash distributions would be $1,224 and the net income for the first year would be computed as follows: _ Cash distributed at the end of the first year $ 100 Capitalized value at the end of the first year of the cash flows for the remaining years 1,224 Total value of the firm at the end of the first year assuming no distributions to stockholders 1,324 Less: Capitalized value at the beginning of the year 1,261 Income for year $63 This income of $63 represents the increase in the total value of the firm during the year. It equals 5 percent of the initial capitalized value of $1,261. It represents, in effect, interest on the capital invested. If the cash distribution each year is greater than the income (interest), the income would decline each year. In the case cited, the incomes for each of the five years would be $63, $61, $42, and $24. If the cash distributed to stock- holders each year is equal to the income and the remaining available cash reinvested by the firm in projects that will yield 5 percent, then both the income and the capitalized value of the firm will remain constant into the future. Finally, note that periodic income is not directly Proportional to the cash distributions in each year. One must include the change in value to convert from income to cash and vice versa. Capitalization under Uncertainty. Two cases present themselves here. In the first, markets are said to be complete. Formally, this means that trades can be made in all commodities and in all states of the world. In the second, markets are said to be incomplete. In other words, trades cannot be made for certain goods or in certain states of the world. When the latter case occurs, and some feel this is the normal case, it becomes technically infeasible to define an ex ante enterprise income number on a capitalized value basis. The essence of the problem is that in the absence of a market there can be no agreement on the value of future benefit streams of assets. It remains possible for each individual to make a personal estimate of. income. In the absence of certainty, the future cash payments represent expected values of probability distributions. For example, if the subjec- tive estimates of the cash dividend for the first year are either $120 with a probability of 0.6 or $70 with a probability of 0.4, the expected value