Traditional accounting architecture

Solution Preview

a. Explain the limitations of the traditional accounting architecture that make it difficult to directly trace the cash flows of an organization.
In the traditional accounting architecture cash flow from financing activities, cash flow from operations and cash flow from investing activities were not separated. This led to several limitations. First, a company could have a poor working capital management and a cash outflow but this may remain masked because of income from investment. Second, a company may make financing losses and cover it up with investing income. Third, a company may have investing losses and cover it up with operating losses. This would make it very difficult for bankers to decide if the company was actually borrowing for the purpose it claimed. This was the main concern of the bankers, the users of information.
Consider now the case of Tyson Foods, Inc. The 10-K for this firm shows that cash provided by operating activities is $1,174 million in 2002, $511 million in 2001, and $587 million in 2000. Given the economic downturn in 2001 and 2002, these numbers look quite respectable.

Upon investigation, one learns that Tyson Foods acquired Iowa Beef Processors (IBF) in August 2001 by paying $1.7 billion in cash. Footnote 2 reveals the fair value of assets and liabilities purchased at August 3, 2001. In particular, the fair value of the current assets except cash is $1,690 million, whereas the fair value of the current liabilities is $1,063 million. These items are displayed in the cash flow statement under the investing activities section.

Returning to the cash flow from operating activities, one notices that Tyson applies the indirect method. Thus, cash provided by operating activities equals net income plus depreciation, amortization, and the write-down of intangible assets, minus the gain on sale of a subsidiary and deferred taxes, minus the change in current assets, and plus the change in current liabilities. Let's combine the last two items into the change in working capital accounts.

What we observe is that cash flow operating activities in 2001 equals the net income of Tyson plus or minus a variety of items and minus the change in working capital. But not all of the working capital accounts are included. The current assets and the current debts acquired from IBF are placed in the investing activities section and excluded from the operating activities section. Given that the computation for cash flow from operations subtracts out the change in working capital, this of course benefits Tyson in terms of the reported cash provided by operating activities. Interestingly, Tyson Foods includes ...