Cash-to-Accrual Accounting PDF

Cash-to-Accrual Accounting Learning Objectives Differentiate the rationale for using Establish the approach to convert Practice and adjust assets, liabilities, cash and accrual information. cash receipts and disbursements to revenues, and expenses to get cash...

Cash-to-Accrual Accounting Learning Objectives Differentiate the rationale for using Establish the approach to convert Practice and adjust assets, liabilities, cash and accrual information. cash receipts and disbursements to revenues, and expenses to get cash relevant accrual data. statements closer to an equivalent set of accrual statements. Link the different financial statements and distinguish their differences when looking at financial metrics. Corporate Finance Institute® Course Instructor About Gabriel... Gabriel is a Subject Matter Expert at CFI and was a commercial lender at TD Bank with 15 years of experience. He recently managed a $100 million portfolio of higher-risk and non- performing credits at the restructuring & insolvency group. Gabe has worked with a broad portfolio of public and private clients, including large auto dealerships, logistics/transportation services, manufacturing, retailing, professional services, and agriculture operators. He is passionate about education and excited to train & Gabriel Lip develop the next generation of lenders SME, CBCA through CFI. Corporate Finance Institute® Overview Introduction Net income is used to assess the impact of managerial decisions. It is of importance for borrowers and lenders alike. Since the commonly used cash method of accounting does not accurately reflect the actual economic profits and losses for others, it requires some revisions. The accrual method of accounting evaluates long-term: Profitability Growth Financing Corporate Finance Institute® Introduction In this course, we will learn the practice of converting from cash to accrual statements whenever we encounter them in our careers. Cash method Accrual method Corporate Finance Institute® Cash Versus Accrual Accounting Methods The critical difference between the accrual and cash accounting methods is when transactions are recognized and recorded. Cash method Accrual method Revenues are recorded Revenues are recorded when cash is received. when cash is earned. Expenses are recorded Expenses are recorded when cash is paid. when they are incurred. Corporate Finance Institute® Cash Versus Accrual Accounting Methods Cash method Recordkeeping Easy to Manage Tax-friendly Some business owners Lower costs Cash-basis net use their checkbook income is very similar for recordkeeping Requires less effort to taxable income and skill US Farms are exempt from accrual rules Corporate Finance Institute® Cash Versus Accrual Accounting Methods Accrual method Profitability Analysis Cashflow Timing Economic Accuracy Revenues are matched Profitability is assessed Business owners can to expenses to regardless of the timing show a higher cash- understand profitability of cashflows basis income by not Known as the Matching paying the expenses; Principle this is, however, not sustainable Corporate Finance Institute® Adjustment Principle Most accounting statements include a balance sheet and an income statement. Balance Income Sheet statement The fundamental principle to remember is what we expect to happen to cash in the future when looking at a specific account. Corporate Finance Institute® Adjustment Principle The necessary adjustments are done based on reviewing the balance sheet and income statement. If we expect to get more cash in the If we will be getting less cash in the future for products or services future because of a down payment produced today, we must add to our made in the past, unearned revenue, current cash receipt to get an then cash receipts would be accrual accounting amount. reduced for the amount not yet Receipts earned in the current period. If we expect to use less cash in a If we expect to use more cash in future period due to cash the future than what is already disbursements already made, we reflected by cash accounting, we must remove it to arrive at an will have to add it to the current accrual amount. cash disbursements to get a proper accrual accounting record. Disbursements Corporate Finance Institute® Balance Sheet Assessment Presentation of current assets and liabilities is ready for questions and discussions with management. Accounts Small supplies Prepaid Inventory receivable and tools expenses Accounts Interest Various taxes Deferred tax payable payable receivable or liability Corporate Finance Institute® Balance Sheet Assessment It was a guess of how If I haven’t paid yet, much I think it was it’s not there. worth had I sold it. Some balance sheets may only partially represent some assets and liabilities. Corporate Finance Institute® Balance Sheet Assessment A balance sheet with a cash method of accounting influence must be adjusted to meet our needs. Therefore, we need information that is comparable to accrual accounting. Cash-based Adjustments Accrual-based net income net income Owner’s Equity The goal is to get an accurate estimate of the accrual net income to make informed decisions. Corporate Finance Institute® Balance Sheet Assessment Assets Liabilities Adjustments that increase assets will increase Adjustments that increase liabilities will decrease accrual income (and owner’s equity). accrual income (and owner’s equity). Adjustments that decrease assets will decrease Adjustments that decrease liabilities will increase accrual income (and owner’s equity). accrual income (and owner’s equity). Corporate Finance Institute® Balance Sheet Assessment Increasing accrued liabilities via adjustments will decrease accrued income while reducing them will increase accrual income. Balance Sheet (Cash-Basis) Balance Sheet (Adjusted) 140 140 120 120 100 100 80 80 60 60 40 40 20 20 0 0 Asset Liability & Owner's Equity Asset Liability & Owner's Equity Non Current Current Owner's Equity Non Current Current Owner's Equity Adjustment Corporate Finance Institute® Balance Sheet Assessment Increasing accrued liabilities via adjustments will decrease accrued income while reducing them will increase accrual income. Balance Sheet (Cash-Basis) Balance Sheet (Adjusted) 140 140 120 120 100 100 80 80 60 60 40 40 20 20 0 0 Asset Liability & Owner's Equity Asset Liability & Owner's Equity Non Current Current Owner's Equity Non Current Current Owner's Equity Adjustment Corporate Finance Institute® Income Statement Assessment Balance sheet adjustments are linked to cash receipts and disbursements. Operating Other income Revenue Expenses statement items Getting to an accrual income is only possible when we have a set of beginning and ending balance sheets to capture the changes within the period. Corporate Finance Institute® Income Statement Assessment Any cash receipt record beyond a bank account suggests there may be other accounts that we may need to consider. Bank Revenue deposits received as cash The aim is to determine if we expect more or less cash to go out (or come into) the business in the future than what we see under the cash method. Corporate Finance Institute® Cash Receipts Adjust Cash Receipts The most basic cash receipt is from cash sales, where clients record sales when they receive cash. We must add to cash If we expect to get more cash in revenue to get an the future for products or accrual amount for the services produced or sold today same period We must remove cash If we expect to get less cash in revenue to get an the future for products or accrual amount for the services produced or sold today same period Corporate Finance Institute® Adjust Cash Receipts The most basic cash receipt is from cash sales, where clients record sales when they receive cash. The company has Used the cash method receivables, and the and grew their credit amount rose over sales over the past year. the year. Prospective Company This growth means more cash will As revenue currently does not include credit More come into the company when AR sales, the statements will need to be adjusted to cash is collected. match revenue to the suitable period. Corporate Finance Institute® Adjust Accounts Receivable In theory, a balance sheet prepared using a pure cash method has no AR, as credit sales do not involve cash. In practice, companies may use a modified cash method since it aligns the preparation of financial statements to the work of a tax preparer to calculate taxable income. We may see AR, but it may not be perfectly recorded. However, as this account is the primary collateral for operating credit, we investigate it further. Corporate Finance Institute® Adjust Accounts Receivable Corporate Finance Institute® Adjust Accounts Receivable Our due diligence will identify that there was no difference in AR. Adjustments may be in order as this figure does not match what management reported. After adjustments, we will get a net adjustment on the balance sheet. Corporate Finance Institute® Adjust Accounts Receivable – Summary Corporate Finance Institute® Adjust Accounts Receivable – Summary Corporate Finance Institute® Adjust Accounts Receivable – Summary Adjustment on Adjustment on Impact on Net Income Income Statement Item Income Statement Balance Sheet reporting on a cash basis Increase an Asset or Cash receipt Increase Increase Decrease a Liability Decrease an Asset or Cash receipt Decrease Decrease Increase a Liability Increase a Liability or Cash disbursement Increase Decrease Decrease an Asset Decrease a Liability or Cash disbursement Decrease Increase Increase an Asset Depreciation* Increase Decrease an Asset Decrease Increase a Liability or Cash tax payment Increase Decrease Decrease an Asset Decrease a Liability or Cash tax payment Decrease Increase Increase an Asset *Some tax jurisdictions require depreciation of capital assets by mixing the cash and accrual methods. Tax versus accounting depreciation will dictate the adjustment. Corporate Finance Institute® Adjust Inventory Companies buy and make inventory, expecting to get more cash for it once it sells at a profit. VS Cash Method Accrual Method When paying for inventory with cash, we Net income is only correct when the expense it immediately via the cost of expense matches inventory sold goods sold (COGS) account. during a period. Corporate Finance Institute® Adjust Inventory We may not see inventory listed on the balance sheet if it was all sold during a period. At the end of a period, we want to know if any inventory was left after purchases. A company may hand count inventory or use other relevant methods of tracking. Generally, the valuation will be the lower of: Cost or Net Realizable Value. Net Realizable Value is how much inventory is worth if sold, less the disposal costs. Corporate Finance Institute® Adjust Inventory Let us consider two common scenarios: Scenario 1 Scenario 2 What happens if there was inventory at the start of the year, but purchases What happens to inventory left at were less than inventory sold? the end of a period? Corporate Finance Institute® Adjust Inventory Let us consider two common scenarios: Scenario 1 What happens if there was inventory at the start of the year, but purchases were less than inventory sold? Inventory Accrual Adjustments Beginning Ending COGS Net Income If only cash purchases were expensed, the balance sheet would require an update to inventory. Corporate Finance Institute® Adjust Inventory Let us consider two common scenarios: Scenario 2 May add inventory to the We expect to get more balance sheet cash receipts in the future What happens to inventory left at the end of a period? May cause inventory to rise Inventory will fluctuate above beg. amount upon sales being made Inventory Accrual Adjustments Beginning Ending COGS Net Income Corporate Finance Institute® Adjust Inventory – Summary The net adjustment was a $10,000 rise in ending assets. This increase in assets will result in future cash receipts. Corporate Finance Institute® Adjust Inventory – Summary There was a reduction in the COGS by $10,000. Corporate Finance Institute® Adjust Inventory – Summary Adjustment on Adjustment on Impact on Net Income Income Statement Item Income Statement Balance Sheet reporting on a cash basis Increase an Asset or Cash receipt Increase Increase Decrease a Liability Decrease an Asset or Cash receipt Decrease Decrease Increase a Liability Increase a Liability or Cash disbursement Increase Decrease Decrease an Asset Decrease a Liability or Cash disbursement Decrease Increase Increase an Asset Depreciation* Increase Decrease an Asset Decrease Increase a Liability or Cash tax payment Increase Decrease Decrease an Asset Decrease a Liability or Cash tax payment Decrease Increase Increase an Asset *Some tax jurisdictions require depreciation of capital assets, by mixing the cash and accrual methods. Tax versus accounting depreciation will dictate the adjustment Corporate Finance Institute® Adjust Unearned Revenue In theory, a balance sheet prepared using the cash method has no unearned revenue. Unearned revenue We can adjust the balance sheet for received in cash is financial analysis by: treated the same way as cash revenue Assets Increasing unearned revenue liability Current assets Cash Decreasing cash revenue Liabilities Adjustments to the accrued liability will show Current liabilities changes to the account to determine if the Unearned revenue liability remains there or not. We know that a company has a future obligation This matches the cash when received to to complete the sale to revenue when earned. earn the revenue Corporate Finance Institute® Adjust Unearned Revenue We recognize that cash in the bank may have obligations associated with it; for example, it may be fully refundable to the payee. Assets Liabilities (what the company owns) (what the company owes) The general rule for liabilities will apply: The impact will be the same on the balance sheet and income statement. Increasing accrued liabilities via adjustments For unearned revenue, we adjust Accrued income will fall as a portion of cash cash receipts revenue is capitalized We expect to receive less cash in the future because it was now received Corporate Finance Institute® Adjust Unearned Revenue Adjustment on Adjustment on Impact on Net Income Income Statement Item Income Statement Balance Sheet reporting on a cash basis Increase an Asset or Cash receipt Increase Increase Decrease a Liability Decrease an Asset or Cash receipt Decrease Decrease Increase a Liability Increase a Liability or Cash disbursement Increase Decrease Decrease an Asset Decrease a Liability or Cash disbursement Decrease Increase Increase an Asset Depreciation* Increase Decrease an Asset Decrease Increase a Liability or Cash tax payment Increase Decrease Decrease an Asset Decrease a Liability or Cash tax payment Decrease Increase Increase an Asset *Some tax jurisdictions require depreciation of capital assets, by mixing the cash and accrual methods. Tax versus accounting depreciation will dictate the adjustment Corporate Finance Institute® Cash Disbursements Adjust Cash Disbursements Sometimes a company pays cash for daily expenses, while other times, it is for longer-term fixed expenses or in anticipation of future revenue. Asset Liability A company is likely using the cash method if few or none of these accounts are present. Small tools At an extreme, all cash disbursements are Supplies expensed, and future obligations are not shown on the balance sheet. Prepaid expenses Accounts This presentation may not be suitable for payable certain types of financial analysis. Other payables Corporate Finance Institute® Adjust Cash Disbursements Cash Disbursements Expect to use more cash in the Add to cash disbursements to get an future for obligations taken on today = accrual expense for a specific period Take out of cash disbursements and Expect to use less cash in the future for obligations taken on today = expenses during the period to match future revenue Prepaid their insurance and received trade credit Prospect Disbursements and expenses included the prepayment and excluded the trade credit Uses the cash method with some modifications: We need to adjust to match expenses to the suitable period Corporate Finance Institute® Adjust Consumable Assets Characteristics In Practice If purchases for the period were Consumable assets are used in full: like inventory Cash = Accrual They are not typically converted back to cash We want to determine what was used and what is left It tracks future expenses already paid for in cash and It is accounted for on the matches expenses when balance sheet before flowing used it to the income statement Corporate Finance Institute® Adjust Consumable Assets Let us consider two common scenarios: Scenario 1 Scenario 2 What happens if there were What happens to consumable consumables at the start of the year, assets that remain at the end of a but purchases were less than the period? amount used? Corporate Finance Institute® Adjust Consumable Assets Let us consider two common scenarios: Scenario 1 What happens if there were consumables at the start of the year, but purchases were less than the amount used? Consumable Assets Accrual Adjustments Ending Beginning SG&A Net Income Used during year After adjusting the balances, the reduced amount is reflected on an accrual balance sheet. Corporate Finance Institute® Adjust Consumable Assets Let us consider two common scenarios: Scenario 2 What happens to consumable assets that remain at the end of a period? Consumable Assets Accrual Adjustments Ending Effect SG&A Net Income Expensed too much When we expect to use less cash in the future than what was already paid, we adjust to reduce cash expenses. Corporate Finance Institute® Adjust Consumable Assets – Summary There will be less cash disbursement in the future. Cash expenses were overstated. Corporate Finance Institute® Adjust Consumable Assets – Summary With the drop in expenses, net income rose by $40,000. Corporate Finance Institute® Adjust Consumable Assets – Summary Adjustment on Adjustment on Impact on Net Income Income Statement Item Income Statement Balance Sheet reporting on a cash basis Increase an Asset or Cash receipt Increase Increase Decrease a Liability Decrease an Asset or Cash receipt Decrease Decrease Increase a Liability Increase a Liability or Cash disbursement Increase Decrease Decrease an Asset Decrease a Liability or Cash disbursement Decrease Increase Increase an Asset Depreciation* Increase Decrease an Asset Decrease Increase a Liability or Cash tax payment Increase Decrease Decrease an Asset Decrease a Liability or Cash tax payment Decrease Increase Increase an Asset *Some tax jurisdictions require depreciation of capital assets by mixing the cash and accrual methods. Tax versus accounting depreciation will dictate the adjustment Corporate Finance Institute® Adjust Accounts Payable Like accounts receivable, we would not expect to find accounts payable in statements prepared on a cash basis. Users of Financial Information Trade Credit from Suppliers It is important to review AP and other This is one form of AP; some liabilities accrued payables to not misunderstand may take precedence over financing from the company’s future obligations. senior creditors in certain situations. Adjusting Financial Information Determining and accruing liabilities is a way to vet financial information before making informed decisions. Corporate Finance Institute® Adjust Accounts Payable Accounts Payable Adjustments When adjusting AP results in: We want to account for an expense as we realize the benefit from it rather than expense it when settled with cash. Net increase in liabilities Period 1… …Period 12 We expect to use cash in the $1,000 $1,000 $... $1,000 future to settle it. Adjusted Cash Adjusted Cash-basis < < expenses disbursement income income Corporate Finance Institute® Adjust Accounts Payable Accounts Payable Adjustments When adjusting AP results in: The reduction in liability means less cash needed in the future for the debt. Net decrease in liabilities It is appropriate to adjust Cash that spend from cash If cash disbursements paid for needed expenses in the income expenses that should have been statement. accrued in a prior period. Adjusted Cash Adjusted Cash-basis < < expenses disbursement income income Corporate Finance Institute® Adjust Accounts Payable – Summary $50,000 AP increase SG&A When we adjust Net Income liabilities on the balance sheet, we understand that a net increase will increase future cash disbursement. Corporate Finance Institute® Adjust Accounts Payable – Summary Reviewing three years of financial information is the norm; we cannot adjust two years’ worth of income without it. Assets Liabilities (what the company owns) (what the company owes) Except for transactions that should have no impact on cash receipts or expenses: Whenever we adjust liabilities Whenever we adjust accrued assets Adjusted liabilities increases Accrued assets increases Net income decreases Net income increases Corporate Finance Institute® Other Cash and Non-Cash Expenses Adjust Interest Payable This chapter will focus on adjusting EBITDA, or earnings before interest, taxes, depreciation, and amortization. As with other payables, Whether from financial Adjustments in this By compiling all notes, we would not expect notes or other data section may take more debt, or other interest- to find interest sources, if we identify action to complete, but bearing instruments, we payable in statements what there is, we can perhaps less than from a will be able to figure out if prepared purely on a determine if the cash borrower’s perspective. the interest paid in cash cash basis. paid for interest was was only for the current reasonable for the year. period or if an accrual adjustment will be necessary. Corporate Finance Institute® Adjust Interest Payable – Summary In this example, we determined that interest payable was not recorded. We estimated what it would be based on our understanding of the debt. Corporate Finance Institute® Adjust Taxes Payable Adjustments and their impact on the income statement have the same approach for taxes payable. As these accrued expenses are estimated, any No matter the jurisdiction, tax estimates can vary from adjustments to the balance sheet are on a best- the actual balance owed when they are due; some are effort basis and not an exact match. paid more frequently than others. Cash Some lenders focus on specific taxes, such as those disbursements. outside SG&A expenses in the income statement. Accrued This course will focus on changes to tax liabilities. If, for expenses example, there was a significant increase, we may request a review by a tax advisor. Corporate Finance Institute® Adjust Taxes Payable Adjustments and their impact on the income statement have the same approach for taxes payable. As these accrued expenses are estimated, any No matter the jurisdiction, tax estimates can vary from adjustments to the balance sheet are on a best- the actual balance owed when they are due; some are effort basis and not an exact match. paid more frequently than others. Liabilities Net Income Some lenders focus on specific taxes, such as those. outside SG&A expenses in the income statement. Liabilities Net Income This course will focus on changes to tax liabilities. If, for example, there was a significant increase, we may request a review by a tax advisor. Corporate Finance Institute® Adjust Taxes Payable – Summary Adjustment Method Adjusted Taxes Taxes Tax paid as liabilities agreed Other Accepted accrued good tax liabilities advice Corporate Finance Institute® Adjust Taxes Payable – Summary It is important to note whether a company has enough liquidity to satisfy surprises from an audit or to address issues with its liabilities, should something arise. In the event of a tax assessment being unavailable, it is important to estimate and budget for taxes using historical information. Be cautious of times where there is a claim of no taxes owing; finding a tax lien during a refinancing process can be troublesome. Corporate Finance Institute® Adjust Depreciation As depreciation does not involve cash, it will not be found on financial statements prepared using the cash method. Depreciation Adjustments Many jurisdictions have policies that Focus will be on the difference between modify the cash method when reported amortization for tax purposes determining taxes. and the company’s accounting treatment. An example would be to incentivize CAPEX investment. Some assets may not be depreciated for tax purposes but are still tracked for the It is rare not to see amortization and cost of use over time. depreciation on an income statement. Some circumstances cause a difference between the tax basis and carrying value. Corporate Finance Institute® Adjust Depreciation – Summary Decreasing an asset Using the modified cash related to cash method for disbursement: depreciation: Reporting Statements The statements did not line up. Expenses PP&E Assets The depreciation expense had to be reduced to match the Non-Cash depreciation method used to Net Income Expense Adj. reduce the assets on the books. decreased rather than increased Corporate Finance Institute® Adjust Depreciation – Summary Assets 2,880,000 (230,000) 2,650,000 Depreciation 280,000 (50,000) 230,000 Depreciation calculated via tax basis vs. carrying Net Income value on the books 650,000 (230,000) 420,000 Corporate Finance Institute® Adjust Deferred Tax Assets and Liabilities Deferred taxes can arise from many items on the balance sheet. It is typically determined by tax advisors to match the outcomes of tax rules; it is a valuation for tax reasons. Current Fixed assets assets Related to the difference in valuations of assets and. liabilities due to calculations on a tax basis vs. a company’s internal policies. Intangible Certain assets accrued liabilities Tracked on the balance sheet and net adjustments are brought into the income statement just as other expenses are. Corporate Finance Institute® Conclusion and Impact Impact on Profit We have now learned how to adjust many cash receipts and disbursements by using the beginning and ending balances of various accounts and changes over two points in time. Changes to the Net Analyze overall Income Adjustments result Statement Corporate Finance Institute® Impact on Profit Modified Cash Method (in thousands) $1,200 $1,100 1000 $1,000 $900 940 $800 770 $700 $600 660 $500 $400 330 $300 $200 250 $100 $0 Net Income EBIT EBITDA Corporate Finance Institute® Impact on Profit With Accrual Adjustments (in thousands) $1,200 $1,100 1000 $1,000 $900 940 $800 770 $700 $600 660 $500 $400 330 $300 $200 250 $100 $0 Net Income EBIT EBITDA Corporate Finance Institute® Impact on Profit The original figures all understated these measures of profitability; it is also easy to overstate these figures. All available Company Incomplete information information information needs to be cannot be affects assessed before benchmarked decisions, applying metrics until it is often for the in decision- presented in a worse. making. suitable format. Corporate Finance Institute® Impact on Financial Metric Liquidity Modified Cash Method Accrual Adjusted Current Ratio 0.90 0.87 Working Capital -90 -220 Overall: liquidity worsened Corporate Finance Institute® Impact on Financial Metric Solvency Modified Cash Method Accrual Adjusted Debt to Asset 0.49 0.58 Debt to Equity 0.98 1.38 Overall: debt ratios increased Corporate Finance Institute® Impact on Financial Metric Efficiency Modified Cash Method Accrual Adjusted Operating Expense Ratio 53% 51% Interest Expense Ratio 23% 16% Net Income Ratio 16% 20% Overall: efficiency improved due to higher accrued revenue and lower accrued expenses Corporate Finance Institute® Conclusion Learning Objectives Differentiate the rationale for using Establish the approach to convert Practice and adjust assets, liabilities, cash and accrual information. cash receipts and disbursements to revenues, and expenses to get cash relevant accrual data. statements closer to an equivalent set of accrual statements. Link the different financial statements and distinguish their differences when looking at financial metrics. Corporate Finance Institute®