Summary of Week 3

We started the week by talking about the direct method. The direct method is more focused on explicitly highlighting cash inflows and cash outflows. Companies report cash collected from customers as the inflow, and cash paid to suppliers, the government (for taxes), and to other parties in operating expenses as the outflow. We went through some formulas that help to get at these.

We also talked about how to prepare the investing and financing sections of the statement of cash flows. Both sections make use of the direct method, meaning that we focus on cash inflows and outflows. For the investing section, inflows come in the form of proceeds from selling long-lived assets or investments, while outflows occur when we buy long-lived assets or investments. For the financing section, inflows come in the form of money borrowed from creditors or proceeds from selling equity, while outflows occur when we pay back debt, re-purchase stock, or pay dividends.

We had a brief discussion of the pros and cons of the direct versus indirect method. Basically, the indirect method is easier, but some argue that the direct method is more informative about cash inflows and outflows. The indirect method does highlight the differences between accrual income and cash flow, which can be nice when evaluating the quality of earnings.

We also walked through some other technical details related to cash flow. The first group involved thinking about other non-cash expenses (like depreciation) that need to be added back to net income when using the indirect method. For example, when firms show an increase in their deferred tax liability, this will decrease net income (through income tax expense), but there is no cash piece. The second group had us think about issues such as stock options and pensions. Recall that issuing stock options yields compensation expense but no cash outlay, so this needs to be added back to net income (net of tax of course because of the deferred taxes piece). Additionally, any change in the funded status of a pension fund needs to be adjusted for because we want to end up with cash contributed to the plan not pension expense (that is in net income).

Chapter 24: Full Disclosure

We began the full disclosure chapter with a discussion of the full disclosure principle. Basically it says that financial reporting should present any financial facts that are significant enough for an informed decision maker to care. Disclosure comes from a lot of sources ranging from financial statements, the notes to the financial statements, other management communication (such as MD&A and forecast), and info provided by people outside the firm (analysts, journalists, etc.).

We discussed the idea of subsequent events (i.e. events that happen after the fiscal year end, but before final publication of the financial statements). If the subsequent event provided additional information about conditions that existed at the balance sheet (like resolution of a pending lawsuit), then firms need to go back and adjust the F/S at the balance sheet date. If the event is a new event (like a fire at the factory), you don't have to retroactively adjust your financials, but you do have to disclose the existence of the significant subsequent event.

We went through the idea of segment reporting, which requires firms to provide information about their different business lines using the same framework that management uses to run the firm. Firms must provide segment details about segments that pass at least one of the following tests:

Segment revenue is at least 10% of total revenue for all segments
Segment Profit or loss is at least 10% of the greater of the total segment profit for all profitable segments or the total segment loss for all loss segments
Segment assets are at least 10% of total assets for all segments
75% of segment stuff is covered


When segment reporting is required, firms must disclose a general background about the segment, give profit and loss results, total assets, and reconciliations between the reported segment figures and what is on the balance sheet/income statement for the overall firm.