© 2005 by Robert F. Halsey, all rights reserved Agenda Review Accrual Basis Income Statements Preparation of Statement of Cash Flows Interpretation of.

© 2005 by Robert F. Halsey, all rights reserved

Agenda

Review Accrual Basis Income Statements Preparation of Statement of Cash Flows Interpretation of Statement of Cash Flows

Reversal of S-T accruals (IBM) Manipulation of NCFO (Tyco)

Valuation of cash flows Free Cash Flow definitions

Accrual accounting has two principal components:

1) The Revenue Recognition Principle, which states that revenue is recorded when it is “earned”, and

2) The Matching Principle, which states that expenses recognized when “incurred”

Neither the recognition of revenue nor that of expense necessarily involves the receipt or payment of cash.

Accrual basis earnings, therefore, do not convey much information about cash inflows to and outflows from the business.

• Over the life of the firm, profit equals net cash flow.

• In any one period,however, the two will not be equal because of accrual accounting.

• Analysts have learned that the difference between reported earnings and cash flows may provide clues about the “quality of earnings” (i.e., whether the firm is managing its earnings) – Profit=cash flow +Accruals

Cash flow preparation exercise


Change Assets Cash 5,000 Accts Rec 20,000 Inventories 25,000 Fixed Assets 50,000 Accum.Depn 10,000 Fixed Assets (net) 40,000 Total Assets 90,000 Liabilities Accounts Payable 20,000

Bonds Payable (20,000) Equity Common Stock 50,000 Retained Earnings 40,000 Total Liab. and Equity 90,000 Sales Cost of Goods sold Salaries expense Depreciation expense Gain on sale Net income

300,000 190,000 50,000

20,000 (10,000) 50,000


SCF Statement Examples


Reversing nature of accruals Companies can shift income from one

period into another by the use of accruals. Short-term accruals reverse over a 1-3 year

period Accruals for wages reverse in following month Restructuring accruals re verse over several

years Evidence suggests that the market does not

fully appreciate the reversing nature of accruals

IBM mini-case


IBM Mini-Case

IBM STACC/Sales 1981-2000

-0.2

-0.15

-0.1

-0.05

0

0.05

0.1

1 3 5 7 9 11 13 15 17 19

Years

ST

AC

C/S

ale

s

STACC/Sales


Are these short-term swings in accruals priced?

Annual Size-Adjusted Returns for Extreme Accrual Portfolios

-30.00%

-20.00%

-10.00%

0.00%

10.00%

20.00%

30.00%

-5 -4 -3 -2 -1 0 1 2 3 4 5

Year Relative to Accrual Ranking Year

An

nu

al S

ize-

Ad

just

ed R

etu

rn

Low Accruals

High Accruals

Source: Sloan (1996)


J C PenneyEPS vs. Trend EPS

0

1

2

3

4

5

1955 1960 1965 1970 1975 1980 1985 1990

YEAR

$/s

ha

re

EPS Trend EPS

Source: R.F. Halsey “Stationary Components of Earnings and Stock Prices,” Advances in Quantitative Analysis of Finance and Accounting (2001)


Pricet = 0 + 1Trendt + 2Cyclet + 3Irregulart

+ t

PCYCt = 0 + 1Cyclet + t

0 1 2 3 Adj-R2

Coefficient(T-statistic)

24.56(107.60)

6.16(42.38)

2.90(8.67)

1.38(5.19)

10.55 %

0 1 Adj-R2

Coefficient(T-statistic)

-1.46(-41.21)

2.02(56.47)

13.65 %

Source: R.F. Halsey “Stationary Components of Earnings and Stock Prices,” Advances in Quantitative Analysis of Finance and Accounting (2001)


Stock Prices, Income and Cash Flow


Stock Prices and Reporting Window

Cash Flow Problem Areas Securitization of A/R Financing of customers as investing vs. operating

activity Trading securities Exercise of ESOs

Income tax payable xxx APIC Tax Benefit xxx

Leaning on A/P and reducing operating expenses Tyco accounting for purchase of alarm contracts as

CAPEX, yet cash inflows counted as operating Transitory items (acquisitions, litigation,

restructuring Cash generated by discontinued operations Tax paid (benefit) on nonoperating income (expense) Capitalizing operating costs (WorldCom) 4Q drop in NWC (quarterlies are not audited)


Tyco mini-case


Tyco Free Cash Flow Computation ($ IN MILLIONS) FISCAL 2001 FISCAL 2000 FISCAL 1999 --------------- ----------- ----------- ----------- Tyco Industrial operating income, before certain charges (credits) and accounting change(1)........................ $7,623.5 $6,094.1 $3,949.6 Depreciation and amortization of intangible assets(2)....... 1,603.2 1,300.0 1,095.1 Net increase in deferred income taxes....................... 219.0 507.8 351.6 Less: Net increase in working capital(3)........................ (466.0) (64.9) (122.6) Interest expense, net..................................... (776.5) (769.6) (485.6) Income tax expense........................................ (1,284.9) (1,926.0) (637.5) Restructuring expenditures(4)............................. (215.5) (155.2) (633.6) Other, net................................................ 222.7 288.8 32.8 -------- -------- -------- Cash flow from operating activities......................... 6,925.5 5,275.0 3,549.8 Less: Capital expenditures(5)................................... (1,797.5) (1,703.8) (1,632.5) Tyco Capital factoring receivables........................ (297.8) -- -- Dividends paid............................................ (90.0) (86.2) (187.9) -------- -------- -------- Free cash flow.............................................. $4,740.2 $3,485.0 $1,729.4 ======== ======== ======== </Table> ------------------------------ (1) This amount is the sum of the operating income of the four Tyco Industrial business segments as set forth above, less certain corporate expenses, and is before merger, restructuring and other non-recurring charges (credits), a charge for the write-off of purchased in-process research and development, charges for the impairment of long-lived assets, goodwill amortization and the adoption of SAB 101. (2) This amount is the sum of depreciation of tangible property ($1,243.1 million, $1,095.0 million and $979.6 million in Fiscal 2001, Fiscal 2000 and Fiscal 1999, respectively) and amortization of intangible assets other than goodwill ($360.1 million, $205.0 million and $115.5 million in Fiscal 2001, Fiscal 2000 and Fiscal 1999, respectively). (3) This amount includes $490.6 million (of which $297.8 million relates to sales to Tyco Capital), $100.0 million and $50.0 million received on the sale of accounts receivable in Fiscal 2001, Fiscal 2000 and Fiscal 1999, respectively. (4) This amount is cash paid for merger, restructuring and other non-recurring charges. (5) This amount excludes expenditures related to construction of the TGN of $2,247.7 million and $111.1 million for the years ended September 30, 2001 and 2000, respectively. This amount includes $427.7 million and $172.0 million received in sale-leaseback transactions for the years ended September 30, 2001 and 2000, respectively.


Income from continuing operations 6202.1 Merger costs 233.6 IPRND 184.3 FA impairment 120.1 Goodwill amort 957.3 SAB 101 241.1 Corp exp -315 Tyco operating income 7623.5 Tyco FCF 4740.2 Possible adjustments: Tycom CAPEX -2247.7 (netted against IPO proceeds) Sale/leaseback -427.7 (transitory) Tax benefit – options -230.9 (no expense recorded) Zero coupon interest -108.4 (not rec in ops since settled in debt) Purchase accounting liabilities -1120 (cash pmts chgd to pr yr liab, no exp) Sale of A/R -490.6 (financing, not operating) Adjusted FCF 114.9


Differing Free Cash Flow Definitions

Benchmark definition:


Akamai’s definition


Delphi’s “Free” Cash Flow


Delphi’s “Free” Cash Flow

© 2005 by Robert F. Halsey, all rights reserved Agenda Review Accrual Basis Income Statements Preparation of Statement of Cash Flows Interpretation of.

Documents

cash flow slide

rights reserved slide

restructuring cash

cash inflows

cycle t t

payment of cash

rights reserved price

irregular t t pcyc t