1. © 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

2. 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.

3. 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

4. © 2005 by Robert F. Halsey, all rights reserved

5. SCF Statement Examples

6. © 2005 by Robert F. Halsey, all rights reserved 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

7. © 2005 by Robert F. Halsey, all rights reserved IBM Mini-Case

8. © 2005 by Robert F. Halsey, all rights reserved Are these short-term swings in accruals priced? Source: Sloan (1996)

9. © 2005 by Robert F. Halsey, all rights reserved Source: R.F. Halsey “Stationary Components of Earnings and Stock Prices,” Advances in Quantitative Analysis of Finance and Accounting (2001)

10. © 2005 by Robert F. Halsey, all rights reserved Price t =  0 +  1  Trend t +  2  Cycle t +  3  Irregular t +  t PCYC t =  0 +  1  Cycle t +  t 00 11 22 33 Adj-R 2 Coefficient (T-statistic) 24.56 (107.60) 6.16 (42.38) 2.90 (8.67) 1.38 (5.19) 10.55 % 00 11 Adj-R 2 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)

11. © 2005 by Robert F. Halsey, all rights reserved Stock Prices, Income and Cash Flow

12. © 2005 by Robert F. Halsey, all rights reserved Stock Prices and Reporting Window

13. 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)

14. © 2005 by Robert F. Halsey, all rights reserved Tyco mini-case

15. © 2005 by Robert F. Halsey, all rights reserved

17. Differing Free Cash Flow Definitions Benchmark definition:

18. © 2005 by Robert F. Halsey, all rights reserved Akamai’s definition

19. © 2005 by Robert F. Halsey, all rights reserved Delphi’s “Free” Cash Flow

20. © 2005 by Robert F. Halsey, all rights reserved Delphi’s “Free” Cash Flow