| Cash Flows: | | | | There are also some transactions that occur every |
| A revenue or expense stream that changes a cash | | | | accounting period. These can be summarized in a |
| account over a given period in your Project. Cash | | | | series of standard journal entries that simplify the |
| inflows usually arise from one of three activities - | | | | accounting process. For example, the depreciation of |
| financing, operations or investing - although this also | | | | Fixed Assets occurs every month, generally |
| occurs as a result of donations or gifts in the case of | | | | recognized as one-twelfth of the annual depreciation |
| personal finance. Cash outflows result from expenses | | | | amount. (Sometimes a company recognizes |
| or investments. This holds true for both Projects | | | | depreciation based on the number of days in a |
| and personal finance. | | | | month or some other predictable amount.) |
| Because many people view cash as indicative of a | | | | Therefore, also in the General Journal, standard |
| business's financial well-being, a great deal of | | | | journal entries are recorded every month, providing a |
| attention is directed toward cash, cash management, | | | | basis for the recognition of all relevant financial |
| cash availability, and a range of other issues | | | | consequences in the appropriate accounting period. |
| surrounding cash and cash equivalents. The third | | | | Closing Procedures |
| major financial statement, the Statement of Cash | | | | At the end of each accounting period, all the |
| Flows, represents an effort to present the | | | | transactions for that period are entered, even if the |
| management of cash in a manner that can be | | | | entry takes place after the last day of the |
| understood by the various interested parties. | | | | accounting period. Accounting is more interested in |
| Over the years this interest in cash has gone through | | | | accuracy than in getting everything done as quickly |
| an evolution, from a relatively simple Sources and | | | | as possible. This sometimes creates conflicts |
| Uses of Cash statement to the Cash Flow | | | | between the accountants and the operating Project |
| Statement to today's Statement of Cash Flows in a | | | | Managers. Operating Project Managers want to know |
| form that addresses the interests of management, | | | | as soon as possible what the results were and what |
| lenders, and investors in the same document. | | | | happened. After all, it is easier to make corrections in |
| The Statement of Cash Flows summarizes the | | | | practices if you know about the problems soon |
| changes in the Balance Sheet during the reporting | | | | enough. Think about training a puppy. To change a |
| period, separated into transactions reflecting | | | | behavior, you must educate the puppy while he still |
| operating activities, investing activities, and financing | | | | remembers what you are training him about. |
| activities. It identifies where the company got the | | | | To satisfy both the accountants and the Project |
| funds it used and what it did with them, and it | | | | Managers, a closing schedule is established that brings |
| facilitates assessment of management's | | | | most of the relevant accounting information to the |
| effectiveness in directing the business. | | | | accounting department quickly. The few transactions |
| The results of the Statement of Cash Flows reflect | | | | that are missed are generally not material. That is, |
| the change in the cash balances of the company. If | | | | they do not significantly affect the final results. |
| an item, or a total, is negative, it represents cash | | | | As soon as the last of the transactions are recorded, |
| outflow; if positive, it reflects inflows. On the | | | | the accountants summarize the general journal, |
| following pages we present and describe the basic | | | | perhaps automatically as part of the computerized |
| elements of the Statement of Cash Flows. | | | | accounting system, making closing journal entries that |
| For internal management each contributor to cash | | | | bring the current period to a close. These entries |
| flow may be computed separately as part of an | | | | bring the Income Statement balances for the period |
| effort to track amounts and causes and | | | | back to zero by transferring the net amount to the |
| consequences. This detailed approach is known by | | | | equity side of the Balance Sheet, creating a balance |
| some as the Direct Method Cash Flow Statement; | | | | between the assets and the liabilities. At this time, |
| the one presented in Exhibit below is known as the | | | | the system is ready to start the next period's |
| Indirect Method Cash Flow Statement. | | | | Income Statement. |
| The simple structuring of cash flows in Exhibits below | | | | To begin the process of setting up George's |
| helps you recognize the double entry nature of | | | | accounting system, he will need to make a detailed |
| bookkeeping entries and the effect that a | | | | listing of all the names of the accounts that GG Org, |
| transaction has on cash resources. It demonstrates | | | | Inc. might find useful for reporting transactions. This |
| clearly the relationship of cash to other accounts on | | | | detailed listing is referred to as a chart of accounts. |
| the Balance Sheet and permits you to test the | | | | Because of the double entry system all of GG Org's |
| effect of a transaction before you undertake it. | | | | transactions will involve a combination of two or |
| Exhibit: Statement of Changes in Financial Position | | | | more accounts from the balance sheet and/or the |
| (Cash Flow Statement) | | | | income statement. Koppala lists out some sample |
| If you include cash and cash equivalents in your | | | | accounts that George will probably need to include on |
| generation of the table in Exhibit , the two columns | | | | his chart of accounts: |
| will be equal. If you exclude cash and cash | | | | Balance Sheet accounts: |
| equivalents, the difference in the two columns is the | | | | - Asset accounts (Examples: Cash, Accounts |
| change in liquid assets. If this table is produced as | | | | Receivable, Supplies, Equipment) |
| part of the planning process, the difference between | | | | - Liability accounts (Examples: Notes Payable, |
| the columns (and it will generally be negative) is the | | | | Accounts Payable, Wages Payable) |
| cash generated (+) or the cash needed (–) for | | | | - Stockholders' Equity accounts (Examples: Common |
| the period being projected. | | | | Stock, Retained Earnings) |
| Exhibit: Alternative View of Cash Flow Statement | | | | Income Statement accounts: |
| An accounting statement called the "statement of | | | | - Revenue accounts (Examples: Service Revenues, |
| cash flows", which shows the amount of cash | | | | Investment Revenues) |
| generated and used by a company in a given period. | | | | - Expense accounts (Examples: Wages Expense, |
| It is calculated by adding noncash charges (such as | | | | Rent Expense, Depreciation Expense) |
| depreciation) to net income after taxes. Cash flow | | | | To help George really understand how this works, |
| can be attributed to a specific project, or to a | | | | Koppala illustrates the double entry with some sample |
| business as a whole. Cash flow can be used as an | | | | transactions that George will likely encounter. |
| indication of a Projects financial strength. | | | | Sample Transactions #1: |
| In projects, as in personal finance, cash flows are | | | | On December 1, 2007 George starts his business GG |
| essential to solvency. They can be presented as a | | | | Org, Inc. The first transaction that George will record |
| record of something that has happened in the past, | | | | for his company is his personal investment of |
| such as the sale of a particular product, or | | | | $20,000 in exchange for 5,000 shares of GG Org's |
| forecasted into the future, representing what a | | | | common stock. GG Org's accounting system will |
| Projects or a person expects to take in and to | | | | show an increase in its account Cash from zero to |
| spend. Cash flow is crucial to an projects survival. | | | | $20,000, and an increase in its stockholders' equity |
| Having ample cash on hand will ensure that creditors, | | | | account Common Stock by $20,000. Both of these |
| employees and others can be paid on time. If a | | | | accounts are balance sheet accounts. There are no |
| project or person does not have enough cash to | | | | revenues because no delivery fees were earned by |
| support its operations, it is said to be insolvent, and a | | | | the company, and there were no expenses. |
| likely candidate for bankruptcy should the insolvency | | | | After George enters this transaction, GG Org's |
| continue. | | | | balance sheet will look like this: |
| The statement of a Project's cash flows is often | | | | GG Org, Inc. |
| used by analysts to gauge financial performance. | | | | Balance Sheet |
| Companies with ample cash on hand are able to | | | | December 1, 2006 |
| invest the cash back into the Project in order to | | | | Assets |
| generate more cash and profit. | | | | Liabilities & Stockholders' Equity |
| Fig: Cash Flows | | | | Cash |
| Cash Flow Per Share: | | | | $ 20,000 |
| A measure of a firm's financial strength, calculated | | | | Liabilities |
| as follows: | | | | Stockholders' Equity |
| Many analysts, as well as some of the greatest | | | | Common Stock |
| investors of all time, place more weight on cash flow | | | | $ 20,000 |
| per share than earnings per share(EPS). Because EPS | | | | Total Assets |
| is more easily manipulated, its reliability can at times | | | | $ 20,000 |
| be questionable. Cash, on the other hand, is difficult - | | | | Total Liabilities & Stockholders' Equity |
| if not impossible - to fake. You either have cash or | | | | $ 20,000 |
| you don't. Therefore, cash flow per share is a useful | | | | Koppala asks George if he can see that the balance |
| measure for the strength of a firm and the | | | | sheet is just that—in balance. George looks at the |
| sustainability of its business model. | | | | total of $20,000 on the asset side, and looks at the |
| Cash Flow Return on Investment (CFROI): | | | | $20,000 on the right side, and says yes, of course, |
| A valuation model that assumes the stock market | | | | he can see that it is indeed in balance. |
| sets prices based on cash flow, not on corporate / | | | | Koppala shows George something called the basic |
| Projects/ Operations performance and earnings. | | | | accounting equation, which, he explains, is really the |
| It's valuable to consider as many models as possible | | | | same concept as the balance sheet, it's just |
| when looking at the stock market. Financial theory is | | | | presented in an equation format: |
| similar to scientific theory; no model can be entirely | | | | Assets |
| proved or disproved, and a diversity of opinions is | | | | = |
| encouraged | | | | Liabilites |
| The Essentials Of Cash Flow: | | | | + |
| If operations reports earnings of $1 billion, does this | | | | Stockholders' (or Owner's) Equity |
| mean it has this amount of cash in the bank? Not | | | | $20,000 |
| necessarily. Financial statements are based on accrual | | | | = |
| accounting, which takes into account non-cash items. | | | | $0 |
| It does this in an effort to best reflect the financial | | | | + |
| health of a company. | | | | $20,000 |
| Projects are all about trade, the exchange of value | | | | The accounting equation (and the balance sheet) |
| between two or more parties, and cash is the asset | | | | should always be in balance. |
| needed for participation in the economic system. For | | | | Debits and Credits: |
| this reason - while some industries are more cash | | | | Did the first sample transaction follow the double |
| intensive than others - no Project can survive in the | | | | entry system and affect two or more accounts? |
| long run without generating positive cash flow per | | | | George looks at the balance sheet again and answers |
| share for its shareholders. To have a positive cash | | | | yes, both Cash and Common Stock were affected |
| flow, the company's long-term cash inflows need to | | | | by the transaction. |
| exceed its long-term cash outflows. | | | | Koppala introduces the next basic accounting |
| An outflow of cash occurs when a project transfers | | | | concept: the double entry system requires that the |
| funds to another party (either physically or | | | | same dollar amount of the transaction must be |
| electronically). Such a transfer could be made to pay | | | | entered on both the left side of one account, and on |
| for employees, suppliers and creditors, or to purchase | | | | the right side of another account. Instead of the |
| long-term assets and investments, or even pay for | | | | word left, accountants use the word debit; and |
| legal expenses and lawsuit settlements. It is | | | | instead of the word right, accountants use the word |
| important to note that legal transfers of value | | | | credit. (The terms debit and credit are derived from |
| through debt - a purchase made on credit - is not | | | | Latin terms used 500 years ago.) |
| recorded as a cash outflow until the money actually | | | | Debit means left. |
| leaves the company's hands. | | | | Credit means right. |
| A cash inflow is of course the exact opposite; it is | | | | George asks Koppala how he will know which |
| any transfer of money that comes into the Project's | | | | accounts he should debit—meaning he should |
| possession. Typically, the majority of Projects cash | | | | enter the numbers on the left side—and which |
| inflows are from customers, lenders (such as banks | | | | accounts he should credit—meaning he should |
| or bondholders) and investors who purchase | | | | enter the numbers on the right side. Koppala points |
| company equity from the company. Occasionally cash | | | | back to the basic accounting equation and tells |
| flows come from sources like legal settlements or | | | | George that if he memorizes this simple equation, it |
| the sale of Operations real estate or equipment. | | | | will be easier to understand the debits and credits. |
| Cash Flow vs Income | | | | Memorizing the simple accounting equation willhelp you |
| It is important to note the distinction between being | | | | learn the debit and credit rules. |
| profitable and having positive cash flow transactions: | | | | Let's take a look at the accounting equation again: |
| just because a project is bringing in cash does not | | | | Assets |
| mean it is making a profit (and vice versa). | | | | = |
| For example, say a manufacturing company is | | | | Liabilites |
| experiencing low product demand and therefore | | | | + |
| decides to sell off half its factory equipment at | | | | Stockholders' (or Owner's) Equity |
| liquidation prices. It will receive cash from the buyer | | | | Assets are on the left side (or debit side) of the |
| for the used equipment, but the manufacturing | | | | accounting equation, so assets have their account |
| company is definitely losing money on the sale: it | | | | balances on the left side. To increase an asset's |
| would prefer to use the equipment to manufacture | | | | balance, you put more on the left side of the asset |
| products and earn an operating profit. But since it | | | | account. In accounting jargon, you debit the asset |
| cannot, the next best option is to sell off the | | | | account. To decrease an asset you credit the |
| equipment at prices much lower than the company | | | | account, that is, you enter the amount on the right |
| paid for it. In the year that it sold the equipment, the | | | | side. |
| company would end up with a strong positive cash | | | | Liabilities and stockholders' equity are on the right side |
| flow, but its current and future earnings potential | | | | (or credit side) of the accounting equation, and |
| would be fairly bleak. Because cash flow can be | | | | liabilities and equity have their account balances on |
| positive while profitability is negative, investors should | | | | the right side. To increase the balance in a liability or |
| analyze income statements as well as cash flow | | | | stockholders' equity account, you put more on the |
| statements, not just one or the other. | | | | right side. In accounting jargon, you credit the liability |
| What Is the Cash Flow Statement? | | | | or the equity account. To decrease a liability or |
| There are three important parts of a Project's | | | | equity, you debit the account, that is, you enter the |
| financial statements: the balance sheet, the income | | | | amount on the left side. |
| statement and the cash flow statement. The balance | | | | As with all rules, there are exceptions, but Koppala's |
| sheet gives a one-time snapshot of a Project's | | | | advice of using the accounting equation will be helpful |
| ASSETS(see Reading the Balance Sheet). And the | | | | with the majority of George's transactions. |
| income statement indicates the Project's profitability | | | | Since many transactions involve cash, Koppala |
| during a certain period (see Understanding The | | | | suggests that George memorize how the Cash |
| Income Statement). | | | | account is affected when a transaction involves cash: |
| The cash flow statement differs from these other | | | | if GG Org receives cash, the Cash account is debited; |
| financial statements because it acts as a kind of | | | | when GG Org pays cash, the Cash account is |
| corporate checkbook that reconciles the other two | | | | credited. |
| statements. Simply put, the cash flow statement | | | | When a company receives cash, the Cash account is |
| records the company's cash transactions (the inflows | | | | debited. |
| and outflows) during the given period. It shows | | | | When the company pays cash, the Cash account is |
| whether all those lovely REVENUES booked on the | | | | credited. |
| income statement have actually been collected. At | | | | Koppala refers to the example of December 1. Since |
| the same time, however, remember that the cash | | | | GG Org received $20,000 in cash from George in |
| flow does not necessarily show all the company's | | | | exchange for 5,000 shares of common stock, one of |
| expenses: not all expenses the company accrues | | | | the accounts for this transaction is Cash. Since cash |
| have to be paid right away. So even though the | | | | was received, the Cash account will be debited. |
| company may have incurred liabilities it must | | | | In keeping with double entry, two (or more) |
| eventually pay, expenses are not recorded as a cash | | | | accounts need to be involved. Because the first |
| outflow until they are paid (see the section "What | | | | account (Cash) was debited, the second account |
| Cash Flow Doesn't Tell Us" below). | | | | needs to be credited. All George needs to do is find |
| The following is a list of the various areas of the | | | | the right account to credit. In this case, the second |
| cash flow statement and what they mean: | | | | account is Common Stock. Common stock is part of |
| - Cash flow from operating activities - This section | | | | stockholders' equity, which is on the right side of the |
| measures the cash used or provided by a Project's | | | | accounting equation. As a result, it should have a |
| normal operations. It shows the Project's ability to | | | | credit balance, and to increase its balance the |
| generate consistently positive cash flow from | | | | account needs to be credited. |
| operations. Think of "normal operations" as the core | | | | Accountants indicate accounts and amounts using the |
| business of the Project. For example, Microsoft's | | | | following format: |
| normal operating activity is selling software. | | | | Account Name |
| - Cash flows from investing activities - This area lists | | | | Debit |
| all the cash used or provided by the purchase and | | | | Credit |
| sale of income-producing assets. If Microsoft, again | | | | Cash |
| our example, bought or sold companies for a profit | | | | 20,000 |
| or loss, the resulting figures would be included in this | | | | Common Stock |
| section of the cash flow statement. | | | | 20,000 |
| - Cash flows from financing activities- This section | | | | Accountants usually first show the account and |
| measures the flow of cash between a firm and its | | | | amount to be debited. On the next line, the account |
| owners and creditors. Negative numbers can mean | | | | to be credited is indented and the amount appears |
| the Project is servicing debt but can also mean the | | | | further to the right than the debit amount shown in |
| Project is making dividend payments and stock | | | | the line above. This entry format is referred to as a |
| repurchases, which investors might be glad to see. | | | | general journal entry. |
| When you look at a cash flow statement, the first | | | | (With the decrease in the price of computers and |
| thing you should look at is the bottom line item that | | | | accounting software, it is rare to find a small business |
| says something like "net increase/decrease in cash | | | | still using a manual system and making entries by |
| and cash equivalents", since this line reports the | | | | hand. |
| overall change in the Project's cash and its | | | | Sample Transaction #2: |
| equivalents (the assets that can be immediately | | | | Koppala illustrates for George a second transaction. |
| converted into cash) over the last period. If you | | | | On December 2, GG Org purchases a used Project |
| check under current assets on the balance sheet, | | | | van for $14,000 by writing a check for $14,000. The |
| you will find cash and cash equivalents (CCE or | | | | two accounts involved are Cash and Vehicles (or |
| CC&E). If you take the difference between the | | | | Delivery Equipment). When the check is written, the |
| current CCE and last year's or last quarter's, you'll get | | | | accounting software will automatically make the entry |
| this same number found at the bottom of the | | | | into these two accounts. |
| statement of cash flows. | | | | Koppala explains to George what is happening within |
| In the sample Microsoft annual cash flow statement | | | | the software. Since the company pays $14,000, the |
| (from June 2004) shown below, we can see that the | | | | Cash account is credited. (Accountants consider the |
| business ended up with about $9.5 billion more cash | | | | checking account to be Cash, and the TIP you |
| at the end of its 2003/04 fiscal year than it had at | | | | learned is that when cash is paid, you credit Cash.) So |
| the beginning of that fiscal year (see "Net Change in | | | | we know that the Cash account will be credited for |
| Cash and Equivalents"). Digging a little deeper, we see | | | | $14,000 and we know the other account will have to |
| that the Company had a negative cash outflow of | | | | be debited for $14,000. We need only identify the |
| $2.7 billion from investment activities during the year | | | | best account to debit. In this case we choose |
| (see "Net Cash from Investing Activities"); this is | | | | Vehicles (or Delivery Equipment) and the entry is: |
| likely from the purchase of long-term investments, | | | | Account Name |
| which have the potential to generate a profit in the | | | | Debit |
| future.Generally, a negative cash flow from investing | | | | Credit |
| activities are difficult to judge as either good or bad - | | | | Vehicles |
| these cash outflows are investments in future | | | | 14,000 |
| operations of the Company (or another Company); | | | | Cash |
| the outcome plays out over the long term. | | | | 14,000 |
| The "Net Cash from Operating Activities" reveals that | | | | The balance sheet will look like this after the vehicle |
| Microsoft generated $14.6 billion in positive cash flow | | | | transaction is recorded: |
| from its usual business operations - a good sign. | | | | GG Org, Inc. |
| Notice the Project has had similar levels of positive | | | | Balance Sheet |
| operating cash flow for several years. If this number | | | | December 2, 2006 |
| were to increase or decrease significantly in the | | | | Assets |
| upcoming year, it would be a signal of some | | | | Liabilities & Stockholders' Equity |
| underlying change in the Project's ability to generate | | | | Cash |
| cash. | | | | $ 6,000 |
| Digging Deeper into Cash Flow | | | | Liabilities |
| All companies and its Projects provide cash flow | | | | Vehicles |
| statements as part of their financial statements, but | | | | 14,000 |
| cash flow (net change in cash and equivalents) can | | | | Stockholders' Equity |
| also be calculated as net income plus depreciation and | | | | Common Stock |
| other non-cash items. | | | | $ 20,000 |
| Generally, a Project's principal industry of operation | | | | Total Assets |
| determine what is considered proper cash flow levels; | | | | $ 20,000 |
| comparing a Project's cash flow against its industry | | | | Total Liabilities & Stockholders' Equity |
| peers is a good way to gauge the health of its cash | | | | $ 20,000 |
| flow situation. A Project not generating the same | | | | The balance sheet and the accounting equation |
| amount of cash as competitors is bound to lose out | | | | remain in balance: |
| when times get rough. | | | | Assets |
| Even a Project that is shown to be profitable | | | | = |
| according to accounting standards can go under if | | | | Liabilites |
| there isn't enough cash on hand to pay bills. | | | | + |
| Comparing amount of cash generated to outstanding | | | | Stockholders' (or Owner's) Equity |
| debt, known as the operating cash flow ratio, | | | | $20,000 |
| illustrates the Project's ability to service its loans and | | | | = |
| interest payments. If a slight drop in a Project's | | | | $0 |
| quarterly cash flow would jeopardize its loan | | | | + |
| payments, that Project carries more risk than a | | | | $20,000 |
| Project with stronger cash flow levels. Hence, we | | | | As you can see in the balance sheet, the asset Cash |
| always require a Project Manager with finance | | | | decreased by $14,000 and another asset Vehicles |
| acumen. | | | | increased by $14,000. |
| Unlike reported earnings, cash flow allows little room | | | | Liabilities and stockholders' equity were not involved |
| for manipulation. Every Company of its consolidated | | | | and did not change. |
| Project filing reports with the Securities and | | | | Sample Transaction #3: |
| Exchange Commission (SEC) is required to include a | | | | The third sample transaction also occurs on |
| cash flow statement with its quarterly and annual | | | | December 2 when George contacts an insurance |
| reports. Unless tainted by outright fraud, this | | | | agent regarding insurance coverage for the vehicle |
| statement tells the whole story of cash flow: either | | | | GG Org just purchased. The agent informs him that |
| the Project has cash or it doesn't. | | | | $1,200 will provide insurance protection for the next |
| What Cash Flow Doesn't Tell Us | | | | six months. George immediately writes a check for |
| Cash is one of the major lubricants of Project | | | | $1,200 and mails it in. |
| activity, but there are certain things that cash flow | | | | Let's consider this transaction. Using double entry, we |
| doesn't shed light on. For example, as we explained | | | | know there must be a minimum of two accounts |
| above, it doesn't tell us the profit earned or lost | | | | involved—one (or more) of the accounts must be |
| during a particular period: profitability is composed also | | | | debited, and one (or more) must be credited. |
| of things that are not cash based. This is true even | | | | Since a check is written, we know that one of the |
| for numbers on the cash flow statement like "cash | | | | accounts involved is Cash. Since cash was paid, the |
| increase from sales minus expenses", which may | | | | Cash account will be credited. (Take another look at |
| sound like they are indication of profit but are not. | | | | the last TIP.) While we have not yet identified the |
| As it doesn't tell the whole profitability story, cash | | | | second account, what we do know for certain is that |
| flow doesn't do a very good job of indicating the | | | | the second account will have to be debited. |
| overall financial well-being of the Project. Sure, the | | | | At this point we have most of the entry—all we |
| statement of cash flow indicates what the Project is | | | | are missing is the name of the account to be debited: |
| doing with its cash and where cash is being | | | | Account Name |
| generated, but these do not reflect the Project's | | | | Debit |
| entire financial condition. The cash flow statement | | | | Credit |
| does not account for liabilities and assets, which are | | | | ??? |
| recorded on the balance sheet. Furthermore accounts | | | | 1,200 |
| receivable and accounts payable, each of which can | | | | Cash |
| be very large for a Project, are also not reflected in | | | | 1,200 |
| the cash flow statement. | | | | We know the transaction involves insurance, and a |
| In other words, the cash flow statement is a | | | | quick look through the chart of accounts reveals two |
| compressed version of the Project's checkbook that | | | | possibilities: |
| includes a few other items that affect cash, like the | | | | Prepaid Insurance (an asset account reported on the |
| financing section, which shows how much the Project | | | | balance sheet) and Insurance Expense (an expense |
| spent or collected from the repurchase or sale of | | | | account reported on the income statement) |
| stock, the amount of issuance or retirement of debt | | | | Assets include costs that are not yet expired (not |
| and the amount the Project paid out in dividends. | | | | yet used up), while expenses are costs that have |
| Cash accounting: | | | | expired (have been used up). Since the $1,200 |
| An accounting method which reports expenditures | | | | payment is for an expense that will not expire in its |
| and revenues when the actual cash outflow or inflow | | | | entirety within the current month, it would be logical |
| has occurred. | | | | to debit the account Prepaid Insurance. (At the end |
| Cash discount: | | | | of each month, when $200 has expired, $200 will be |
| A reduction, usually expressed as a percentage, in | | | | moved from Prepaid Insurance to Insurance |
| the price of a product or the amount of a bill if | | | | Expense.) |
| payment is made promptly and in cash. | | | | The entry in the general journal format is: |
| Cash market: | | | | Account Name |
| The market in which commodities, | | | | Debit |
| Cash payment: | | | | Credit |
| In international trade transactions, this refers to the | | | | Prepaid Insurance |
| portion paid by the importer prior to shipment (usually | | | | 1,200 |
| 15% of the total sales price or invoice value). It is | | | | Cash |
| mandatory for the extension of most medium and | | | | 1,200 |
| long-term guarantee/insurance and trade financing | | | | After the first three transactions have been |
| facilities. | | | | recorded, the balance sheet will look like this: |
| | | | GG Org, Inc. |
| Cash with order (CWO): | | | | Balance Sheet |
| A payment technique whereby the buyer pays for | | | | December 2, 2006 |
| the goods when ordering them, with the transaction | | | | Assets |
| being binding on both parties. | | | | Liabilities & Stockholders' Equity |
| Concluded Note: | | | | Cash |
| Like so much in the world of finance, the cash flow | | | | $ 4,800 |
| statement is not straightforward. You must | | | | Liabilities |
| understand the extent to which a Project relies on | | | | Prepaid Insurance |
| the capital and the extent to which it relies on the | | | | 1,200 |
| cash it has itself generated. No matter how profitable | | | | Stockholders' Equity |
| a Project may be, if it doesn't have the cash to pay | | | | Vehicles |
| its bills, it will be in serious trouble. | | | | 14,000 |
| At the same time, while investing in a Project that | | | | Common Stock |
| shows positive cash flow is desirable, there are also | | | | $ 20,000 |
| opportunities in companies that aren't yet cash-flow | | | | Total Assets |
| positive. The cash flow statement is simply a piece | | | | $ 20,000 |
| of the puzzle. So, analyzing it together with the other | | | | Total Liabilities & Stockholders' Equity |
| statements can give you a more overall look at a | | | | $ 20,000 |
| Project' financial health. Remain diligent in your analysis | | | | Again, the balance sheet and the accounting equation |
| of a Project's cash flow statement and you will be | | | | are in balance and all of the changes occurred on the |
| well on your way to removing the risk of one of | | | | asset/left/debit side of the accounting equation. |
| your stocks falling victim to a cash flow crunch. | | | | Liabilities and Stockholders' Equity were not affected |
| The flow of cash payments to or from a firm during | | | | by the insurance transaction. |
| a given period of time. Expenditures are sometimes | | | | Sample Transaction #4: |
| referred to as "negative" cash flows. | | | | The fourth transaction occurs on December 3, when |
| - Statement of Cash Flows | | | | a customer gives GG Org a check for $10 to deliver |
| (Note: The Separate POME Chapter of Cash Flows | | | | two parcels on that day. Because of double entry, |
| illustrated more in detail about this) | | | | we know there must be a minimum of two accounts |
| The third financial statement that George needs to | | | | involved—one of the accounts must be debited, |
| understand is the Statement of Cash Flows. This | | | | and one of the accounts must be credited. |
| statement shows how GG Org's cash amount has | | | | Because GG Org received $10, it must debit the |
| changed during the time interval shown in the heading | | | | account Cash. It must also credit a second account |
| of the statement. George will be able to see at a | | | | for $10. The second account will be Service |
| glance the cash generated and used by his | | | | Revenues, an income statement account. The reason |
| company's operating activities, its investing activities, | | | | Service Revenues is credited is because GG Org |
| and its financing activities. Much of the information on | | | | must report that it earned $10 (not because it |
| this financial statement will come from GG Org's | | | | received $10). Recording revenues when they are |
| balance sheets and income statements. | | | | earned results from a basic accounting principle |
| The three financial reports that Koppala introduced to | | | | known as the revenue recognition principle. The |
| George—the income statement, the balance | | | | following tip reflects that principle. |
| sheet, and the statement of cash | | | | Revenues accounts are credited when the company |
| flows—represent one segment of the valuable | | | | earns a fee (or sells merchandise) regardless of |
| output that good accounting software can generate | | | | whether cash is received at the time. |
| for business owners. | | | | Here are the two parts of the transaction as they |
| Koppala now explains to George the basics of getting | | | | would look in the general journal format: |
| started with recording his transactions. | | | | Account Name |
| Double Entry System | | | | Debit |
| The field of accounting—both the older manual | | | | Credit |
| systems and today's basic accounting | | | | Cash |
| software—is based on the 500-year-old | | | | 10 |
| accounting procedure known as double entry. Double | | | | Service Revenues |
| entry is a simple yet powerful concept: each and | | | | 10 |
| every one of a company's transactions will result in | | | | Sample Transaction #5 |
| an amount recorded into at least two of the | | | | Let's assume that on December 3 the company gets |
| accounts in the accounting system. | | | | its second customer—a local company that needs |
| The Chart of Accounts | | | | to have 5 work packages immediately. George's price |
| People develop accounting systems to make it easier | | | | of $250 is very appealing, so George's company is |
| to process accounting transactions and to generate | | | | hired to deliver the work packages. The customer |
| financial statements and other financial information. | | | | tells George to submit an invoice for the $250, and |
| To process the accounting transactions such as | | | | they will pay it within seven days. |
| those in the preceding section, accountants have | | | | George delivers the work packages on December 3 |
| developed a systematic account numbering system | | | | as agreed, meaning that on December 3 GG Org has |
| that helps assure that transactions are properly | | | | earned $250. Hence the $250 is reported as revenues |
| reflected in the financial statements. | | | | on December 3, even though the company did not |
| Such a systematic numbering system, called the chart | | | | receive any cash on that day. The effort needed to |
| of accounts, provides a shorthand entry control | | | | complete the job was done on December 3. |
| system for assuring that related transactions are | | | | (Depositing the check for $250 in the bank when it |
| accumulated together. Properly constructed, the | | | | arrives seven days later is not considered to take |
| chart of accounts should lead directly to the | | | | any effort.) |
| production of financial statements, making it easy to | | | | Let's identify the two accounts involved and |
| close the books each period, produce financial | | | | determine which needs a debit and which needs a |
| statements, and provide consistent information for | | | | credit. |
| analysis and interpretation. Thus, the accounting | | | | Because GG Org has earned the fees, one account |
| system and the processing of transactions contribute | | | | will be a revenues account, such as Service |
| to the timely and effective management of the | | | | Revenues. (If you refer back to the last TIP, you will |
| operations. | | | | read that revenue accounts —such as Service |
| The numbering system in a well-constructed chart of | | | | Revenues—are usually credited, meaning the |
| accounts reflects the same sequence as appears in | | | | second account will need to be debited.) |
| the financial statements, beginning with cash, the first | | | | In the general journal format, here's what we have |
| Balance Sheet Asset account, and continuing through | | | | identified so far: |
| taxes, an expense reflected at the bottom of the | | | | Account Name |
| Income Statement. The result of such a structure is | | | | Debit |
| that as the accountant closes the books for the | | | | Credit |
| period, these basic financial statements will be | | | | ??? |
| automatically prepared. | | | | 250 |
| A typical chart of accounts might be constructed like | | | | Service Revenues |
| the one in Exhibit below As you can see, the | | | | |
| structure of the numbering system leads directly to | | | | Account Name |
| the presentation of financial statements. | | | | Debit |
| - 1000s are Assets | | | | Credit |
| - 2000s are Liabilities | | | | Accounts Receivable |
| - 3000 are Equity accounts | | | | 250 |
| - 4000s are Revenues | | | | Service Revenues |
| - 5000s are Cost of Sales accounts | | | | 250 |
| - 6000s are Operating Expenses | | | | Again, reporting revenues when they are earned |
| - 7000s are Other Income and Expense accounts | | | | results from the basic accounting principle known as |
| - 8000s are Taxes | | | | the revenue recognition principle. |
| This type of structure makes it very easy for the | | | | Sample Transaction #6 |
| accountants and Project Managers to review the | | | | For simplicity, let's assume that the only expense |
| results of the accounting period and report to | | | | incurred by GG Org so far was a fee to a temporary |
| management, and to other interested parties, the | | | | help agency for a person to help George in |
| summarized results and the reasons behind them. | | | | completing the work packages on December 3. The |
| As a company becomes more complicated, with | | | | temp agency fee is $80 and is due by December 12. |
| divisions or subsidiaries, with multiple departments, or | | | | If a company does not pay cash immediately, you |
| with other specialized reporting interests, the | | | | cannot credit Cash. But because the company owes |
| accounts within each category may be expanded by | | | | someone the money for its purchase, we say it has |
| inserting numbers or adding additional digits to permit | | | | an obligation or liability to pay. Most accounts involved |
| reporting by smaller or more specific units. | | | | with obligations have the word "payable" in their |
| For example, Peachtree Accounting Software, an | | | | name, and one of the most frequently used accounts |
| inexpensive PC-based accounting software package, | | | | is Accounts Payable. Also keep in mind that expenses |
| permits a chart of accounts numbering system of up | | | | are almost always debited. |
| to 15 characters, both letters and numbers. Such a | | | | The accounts and amounts for the temporary help |
| chart of accounts permits as much detail as any | | | | are: |
| smaller business might want or need. | | | | Account Name |
| In fact, the availability of 15 characters would permit | | | | Debit |
| such detail as would be needed to track the costs of | | | | Credit |
| a specific project or activity within a department | | | | Temporary Help Expense |
| within a facility within a division within a subsidiary | | | | 80 |
| within a company. At the same time, by sorting on | | | | Accounts Payable |
| specific digits within the account code, management | | | | 80 |
| could determine how much was spent on a particular | | | | Expenses are (almost) always debited. |
| expense category, such as Telephone or Delivery. | | | | If a company does not pay cash right away for an |
| As an example of a 15-digit account number consider | | | | expense or for an asset, you cannot credit Cash. |
| the following: | | | | Because the company owes someone the money |
| AAA | | | | for its purchase, we say it has an obligation or liability |
| = Company, subsidiary, division or affiliate | | | | to pay. The most likely liability account involved in |
| BBBB | | | | business obligations is Accounts Payable. |
| = Account number | | | | Revenues and expenses appear on the income |
| CCC | | | | statement as shown below: |
| = Department or responsibility | | | | GG Org, Inc. |
| DDDDD | | | | Income Statement |
| = Project, territory, class of trade | | | | For the Three Days Ended December 3, 2006 |
| With this type of structure a company can identify | | | | Service Revenue |
| spending activity in almost any combination of ways | | | | $ 260 |
| to provide all Project Managers with the information | | | | Temporary Help Expense |
| they need to manage their area and level of | | | | 80 |
| responsibility. | | | | Net Income |
| The Accounting Cycle | | | | $ 180 |
| Accountants collect financial information as it occurs | | | | After the entries through December 3 have been |
| but report it based on predetermined accounting time | | | | recorded, the balance sheet will look like this: |
| periods, generally months, quarters, and years. It | | | | GG Org, Inc. |
| could, however, be reported for any time period that | | | | Balance Sheet |
| management or some interested party decided was | | | | December 3, 2006 |
| important. | | | | Assets |
| | | | Liabilities & Stockholders' Equity |
| Where: | | | | Cash |
| Exhibit: Chart of Accounts | | | | $ 4,810 |
| Consider a purchase of $1,000 of special widgets | | | | Liabilities |
| needed for a special project. | | | | Accounts Receivable |
| The Project Manager would place an order with the | | | | 250 |
| local office of Specialty Widget Corporation Based | | | | Accounts Payable |
| Projects for the supplies. This action would have no | | | | $ 80 |
| impact on the accounting system. | | | | Prepaid Insurance |
| When the supplies are shipped, Specialty Widget | | | | 1,200 |
| issues an invoice for $1,000. On Specialty Widget's | | | | Stockholders' Equity |
| books this transaction is recorded as: | | | | Vehicles |
| Dr (Debit) | | | | 14,000 |
| Cr (Credit) | | | | Common Stock |
| Sales | | | | 20,000 |
| $1,000.00 | | | | Retained Earnings |
| Accounts Receivable | | | | 180 |
| $1,000.00 | | | | Total Stockholders' Equity |
| Cost of Sales | | | | 20,180 |
| 700.00 | | | | Total Assets |
| Inventory | | | | $ 20,260 |
| 700.00 | | | | Total Liabilities & Stockholders' Equity |
| You will recognize that Specialty Widget has achieved | | | | $ 20,260 |
| a $300 contribution to profit on this transaction. The | | | | Notice that the year-to-date net income (bottom line |
| difference between sales and cost of sales is known | | | | of the income statement) increased Stockholders' |
| as gross profit. | | | | Equity by the same amount, $180. This connection |
| On the purchasing company's books, the same | | | | between the income statement and balance sheet is |
| transaction appears as: | | | | important. For one, it keeps the balance sheet and |
| Supplies Expense | | | | the accounting equation in balance. Secondly, it |
| $1,000.00 | | | | demonstrates that revenues will cause the |
| Accounts Payable | | | | stockholders' equity to increase and expenses will |
| $1,000.00 | | | | cause stockholders' equity to decrease. After the |
| The supplies are not generally treated as inventory | | | | end of the year financial statements are prepared, |
| because they are not for resale, are not held for use | | | | you will see that the income statement accounts |
| in some future time period, and are not to be stored | | | | (revenue accounts and expense accounts) will be |
| for use as part of the product to be sold. | | | | closed or zeroed out and their balances will be |
| When the purchasing company pays for the supplies, | | | | transferred into the Retained Earnings account. This |
| after 30 days or whatever credit period was | | | | will mean the revenue and expense accounts will |
| determined in negotiation between the two | | | | start the new year with zero balances—allowing |
| companies, the respective entries are as follows: | | | | the company "to keep score" for the new year. |
| On the books of the purchasing company: | | | | Koppala suggested that perhaps this introduction was |
| Accounts Payable | | | | enough material for their first meeting. She wrote out |
| $1,000.00 | | | | the following notes, summarizing for George the |
| Cash | | | | important points of their discussion: |
| $1,000.00 | | | | 1. When a company pays cash for something, the |
| And on the books of the Specialty Widget | | | | company will credit and will have to debit a second |
| Corporation Based Projects : | | | | account. Assuming that a company prepares monthly |
| Cash | | | | financial statements— |
| $1,000.00 | | | | - If the amount is used up or will expire in the current |
| Accounts Receivable | | | | month, the account to be debited will be an expense |
| $1,000.00 | | | | account. (Advertising Expense, Rent Expense, Wages |
| You can see from this example that each entry is | | | | Expense are three examples.) |
| balanced. Following these entries to the financial | | | | - If the amount is not used up or does not expire in |
| statements highlights some additional important | | | | the current month, the account to be debited will be |
| considerations. | | | | an asset account. (Examples are Prepaid Insurance, |
| On the books of Specialty Widget, the Sales exceed | | | | Supplies,, Prepaid Advertising, Prepaid Association |
| the Cost of Sales by an amount that, were this the | | | | Dues, Land, Buildings, and Equipment.) |
| only transaction of the month, would result in a profit | | | | - If the amount reduces a company's obligations, the |
| of $300. This profit, when closed to Retained | | | | account to be debited will be a liability account. |
| Earnings during the closing process, would assure that | | | | (Examples include Accounts Payable, Notes Payable, |
| the Balance Sheet balanced because the increase in | | | | Wages Payable, and Interest Payable.) |
| assets of $300 (the absolute difference between the | | | | 2. When a company receives cash, the company will |
| increase in Accounts Receivable [later transferred to | | | | debit Cash and will have to credit another account. |
| Cash] and the decrease in Inventory) is equal to the | | | | Assuming that a company will prepare monthly |
| increase in Retained Earnings. | | | | financial statements— |
| On the books of the purchasing company, the | | | | - If the amount received is from a cash sale, or for a |
| $1,000.00 in Supplies Expense, were it the only | | | | service that has just been performed but has not |
| transaction of the month, would result in a reported | | | | yet been recorded, the account to be credited is a |
| loss of $1,000.00. This amount, when closed to | | | | revenue account such as Service Revenues or Fees |
| Retained Earnings at the end of the month, would | | | | Earned. |
| result in balancing the Balance Sheet, as the decrease | | | | - If the amount received is an advance payment for |
| in Cash of $1,000.00 would equal the decrease in | | | | a service that has not yet been performed or |
| Retained Earnings of $1,000.00. | | | | earned, the account to be credited is Unearned |
| In traditional accounting education, each of these | | | | Revenue. |
| transactions would be recorded in an appropriate | | | | - If the amount received is a payment from a |
| journal, a book of transactions that would be | | | | customer for a sale or service delivered earlier and |
| summarized as the first steps in the monthly closing | | | | has already been recorded as revenue, the account |
| process. In practice today, these journals are | | | | to be credited is Accounts Receivable. |
| generally automatically recorded and summarized | | | | - If the amount received is the proceeds from the |
| within the computerized accounting system. Let's see | | | | company signing a promissory note, the account to |
| how this would look for an ordinary individual. If you | | | | be credited is Notes Payable. |
| pay all your bills by check and record all transactions | | | | - If the amount received is an investment of |
| in your checkbook, the checkbook is the journal, and | | | | additional money by the owner of the corporation, a |
| you could prepare personal financial statements | | | | stockholders' equity account such as Common Stock |
| every month using the checkbook as the basis for all | | | | is credited. |
| your closing entries. | | | | Determining the Cash Flows of a Project |
| If you analyze your business, you will recognize a | | | | For all of the years of the capital project evaluation, |
| series of journals that you can visualize as the | | | | usually six or seven, all of the income and expenses |
| accounting system: | | | | associated with the project activity need to be |
| - Sales Journal—Records all sales orders. | | | | determined. The evaluation is concerned only with |
| - Cash Receipts Journal—Records all cash receipts. | | | | the incremental activity, not the already existing fixed |
| The Cash Receipts Journal should confirm deposit | | | | costs that will be allocated to the sales and |
| information appearing in the bank statement. | | | | operations involved. The choice of a useful life limited |
| - Purchases Journal—Records all purchase orders | | | | to six or seven years recognizes the difficulty of |
| that have been fulfilled. It records obligations before | | | | estimating results too far into the future. It also |
| they have been paid. Payments appear in the Cash | | | | recognizes that the present value interest factors |
| Disbursements Journal. | | | | beyond six or seven years are sufficiently low that |
| - Cash Disbursements Journal—Records all | | | | the present value of cash flows then is probably |
| payments made. The difference between the cash | | | | modest. |
| disbursements journal summary and the cash receipts | | | | In many cases incremental revenues are easy to |
| journal summary is the net entry to Cash on the | | | | determine. The analyst needs to be aggressive in |
| Balance Sheet. | | | | seeking out the costs because they are much more |
| - Payroll Journal—Records all payroll transactions. | | | | difficult to identify. |
| The amounts entered into the payroll journal also | | | | This difficulty is compounded by the fact that the |
| show up as transactions in the cash disbursements | | | | Project Manager who is recommending the project is |
| journal. | | | | usually optimistic and positive about all aspects of the |
| - General Journal—Records all adjusting entries, | | | | project; he or she may leave out expenses and |
| summary totals from the other journals, and all | | | | other costs, generally inadvertently. Nevertheless, |
| transactions that do not affect cash receipts or cash | | | | determining the cash flows associated with a project, |
| disbursements. The general journal provides the link | | | | and taking all elements into account, may be difficult. |
| to the financial statements for all accounting activities | | | | The consequence will be optimistic projections of |
| that do not pass through the other journals or other | | | | profits and cash flows resulting from the investment. |
| detailed records of the company. | | | | For each year, the revenues and costs are computed |
| Because each accounting period is supposed to | | | | and structured into an Income Statement format, |
| provide a complete and accurate summary of | | | | accounting for depreciation as an expense before |
| financial transactions and financial conditions, it is | | | | computing the after-tax profit associated with the |
| sometimes necessary to recognize the financial | | | | project. The depreciation is then added back to the |
| effects of transactions that have not yet happened | | | | after-tax profit because it is a non-cash expense and |
| or are not yet complete. Consider the partial | | | | we are concerned with cash flows. These cash flows |
| completion of some production. You would need to | | | | are then adjusted for time in computing the return |
| record the value of the work completed to date, | | | | on investment, as we will see shortly. |
| even though it is not yet finished. The accounting for | | | | Determining the Terminal Cash Flows |
| value added to work in process needs to be | | | | As noted above, the normal time frame for |
| recorded, but for the next period, you need to undo, | | | | evaluation is generally six or seven years, even |
| or reverse, this entry in order to record the final | | | | though the equipment or other acquisition will last |
| value of the now completed product. Such an entry, | | | | longer than that. The time value of cash flows after |
| and there are many of them, is handled in the | | | | the six or seven years, when the discount rate is |
| accounting system as a reversing journal entry, that | | | | applied, will be relatively small, and the uncertainty |
| is, an entry that will be reversed in the next | | | | that far out is substantial. Therefore, for evaluation |
| accounting period. Each period will then have the right | | | | purposes, the assessment is terminated at the end |
| amounts in it. The first entry, in the first period, | | | | of this time. |
| records the work completed to date. The second set | | | | On termination of the investment, whenever it |
| of entries, in the following period, will record a | | | | occurs, the Projects may incur removal and disposal |
| negative amount for the work completed earlier and | | | | expenses. If the environment has been changed, |
| the full value of the completed product. The net of | | | | there may be restoration costs. Additionally, there |
| these two parts equals the value added in the | | | | are salvage or sales values that may be significant |
| second period. | | | | and may involve recovery of some portion of the |
| Therefore, reversing journal entries are part of the | | | | original investment. And the working capital will be |
| general journal and are normally recorded separately, | | | | recovered as well. All of these cash flows as well as |
| permitting their immediate (at the beginning of the | | | | the projected cash flows of this final year must be |
| next accounting period) reversal, setting the stage | | | | taken into account in computing the terminal cash |
| for the next accounting cycle. | | | | flow. |