Question 17.7: Discrepancy between Net Income and Operating Cash Flows Allo......
Discrepancy between Net Income and Operating Cash Flows
Allou Health & Beauty Care, Inc.
Allou Health & Beauty Care, Inc. was a manufacturer and distributor of hair and skin care products. Exhibit 8 presents excerpts from the company’s financial statements from 2000 to 2002. Following the periods reported in these statements, Allou’s warehouses were destroyed by fire, for which the management was found to be responsible. Allou was subsequently shown to have fraudulently inflated the amount of its sales and inventories in those years.
Referring to Exhibit 8 , answer the following questions:
1 . Based on the income statement data, evaluate Allou’s performance over the period shown.
2 . Compare Allou’s income from continuing operations and cash flows from operating activities.
3 . Interpret the amounts shown as adjustments to reconcile income from continuing operations to net cash used in operating activities.
| EXHIBIT 8 Illustration of Fraudulent Reporting in which Reported Net Income Significantly Exceeded Reported Operating Cash Flow, Annual Data 10-K for Allou Health & Beauty Care, Inc., and Subsidiaries | |||
| Years ended 31 March | 2002 | 2001 | 2000 |
| Excerpt from Income Statement | |||
| Revenues, net | $564,151,260 | $548,146,953 | $421,046,773 |
| Costs of revenue | 500,890,588 | 482,590,356 | 367,963,675 |
| Gross profit | $63,260,672 | $65,556,597 | $53,083,098 |
| ⋮ | ⋮ | ⋮ | |
| Income from operations | 27,276,779 | 28,490,063 | 22,256,558 |
| ⋮ | ⋮ | ⋮ | |
| Income from continuing operations* | $6,589,658 | $2,458,367 | $7,043,548 |
| Excerpt from Statement of Cash Flows | |||
| Cash flows from operating activities: | |||
| Net income from continuing operations | $6,589,658 | $2,458,367 | $7,043,548 |
| Adjustments to reconcile net income to net cash used in operating activities: | |||
| [Portions omitted] | ⋮ | ⋮ | ⋮ |
| Decrease (increase) in operating assets: | |||
| Accounts receivable | (24,076,150) | (9,725,776) | (25,691,508) |
| Inventories | (9,074,118) | (12,644,519) | (40,834,355) |
| Net cash used in operating activities | $(17,397,230) | $(34,195,838) | $(27,137,652) |
| *The difference between income from operations and income from continuing operations included deductions for interest expense and provision for income taxes in each year and for a $5,642,678 loss on impairment of investments in 2001. | |||
to 1: Based on the income statement, the following aspects of Allou’s performance are notable. Revenues grew in each of the past three years, albeit more slowly in the latest year shown. The company’s gross margin declined somewhat over the past three years but has been fairly stable. Similarly, the company’s operating margin declined somewhat over the past three years but has been fairly stable at around 5%. The company’s income from continuing operations was sharply lower in 2001 as a result of an impairment loss. The company showed positive net income in each year. Overall, the company showed positive net income in each year, and its performance appears to be reasonably stable based on the income statement data.
Note: Gross margin is gross profit divided by revenues. For example, for 2002, $63,260,672 divided by $564,151,260 is 11.2%. The ratios for 2001 and 2000 are 12.0% and 12.6%, respectively.
Operating margin is income from operations divided by revenues. For example, for 2002, $27,276,779 divided by $564,151,260 is 4.8%. The ratios for 2001 and 2000 are 5.2% and 5.3%, respectively.
to 2: Allou reported positive income from continuing operations but negative cash from operating activities in each of the three years shown. Persistent negative cash from operating activities is not sustainable for a going concern.
to 3: The excerpt from Allou’s Statement of Cash Flows shows that accounts receivable and inventories increased each year. This increase can account for most of the difference between the company’s income from continuing operations and net cash used in operating activities. The company seems to be accumulating inventory and not collecting on its receivables.
Note: The statement of cash flows, prepared using the indirect method, adjusts net income to derive cash from operating activities. An increase in current assets is subtracted from the net income number to derive the cash from operating activities.