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In the United States, we have a highly developed free-enterprise economy with the majority of productive resources privately owned rather than government owned. It’s important in this type of system that a mechanism exists to allocate the scarce resources of our society, both natural resources and labor, in an efficient manner. Resources should be allocated to private enterprises that will use them best to provide goods and services desired by society and not to enterprises that will waste them. The mechanisms that foster this efficient allocation of resources are the capital marketsmechanisms that foster the allocation of resources efficiently.. We can think of the capital markets simply as a composite of all investors and creditors.
The three primary forms of business organization are the sole proprietorship, the partnership, and the corporation. In the United States, sole proprietorships and partnerships outnumber corporations. However, the dominant form of business organization, in terms of the ownership of productive resources, is the corporationthe dominant form of business organization that acquires capital from investors in exchange for ownership interest and from creditors by borrowing.. The corporate form makes it easier for an enterprise to acquire resources through the capital markets. Investors provide resources, usually cash, to a corporation in exchange for evidence of ownership interest, that is, shares of stock. Creditors such as banks lend cash to the corporation. Also, creditors can lend the corporation cash through the medium of bonds. Stocks and bonds usually are traded on organized security markets such as the New York Stock Exchange and the American Stock Exchange. The advantages and disadvantages of the corporate form are discussed at greater length in Chapter 18.
The transfers of these stocks and bonds among individuals and institutions are secondary marketprovide for the transfer of stocks and bonds among individuals and institutions. transactions. Corporations receive no new cash from secondary market transactions. New cash is provided in primary market transactions in which the shares or bonds are sold by the corporation to the initial owners. Nevertheless, secondary market transactions are extremely important to the efficient allocation of resources in our economy. These transactions help establish market prices for additional shares and for bonds that corporations may wish to issue in the future to acquire additional capital. Also, many shareholders and bondholders might be unwilling to initially provide resources to corporations if there were no available mechanism for the future sale of their stocks and bonds to others. What information do investors and creditors need to decide which companies will be provided capital? We explore that question next.
THE INVESTMENT-CREDIT DECISION—A CASH FLOW PERSPECTIVEWhile the decisions made by investors and by creditors are somewhat different, they are similar in at least one important way. They both are concerned with providing resources to companies, usually cash, with the expectation of receiving more cash in return at some time in the future. A corporation’s shareholders will receive cash from their investment through the ultimate sale of the ownership shares of stock. In addition, many corporations distribute cash to their shareholders in the form of periodic dividends. For example, if an investor provides a company with $10,000 cash (that is, purchases ownership shares) at the end of 2005, receives $400 in dividends from the company during 2006, and sells the ownership interest (shares) at the end of 2006 for $10,600 ($600 share price appreciation), the investment would have generated a rate of returnInvestors and creditors both are interested in earning a fair return on the resources provided. of 10% for 2006, calculated as follows:
Investors always are faced with more than one investment opportunity. There are many factors to consider before one of these opportunities is chosen. Two extremely important variables are the expected rate of return from each investment option, and the uncertainty, or risk, of that expected return. For example, consider the following two investment options:
While the rate of return from option 1 is known with virtual certainty, the return from option 2 is uncertain. The amount and timing of the cash to be received in the future from option 2 are unknown. Investors require information about the company that will help them estimate the unknown return. In the long run, a company will be able to provide investors with a return only if it can generate a profit. That is, it must be able to use the resources provided by investors and creditors to generate cash receipts from selling a product or service that exceed the cash disbursements necessary to provide that product or service. If this excess can be generated, the marketplace is implicitly saying that society’s resources have been efficiently allocated. The marketplace is assigning a value to the product or service that exceeds the value assigned to the resources used to produce that product or service.
In summary, the primary objective of financial accounting is to provide investors and creditors with information that will help them make investment and credit decisions. More specifically, the information should help investors and creditors evaluate the amounts, timing, and uncertainty of the enterprise’s future cash receipts and disbursements. The better this information is, the more efficient will be investor and creditor resource allocation decisions. Financial accounting, in providing key elements of the information set used by capital market participants, plays a vital societal role in the resource allocation process. The importance of this role to society explains why the primary focus of financial accounting is on the information needs of investors and creditors.
The Financial Accounting Standards Board, the current private sector body responsible for setting accounting standards in the United States, has published a conceptual framework for financial reporting (discussed later in this chapter). The first concept statement of the framework describes the specific objectives of external financial reporting. These objectives affirm the importance of the cash flow information needs of investors and creditors. Throughout this text, you will be reminded of this cash flow perspective. For example, Chapter 4 describes certain events that are reported separately in the income statement due to the fact that these historical events have implications for future cash flows that are different from the normal operating activities. Separation of these events from normal operating activities provides financial statement users with information to more easily predict an enterprise’s future cash flows. CASH VERSUS ACCRUAL ACCOUNTINGlLO2 Even though predicting future cash flows is the primary objective, the model best able to achieve that objective is the accrual accountingmeasurement of the entity's accomplishments and resource sacrifices during the period, regardless of when cash is received or paid. model. A competing model is cash basis accountingdifference between cash receipts and cash disbursements during a reporting period from transactions related to providing goods and services to customers.. Each model produces a periodic measure of performance that could be used by investors and creditors for predicting future cash flows. Cash Basis Accounting. Cash basis accounting produces a measure called net operating cash flow.difference between cash receipts and cash disbursements during a reporting period from transactions related to providing goods and services to customers. This measure is the difference between cash receipts and cash disbursements during a reporting period from transactions related to providing goods and services to customers.
Net operating cash flow is very easy to understand and all information required to measure it is factual. Also, it certainly relates to a variable of critical interest to investors and creditors. What could be better in helping to predict future cash flows from selling products and services than current cash flows from these activities? Remember, a company will be able to provide a return to investors and creditors only if it can use the capital provided to generate a positive net operating cash flow. However, there is a major drawback to using the current period’s operating cash flow to predict future operating cash flows. Over the life of the company, net operating cash flow definitely is the variable of concern. However, over short periods of time, operating cash flows may not be indicative of the company’s long-run cash-generating ability (that is, its ability to generate positive net operating cash flows in the future). To demonstrate this, consider the following example. In Illustration 1-1 net operating cash flows are determined for the Carter Company during its first three years of operations. Over the three-year period, Carter generated a positive net operating cash flow of $60,000. At the end of this three-year period, Carter has no outstanding debts. Because total sales and cash receipts over the three-year period were each $300,000, nothing is owed to Carter by customers. Also, at the beginning of the first year, Carter prepaid $60,000 for three years’ rent on the facilities. There are no uncompleted transactions at the end of the three-year period. In that sense, we can view this three-year period as a micro version of the entire life of a company.
The company incurred utility costs of $10,000 per year over the period. However, during the first year only $5,000 actually was paid, with the remainder being paid the second year. Employee salary costs of $50,000 were paid in full each year. Is net operating cash flow for year 1 (negative $65,000) an accurate indicator of future cash-generating ability?3 Obviously, it is not a good predictor of the positive net cash flows that occur in the next two years. Is the three-year pattern of net operating cash flows indicative of the company’s year-by-year performance? No. But, if we measure the same activities by the accrual accounting model, we get a more accurate prediction of future operating cash flows and a more reasonable portrayal of the balanced operating performance of the company over the three years.
Accrual Accounting. The accrual accounting model measures the entity’s accomplishments and resource sacrifices during the period, regardless of when cash is received or paid. The accrual accounting model’s measure of periodic accomplishments is called revenues, and the periodic measure of resource sacrifices is called expenses. The difference between revenues and expenses is net income, or net loss if expenses are greater than revenues.4
How would we measure revenues and expenses in this very simplistic situation? Illustration 1-2 offers a possible solution.
Net income of $20,000 for year 1 appears to be a reasonable predictor of the company’s cash-generating ability as total net operating cash flow for the three-year period is a positive $60,000. Also, compare the three-year pattern of net operating cash flows in Illustration 1-1 to the three-year pattern of net income in Illustration 1-2. The net income pattern is more representative of the steady operating performance over the three-year period.5
While this example is somewhat simplistic, it allows us to see the motivation for using the accrual accounting model. Accrual income attempts to measure the accomplishments and sacrifices that occurred during the year, which may not correspond to cash inflows and outflows. For example, revenue for year 1 is the $100,000 in sales. This is a better measure of the company’s accomplishments during year 1 than the $50,000 cash collected from customers. Does this mean that information about cash flows from operating activities is not useful? No. Indeed, when combined with information about cash flows from investing and financing activities, this information provides valuable input into decisions made by investors and creditors. In fact, collectively, this cash flow information constitutes the statement of cash flows—one of the basic financial statements.6 BRIEF-EXERCISES BE1-1 3 A negative cash flow is possible only if invested capital (i.e., owners contributed cash to the company in exchange for ownership interest) is sufficient to cover the cash deficiency. Otherwise, the company would have to either raise additional external funds or go bankrupt. 4 Net income also includes gains and losses, which are discussed later in the chapter. 5 Empirical evidence that accrual accounting provides a better measure of short-term performance than cash flows is provided by Patricia DeChow, “Accounting Earnings and Cash Flows as Measures of Firm Performance: The Role of Accrual Accounting,”Journal of Accounting and Economics 18 (1994), pp. 3–42. 6 The statement of cash flows is discussed in detail in Chapters 4 and 21. |
