2011 Fall Module 3
Accounting & Finance
Lecture 7: Statement of Cash Flows
Auditing
David Robinson
D. Robinson, 2011
Accounting & Finance
Accounting
Managerial
Financial
Auditing
Three financial
statements
Finance
Income St.
Forms of business
Balance Sheet
How investors
use their money
How firms
raise money
St. Cash Flows
Lecture Outline
1. Why we need the
Statement of cash flows
2. Auditing: What it is, why its important
3. Audit failures of the late 1990s
4. Sarbanes-Oxley Act as a response
5. Common sense and auditing
6. Take accounting entries seriously
Why we need the
Statement of Cash Flows
Format for the Income Statement
Revenues
1. Assets
a. Current Assets
b. Fixed (or long-term) assets
2. Liabilities
a. Current Liabilities
b. Long-term Liabilities
3. Owners Equity
Net sales
-Expenses
COGS
------------Gross profit
-Depreciation
-SG&A
-Interest
Before tax
Income (Profit)
Tax (Corporate Income Tax)
Net Income (Bottom line)
Net Income/number of shares =
Earnings per share
Format of the Balance Sheet
22
We cant see if/where dividends were paid, or if and how we
raised new money from just the Income St. & Balance Sheet
Statement of Cash Flows
1. Cash flows from operations
a. + our income
b. - building up inventory, more money owed to the firm
2. Investing
a. + sale of investments or equipment
b. - buying long term PPE
3. Financing
a. + Money from stock and bond sales
b.- Dividends paid, bonds paid off
Adding Back Depreciation
1. Cash flows from operations
Why? Its a
non-cash
expense
a. + our income
+ this years depreciation shown on the Income Statement
b. - building up inventory, more money owed to the firm
Adding Back Depreciation
1. Cash flows from operations
Why? Its a
non-cash
expense
a. + our income
+ this years depreciation shown on the Income Statement
b. - building up inventory, more money owed to the firm
Accumulated Depreciation
$3,000 is expensed
each year
End of
Year
In Yr 2, whom did we
write the check for
Depreciation Accumulated
Net asset value
$3,000 to? Value)
(Book
Depreciation
1
$3,000
$3,000
$12,000
2
$3,000
$6,000
$9,000
3
$3,000
$9,000
$6,000
4
$3,000
$12,000
$3,000
5
$3,000
$15,000
$ -0-
Accumulated Depreciation
$3,000 is expensed
each year
End of
Year
In Yr 2, whom did we
write the check for
Depreciation Accumulated
Net asset value
$3,000 to? Value)
(Book
Depreciation
1
$3,000
$3,000
$12,000
2
$3,000
$6,000
Ans.:
$9,000
3
$3,000
$9,000
4
$3,000
$12,000
$3,000
5
$3,000
$15,000
$ -0-
No one! Its a noncash accounting
$6,000
entry
Accumulated Depreciation
$3,000 is expensed
each year
End of
Year
In Yr 2, whom did we
write the check for
Depreciation Accumulated
Net asset value
$3,000 to? Value)
(Book
Depreciation
1
$3,000
$3,000
$12,000
2
$3,000
$6,000
Ans.:
$9,000
3
$3,000
$9,000
4
$3,000
$12,000
$3,000
5
$3,000
$15,000
$ -0-
No one! Its a noncash accounting
$6,000
entry
Adding Back Depreciation
1. Cash flows from operations
a. + our income
+ this years depreciation shown on the Income Statement
b. - building up inventory, more money owed to the firm
OK, so
where do I
see the
$15,000?
Statement of Cash Flows
1. Cash flows from operations
a. + our income
b. - building up inventory, more money owed to the firm
2. Investing
a. + sale of investments or equipment
b. - buying long term PPE
Right here, all
$15,000 in one
year because
we really did
write a check for
$15,000
SBUX
Statement of Cash Flows
Auditing
Without it, we could not have
public corporations
An Introduction to Auditing
A bit of a
paradox
Public accountants
Regulated licensure by the states
But the Securities & Exchange
Commission (SEC) (Federal) relies
on them
Why we need auditors
1. Each investor doesnt have the time and skill
to check the books of each company
2. The Securities and Exchange Commission
(SEC) would need an army of accountants to
check the books of all firms
3. Instead, we rely on public accountants as
intermediaries to check the books on our
behalf
What auditors check
1. Are the firms financial statements
accurate (do the sums add up?) and
are they supported by proper record
keeping?
2. Is the firm presenting information in
the same way as other firms?
What about
some real
world
checks?
Clearly, auditing has had its problems
We had system a failure:
More than 971 US public companies
restated their earnings in 2005*
Several very large corporations (Enron,
MCI) filed for bankruptcy after accounting
scandals, completely wiping out
shareholders equity
There was a complete destruction of
investor confidence at the retail level
* USA Today, 1/1/2006
Auditing: How did this happen?
Accountants made the rules for accountants to
followthe rules were weighty
(50,000 pages) and lacked common sense
The Big Five made way much more money
from consulting than from auditing resulting in
a loss of independence 2010 p. 38
The accountants have overlooked big adjustments
Failed to alert the press to sketchy activity
For societal reasons, some of
the top management became crooks
Why we should keep Auditing
1. Auditing is essential for public ownership
2. Auditing could do a good job of enforcing
common sense rules
this is a matter of Public Policy
3. Auditing is very good at catching sloppiness
(inaccurate bookkeeping)
4. Auditing is very good at catching
one bad thief
(it will rarely catch a concerted scheme)
Definition: Concerted Scheme
A fraud where one or more people act
together (in concert) to steal money
from a firm
Example:
1. Manager pays supplier for goods that were never
delivered
2. Supplier gets paid by the firm, cashes the check
3. Supplier splits the money with the manager.
The agreement to split the money is the concert
Auditors cant make a company comply.
All they can do is threaten to resign
If the auditors resign, then the market
reacts very badly
Auditors need to do more than
mechanically follow the rules
Common sense would help
Sarbanes-Oxley Reforms
After many corporate failure in the
late 1990s (think Enron)
Congress made some important
reforms
Sarbanes-Oxley Act of 2002
1.
Ended self-regulation of the accounting
profession:
1.
established a new Public Accounting Oversight Board
> Sets standards
> Can review and discipline accountants
Puts limits on non-audit activities
Consulting is still permitted, but must be specifically approved by
the Audit Committee of the firms Board and disclosed
In practice, theres much better splitting upa firm that is auditing
usually wont do much consulting for the same company.
Sarbanes-Oxley Act of 2002
Independent =
dont work for
the company
3. Audit Committees have teeth
(some of the Directors of a firm)
Must be independent directors
Must include at least
one accounting expert
Audit committeenot management
must choose the auditors
Firm must have a
whistle blower mechanism
Sarbanes-Oxley Act of 2002
4. CEOs and CFOs must sign the financials
(Kenny Lay claimed he didnt know what was going
on at Enron)
> Executives lose bonuses if theres a
restatement
> No loans to executives not available to
others
> Limitations on trading own company stock
Effect of Sarb-Ox
Its helped, but some people are calling for more:
Example, rotation of auditors after 5 years, and no cozy job
offers
Did you believe the stories about multinational firms
being reluctant to list on the NYSE because SarbOx
is too much trouble ?
NYSE is too good a place to raise money
SarbOx only asks firms to do what is reasonable anyway
Investors routinely sue accountants: There are
literally hundreds of suits underway
Arthur Andersen got the death penalty for Enronno other
firm wants the same punishment
Accounting firms are standing up to the companies
Many companies are splitting audit/consulting
What Happened
We finally recovered from the huge cloud over
the US Securities markets
MCI/WorldCom: Bernie Ebbers 25 years
Tyco: Koslowski & Schwarz 8 to 25 years
Enron: Andy Fastow: 6years
Kenny Lay,
Jeffrey Skilling 24 yrs 4 months
Good for your career
We are facing nothing less than the challenge
to rehabilitate American capitalism
(William Donaldson, Former Chairman of the SEC)
Theres a new Puritanism andparadoxically
a greater need than ever for good
accountants
One good thing
you can say about
America: We put
our scandals on
the front page
Some important advice for your
professional life
1.
2.
3.
Never shred anything
Refuse to change
accounting entries that
you dont agree with
Resigning from a firm
is preferable to being
convicted of a
Federal felony
This is what you
look like when
youve just been
sentenced to 25
years