Why Do Adjustments Rarely Equal the Changes in Assets and Liabilities on the Balance Sheet?
The reconciling adjustments throughout the statement of cash flows relate to non-cash accounts on the balance sheet, but it is rare that changes in the actual balance sheet accounts equal the reconciling adjustments on the statement of cash flows. For example, in 2012, PepsiCo’s balance for accounts and notes receivable increased from $6,912 million in 2011 to $7,041 million, an increase of $129 million. However, the adjustment on the statement of cash flows—‘‘Change in accounts and notes receivable’’—is $250 million. Similarly, PepsiCo’s balance sheet shows ‘‘Accounts payable and other current liabilities’’ increased from $11,757 million to $11,903 million, an increase of $146 million. However, the adjustment on the statement of cash flows shows a positive adjustment of $548 million. Why do adjustments on the statement of cash flows rarely match the actual changes in the corresponding line items on the balance sheet?
There are four primary reasons that changes we see on the balance sheet do not match the adjustment on the statement of cash flows:
1. Acquisitions and divestitures. If a company acquires another firm for cash, that cash flow appropriately shows up in the investing section of the statement of cash flows. Acquisitions often result in the acquiring company taking over various current assets and liabilities of the acquiree, like receivables, inventory, and payables. These current assets and liabilities will be included in the consolidated balance sheet at the end of the year. However, it would be inappropriate to let the change in the balance sheet totals show up as an adjustment in the operating section of the statement of cash flows, as this would result in double counting. To clarify, assume Company X acquired Company Y for $1,000,000 cash, receiving $300,000 of Company Y’s accounts receivable in the process. Company X will include the additional $300,000 of accounts receivable on its balance sheet. In Company X’s statement of cash flows, the acquisition would appear as a $1,000,000 subtraction in the investing section. In the operating section, the $300,000 would not be included in the ‘‘Change in accounts receivable’’ adjustment. Divestitures would have similar effects, but the direction would be the opposite
2. Non-cash transactions. Non-cash transactions include non-cash acquisitions using common stock, the acquisition of assets under lease agreements, asset exchanges, financed asset acquisitions or settlement of liabilities, debt-for-equity swaps, and other transactions which increase or decrease assets, liabilities, or equities, but do not involve the exchange of cash. Similar to the discussion above, for any such line items on the balance sheet, the changes in balances from beginning to end of year would need to be adjusted when preparing the statement of cash flows. For example, reconsider the Company X example, but assume the acquisition of Company Y was accomplished by issuing common shares to Company Y’s shareholders rather than paying them cash. Significant non-cash transactions are supposed to be highlighted separately, along with cash paid for interest and taxes, either as an addendum to the statement of cash flows or in a footnote.
3. Changes in contra accounts. Some assets, like accounts receivable and fixed assets, include contra accounts. If those assets are shown net on the balance sheet, then changes in the contra accounts can also cause the change on the balance sheet to not match the adjustments in the operating section of the statement of cash flows. For example, assume that Company Z has the following balances for net accounts receivable:
The reconciling adjustments throughout the statement of cash flows relate to non-cash accounts on the balance sheet, but it is rare that changes in the actual balance sheet accounts equal the reconciling adjustments on the statement of cash flows. For example, in 2012, PepsiCo’s balance for accounts and notes receivable increased from $6,912 million in 2011 to $7,041 million, an increase of $129 million. However, the adjustment on the statement of cash flows—‘‘Change in accounts and notes receivable’’—is $250 million. Similarly, PepsiCo’s balance sheet shows ‘‘Accounts payable and other current liabilities’’ increased from $11,757 million to $11,903 million, an increase of $146 million. However, the adjustment on the statement of cash flows shows a positive adjustment of $548 million. Why do adjustments on the statement of cash flows rarely match the actual changes in the corresponding line items on the balance sheet?
There are four primary reasons that changes we see on the balance sheet do not match the adjustment on the statement of cash flows:
1. Acquisitions and divestitures. If a company acquires another firm for cash, that cash flow appropriately shows up in the investing section of the statement of cash flows. Acquisitions often result in the acquiring company taking over various current assets and liabilities of the acquiree, like receivables, inventory, and payables. These current assets and liabilities will be included in the consolidated balance sheet at the end of the year. However, it would be inappropriate to let the change in the balance sheet totals show up as an adjustment in the operating section of the statement of cash flows, as this would result in double counting. To clarify, assume Company X acquired Company Y for $1,000,000 cash, receiving $300,000 of Company Y’s accounts receivable in the process. Company X will include the additional $300,000 of accounts receivable on its balance sheet. In Company X’s statement of cash flows, the acquisition would appear as a $1,000,000 subtraction in the investing section. In the operating section, the $300,000 would not be included in the ‘‘Change in accounts receivable’’ adjustment. Divestitures would have similar effects, but the direction would be the opposite
2. Non-cash transactions. Non-cash transactions include non-cash acquisitions using common stock, the acquisition of assets under lease agreements, asset exchanges, financed asset acquisitions or settlement of liabilities, debt-for-equity swaps, and other transactions which increase or decrease assets, liabilities, or equities, but do not involve the exchange of cash. Similar to the discussion above, for any such line items on the balance sheet, the changes in balances from beginning to end of year would need to be adjusted when preparing the statement of cash flows. For example, reconsider the Company X example, but assume the acquisition of Company Y was accomplished by issuing common shares to Company Y’s shareholders rather than paying them cash. Significant non-cash transactions are supposed to be highlighted separately, along with cash paid for interest and taxes, either as an addendum to the statement of cash flows or in a footnote.
3. Changes in contra accounts. Some assets, like accounts receivable and fixed assets, include contra accounts. If those assets are shown net on the balance sheet, then changes in the contra accounts can also cause the change on the balance sheet to not match the adjustments in the operating section of the statement of cash flows. For example, assume that Company Z has the following balances for net accounts receivable:
Assume that during 2012 Company Z worried that changes in the economy will adversely affect the customers who owe the $500,000, so it increased its allowance for bad debts from $25,000 to $40,000. The change in net accounts receivable is $15,000, which was the result of recognizing non-cash bad debt expense of $15,000. The bad debt expense would decrease net income and would typically appear in the operating section of the statement of cash flows separately as an addback to net income. Refer back to the Target example in Exhibit 3.7. Notice that an adjustment for changes in bad debt expense appears separately from the adjustment for changes in accounts receivable.
4. Foreign currency translation. Globally diversified companies have assets and liabilities located in many countries and frequently denominated in various currencies. When consolidated balance sheets are prepared, the translation of current assets and liabilities from the local currency into the currency of the consolidated parent can change the balances of assets and liabilities, which is a non-cash change. For reasons similar to those discussed for the examples above, the inclusion of foreign currency translation gains or losses within the balances of assets or liabilities would lead to adjustments in the operating section not matching the changes in line item balances on from the balance sheet
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