Cash Flow Statement. (Explanation)

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1 Flow Statement (Explanation) Your AccountingCoach PRO membership includes lifetime access to all of our materials. Take a quick tour by visiting

2 Introduction to the Flow Statement The official name for the cash flow statement is the statement of cash flows. We will use both names throughout AccountingCoach.com. The statement of cash flows is one of the main financial statements. (The other financial statements are the balance sheet, income statement, and statement of stockholders equity.) The cash flow statement reports the cash generated and used during the time interval specified in its heading. The period of time that the statement covers is chosen by the company. For example, the heading may state For the Three Months Ended December 31, 216 or The Fiscal Year Ended September 3, 216. The cash flow statement organizes and reports the cash generated and used in the following categories: 1.Operating activities 2. Investing activities 3. Financing activities 4. Supplemental information - converts the items reported on the income statement from the accrual basis of accounting to cash. - reports the purchase and sale of long-term investments and property, plant and equipment. - reports the issuance and repurchase of the company's own bonds and stock and the payment of dividends. - reports the exchange of significant items that did not involve cash and reports the amount of income taxes paid and interest paid. What Can the Statement of Flows Tell Us? Because the income statement is prepared under the accrual basis of accounting, the revenues reported may not have been collected. Similarly, the expenses reported on the income statement might not have been paid. You could review the balance sheet changes to determine the facts, but the cash flow statement already has integrated all that information. As a result, savvy business people and investors utilize this important financial statement. Here are a few ways the statement of cash flows is used: 1. The cash from operating activities is compared to the company s net income. If the cash from operating activities is consistently greater than the net income, the company s net income or earnings are said to be of a high quality. If the cash from operating activities is less than net income, a red flag is raised as to why the reported net income is not turning into cash. 2. Some investors believe that cash is king. The cash flow statement identifies the cash that is flowing in and out of the company. If a company is consistently generating more cash than it is using, the company will be able to increase its dividend, buy back some of its stock, reduce debt, or acquire another company. All of these are perceived to be good for stockholder value. 3. Some financial models are based upon cash flow. For personal use by the original purchaser only. Copyright AccountingCoach.com. 2

3 Understanding The Changes In We often enhance our comprehension of a topic when we have to think through solutions to problems, so to help you really understand the cash flow statement, we ve put together some questions for you to answer (Answers appear at the end of this explanation.) As you formulate your response you will be learning to think about cash flows the way an accountant does. 1. When Mary Smith invests her personal money into her new company, what will happen to her company s account? 2. When a company purchases inventory (merchandise purchased in order to be resold) what will happen to its account? 3. What happens to the company s account if it borrows money from the bank by signing a note payable? 4. What happens to a company s account if it declares a dividend on its shares of stock? 5. What is the effect on its account when a company pays some of its Accounts Payable? 6. What is the effect on its account when a company prepays a 6-month insurance premium? 7. What is the effect on its account when a company sells merchandise, but allows the customer to pay in 3 days? 8. What is the effect on its account when a company receives payment from one of its customers 3 days after the sale was recorded? 9. If a company s Accounts Payable account decreased, what is the likely effect this will have on? 1. If the asset account Prepaid Insurance increased, what is the likely effect on? 11. If the asset account Land increased, what s the likely effect on? 12. If the asset account Land decreased, what s the likely effect on? 13. If the liability account Bonds Payable increases, what is the likely effect on? 14. If the liability account Bonds Payable decreases, what is the likely effect on? For personal use by the original purchaser only. Copyright AccountingCoach.com. 3

4 Much of what you learned in the practice questions is common sense. For example, when you use cash to buy a book, you now own the book (you ve increased your assets ) but you also have less money (you ve decreased your cash). Based on what you learned, you can make the following general assumptions: When an asset (other than cash) increases, the account decreases. When an asset (other than cash) decreases, the account increases. When a liability increases, the account increases. When a liability decreases, the account decreases. When owner s equity increases, the account increases. When owner s equity decreases, the account decreases. Here s a Tip For a change in assets (other than cash) the change in the account is in the opposite direction. For a change in liabilities and owner's equity the change in the account is in the same direction. Format of the Statement of Flows The statement of cash flows has four distinct sections: 1. involving operating activities 2. involving investing activities 3. involving financing activities 4. Supplemental information. Assuming that the cash flow statement is being prepared using the indirect method (the method used by most companies) the differences in a company s balance sheet accounts will provide much of the needed information. For example, if the statement of cash flows is for the year 216, the balance sheet accounts at December 31, 216 will be compared to the balance sheet accounts at December 31, 215. The changes or differences in these account balances will likely be entered in one of the sections of the statement of cash flows. Shown below is each of the four sections of the statement of cash flows, followed by a list of those balance sheet accounts which affect it. For personal use by the original purchaser only. Copyright AccountingCoach.com. 4

5 1. Provided From or Used By This section of the cash flow statement reports the company s net income and then converts it from the accrual basis to the cash basis by using the changes in the balances of current asset and current liability accounts, such as: Accounts Receivable Supplies Prepaid Insurance Other Current Assets Notes Payable Accounts Payable Wages Payable Payroll Taxes Payable Interest Payable Income Taxes Payable Unearned Revenues Other Current In addition to using the changes in current assets and current liabilities, the operating activities section has adjustments for depreciation expense and for the gains and losses on the sale of long-term assets. 2. Provided From or Used By Investing Activities This section of the cash flow statement reports changes in the balances of long-term asset accounts, such as: Long-term Investments Land Buildings Equipment Furniture & Fixtures Vehicles In short, investing activities involve the purchase and/or sale of long-term investments and property, plant, and equipment. 3. Provided From or Used By This section of the cash flow statement reports changes in balances of the long-term liability and stockholders equity accounts, such as: Notes Payable (generally due after one year) Bonds Payable Deferred Income Taxes Preferred Stock Paid-in Capital in Excess of Par-Preferred Stock Common Stock Paid-in Capital in Excess of Par-Common Stock For personal use by the original purchaser only. Copyright AccountingCoach.com. 5

6 Paid-in Capital from Treasury Stock Retained Earnings Treasury Stock In short, financing activities involve the issuance and/or the repurchase of a company s own bonds or stock as well as short-term and long-term borrowings and repayments. Dividend payments are also reported in this section. 4. Supplemental Information This section of the cash flow statement discloses the amount of interest and income taxes paid. Also reported are significant exchanges not involving cash. For example, the exchange of company stock for company bonds would be reported in this section. Where To Enter The Balance Sheet Changes Take a look at the summary below it shows where the changes in balance sheet accounts should be entered on your statement of cash flows: A change in this balance sheet category Current Assets* Current Long-term Assets Long-term Stockholders Equity...is reported in this section of the cash flow statement Investing Activties * This refers to current assets other than. Adjustments Within The Section When we use the indirect method to prepare a statement of cash flows we begin with the net income figure from the company s income statement as our starting point. We then make adjustments to that figure to arrive at the cash amount. If all of a company s revenues were cash sales (no credit sales), and if the company paid out cash for all of its expenses, then net income would equal the cash from operating activities. However, since some of the revenues and expenses on the income statement were not cash transactions, we must include depreciation, gain or losses on sales of assets, and the changes in current assets and current liabilities. These adjustments will be illustrated in the hypothetical story presented next. Story To Illustrate Matt is a college student who enjoys buying and selling merchandise using the Internet. On January 2, 216, he decides to turn his hobby into a business called Each month the Good Deal Co. will have one or two transactions. At the end of each month we will prepare an income statement, balance sheet, and a statement of cash flows for the current month and for the year-todate period. The purpose is to show how these transactions are reported on the cash flow statement. For personal use by the original purchaser only. Copyright AccountingCoach.com. 6

7 January Transactions and Financial Statements On January 2, 216 Matt invests $2, of his personal money into his sole proprietorship, Good Deal Co. On January 2, Good Deal buys 14 graphing calculators for $5 per calculator this is about 5% less than the selling price Matt has observed at the retail stores. The total cost to Good Deal for all 14 calculators is $7. Good Deal has no other transactions during January. Matt prepares financial statements for his new business as of January 31, 216: Income Statement For the Month Ended January 31, 216 Revenues Expenses $ $ Balance Sheet January 31, 216 ASSETS LIABILITIES & OWNER S EQUITY $1,3 7 $2, Matt Jones, capital Total liabilities & owner s equity $ 2, $2, Statement of Flows For the Month Ended January 31, 216 Increase in inventory provided (used) in operating activities Investing Activities Investment by owner Net increase in cash at the beginning of the month at the end of the month $ (7) (7) 2, 1,3 $1,3 Good Deal s income statement for January showed no profit or loss, since it did not have any sales or expenses. However, the cash flow statement reports that Good Deal s operating activities resulted in a decrease in cash of $7. The decrease in cash occurred because the company increased For personal use by the original purchaser only. Copyright AccountingCoach.com. 7

8 its inventory by $7 during January. The financing activities section shows an increase in cash of $2, which corresponds to the increase in Matt Jones, Capital (Matt s investment in the business). The net change in the account from the owner s investment and the cash outflow for inventory is a positive $1,3. This net change of a positive $1,3 is verified at the bottom of the cash flow statement and on the balance sheet. There was a $ cash at January 1, but at January 31, the balance is $1,3. Here s a Tip For a change in assets (other than cash) the change in the account is in the opposite direction. Recall that when increased by $7, decreased by $7. For a change in liabilities and owner's equity the change in the account is in the same direction. Recall that when the owner invested cash in the company increased and Owner s Equity increased. February Transactions and Financial Statements On February 25, 216, Good Deal sells 1 calculators to a nearby high school for $8 each. Matt delivers the calculators on February 25 and gives the school an $8 invoice due by March 1. Matt receives $8 from the school on March 8. Matt prepared financial statements for his new business as of February 28, 216: Income Statement For the Month Ended Feb. 28, 216 Revenues Expenses $ 8 5 $ 3 The income statement for the month of February shows revenues (or sales) of $8. Under the accrual basis of accounting revenue is recognized when title passes (at the time of shipment or time of delivery), not when the money is received. Expenses (such as the cost of goods sold for $5) appear on the income statement when they best match up with revenues, not when the expenses or goods are paid for. (Other expenses will also appear on the income statement when they are used, not when they are paid for.) As a result of the accrual basis of accounting, the income statement reports $3 of net income even though there was no cash inflow or cash outflow during February. For personal use by the original purchaser only. Copyright AccountingCoach.com. 8

9 Statement of Flows For the Month Ended February 28, 216 Increase in accounts receivable Decrease in inventory provided (used) in operating activities Investing Activities Investment by owner Net increase in cash at the beginning of the month at the end of the month $ 3 (8) 5 1,3 $1,3 As you can see above, the cash flow statement for the month of February reports no change in cash. That agrees with the company s balance sheet that reported of $1,3 on January 31 and will show $1,3 on February 28. Income Statement For the Two Months Ended Feb. 28, 216 Revenues Expenses $ 8 5 $ 3 The year-to-date net income of $3 increases the owner s equity on the balance sheet. Please note the connection between the bottom line of the year-to-date income statement and the change in Matt Jones, Capital on the balance sheet. Matt Jones, Capital has increased from $2, to $2,3. Balance Sheet February 28, 216 ASSETS LIABILITIES & OWNER S EQUITY Accounts receivable $1,3 8 2 $2,3 Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total owner s equity Total liabilities & owner s equity $ 2, 3 2,3 $2,3 For personal use by the original purchaser only. Copyright AccountingCoach.com. 9

10 Statement of Flows For the Two Months Ended February 28, 216 Increase in accounts receivable Increase in inventory provided (used) in operating activities Investing Activities Investment by owner Net increase in cash at the beginning of the year at February 28, 216 $ 3 (8) (2) (7) $2, 1,3 $1,3 Good Deal s income statement for the first two months shows a positive net income of $3. However, the fact that the company s Accounts Receivable increased by $8 means the company did not collect the cash from its sales. And because increased by $2, the company s had also decreased in order to pay for the increase. As a result, the cash flows for the two-month period shows that Good Deal s cash from operating activities is a negative $7. Recall that Good Deal has not received any money yet from its operations (buying and selling merchandise) and it paid out $7 for the 14 calculators it purchased. The cash flow statement also shows $2, of financing by the owner. When this is combined with the negative $7 from operating activities, the net change in cash for the first two months is a positive $1,3. This agrees to the change in cash on the balance sheet none on January 1 but $1,3 on February 28. March Transactions and Financial Statements On March 8 Good Deal receives $8 for the calculators sold to the school on February 25. No other transactions occurred in March. The Good Deal financial statements dated March 31 are: Income Statement For the Month Ended March 31, 216 Revenues Expenses $ $ For personal use by the original purchaser only. Copyright AccountingCoach.com. 1

11 Income Statement For the Three Months Ended March 31, 216 Revenues Expenses $ 8 5 $ 3 Note that the year-to-date net income causes the amount in the owner s capital account (on the balance sheet) to increase from $2, to $2,3. Balance Sheet March 31, 216 ASSETS LIABILITIES & OWNER S EQUITY Accounts receivable $2,1 2 $2,3 Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total owner s equity Total liabilities & owner s equity $ 2, 3 2,3 $2,3 Statement of Flows For the Three Months Ended March 31, 216 Increase in accounts receivable Increase in inventory provided (used) in operating activities Investing Activities Investment by owner Net increase in cash at the beginning of the year at March 31, 216 $ 3 (2) 1 $2, 2,1 $2,1 The income statement for the first three months of the business shows a net income of $3. The operating activities section of the statement of cash flows begins with the $3 in net income, but then shows that $2 of cash was used to increase inventory. As a result, only $1 of cash was provided from operating activities. For personal use by the original purchaser only. Copyright AccountingCoach.com. 11

12 The statement of cash flows also shows that $2, was received from the owner s investment in the company. The net cash inflow from the company s operating, investing, and financing activities for the three months ended March 31, 216 was $2,1. The figure of $2,1 represents the change in cash from the beginning of the accounting year through March 31. If you look at the March 31 balance sheet, you will find that it confirms this there is $2,1 in the account on March 31 and there was $ on January 1. The statement of cash flows presented above was for the three months ended March 31, 216. Let s look at how the statement of cash flows would be prepared for just one month March 216. Since much of the information for the cash flow statement comes from changes in balance sheet accounts, we need to have the balance sheet amounts for both February 28, 216 and March 31, 216. The differences in these account balances from February 28 to March 31 will provide us with information we need on the activities in March. Balance Sheets March 31 and February 28, 216 Assets Accounts receivable $2, $2, $1,3 8 2 $2,3 Change $ 8 (8) -- $ -- & Owner s Equity Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total owner s equity Total liabilities & owner s equity $ -- 2, 3 2,3 $2,3 $ -- 2, 3 2,3 $2,3 $ $ -- (If you are wondering why March 31 is shown before February 28, it is because accountants usually place the most current amounts closest to the account names. This is a courtesy to the reader in that these are assumed to be the more important amounts and will be easier to read if placed closest to the words.) Focus on the Change column above. The first amount, a positive $8 change in the account, will serve as a check figure for the bottom line of the cash flow statement for the month of March. In other words, the cash flow statement for March must end up explaining this $8 increase in the account. The other amounts in the Change column will be used on the statement of cash flows to identify the reasons for the $8 increase in cash. Since there were no sales and no expenses in March, the income statement for the one month of March (see above) reported no net income. This $ of net income is the first amount reported on the statement of cash flows. The changes in the balance sheet accounts from February 28 to March 31 provided the other information needed for the month of March: For personal use by the original purchaser only. Copyright AccountingCoach.com. 12

13 Statement of Flows For the Month Ended March 31, 216 Decrease in accounts receivable Change in inventory provided (used) in operating activities Investing Activities Net increase in cash at the beginning of the month at the end of the month $ ,3 $2,1 Let s review the cash flow statement for the month of March 216: for March is $, since there were no revenues, gains, expenses, or losses. increased by $8 because $8 of accounts receivable were collected during March. did not change, so was not affected. (We could omit this line since it had no effect on cash.) There were no changes in long-term assets during March, so nothing is reported in the investing activities section. There were no changes in long-term liabilities or owner s equity; hence, nothing is reported in the financing activities section. The summation of the amounts on the statement of cash flows is a positive $8. This amount agrees to the increase in the account balance from $1,3 on February 28 to $2,1 on March 31. For personal use by the original purchaser only. Copyright AccountingCoach.com. 13

14 April Transactions and Financial Statements On April 28 Good Deal orders $15 of supplies on account. The supplies arrive on April 3 along with an invoice showing that the full $15 is due by May 3. None of the supplies were used in April. This was the only transaction during April. Matt prepared the following financial statements for as of April 3: Income Statement For the Month Ended April 3, 216 Revenues Expenses $ $ Since no supplies were used in April, there is no change to the Supplies Expense account. The $15 is reported on the balance sheet in the asset account Supplies. Income Statement For the Four Months Ended April 3, 216 Revenues Expenses $ 8 5 $ 3 Balance Sheet April 3, 216 ASSETS LIABILITIES & OWNER S EQUITY Accounts receivable Supplies $2, $2,45 Accounts payable Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total owner s equity Total liabilities & owner s equity $ 15 2, 3 2,3 $2,45 As you can see from the balance sheet the company added assets of $15 (Supplies) and added its first liability of $15 (Accounts Payable). For personal use by the original purchaser only. Copyright AccountingCoach.com. 14

15 A balance sheet comparing April 3 to March 31 and the resulting differences or changes is shown below: Balance Sheets April 3 and March 31, 216 Assets Accounts receivable Supplies $2, $2, $2,1 2 $2,3 Change $ $ 15 $ 15 & Owner s Equity Accounts payable Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total owner s equity Total liabilities & owner s equity $ 15 2, 3 2,3 $2,45 $ 2, 3 2,3 $2,3 $ 15 $ 15 (If you are wondering why April 3 is shown before March 31, it is because accountants usually place the most current amounts closest to the account names. This is a courtesy to the reader in that these are assumed to be the more important amounts and will be easier to read if placed closest to the words.) Statement of Flows For the Month Ended April 3, 216 Increase in supplies Increase in Accounts payable provided (used) in operating activities Investing Activities Investment by owner Net increase in cash at the beginning of the month at the end of the month $ (15) 15 2,1 $2,1 The cash flow statement for the month of April reports that there was no change in the account from March 31 through April 3. The operating activities section reports the increase in Supplies, but also reports the increase in Accounts Payable. For personal use by the original purchaser only. Copyright AccountingCoach.com. 15

16 Here s a Tip On the statement of cash flows, think of the positive amounts (the numbers not in parentheses) as good for your cash balance. For example, if you don't pay your bills, that's good for your cash balance (but bad for the liability Accounts Payable which increases). Think of the negative amounts (the numbers within parentheses) as not good for cash. For example, if you pay a bill, that's not good for your cash balance (but good for the liability Accounts Payable which decreases). Balance Sheets April 3, 216 and December 31, 215 Assets Accounts receivable Supplies $2, $2, $ $ Change $2, $2,45 & Owner s Equity Accounts payable Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total owner s equity Total liabilities & owner s equity $ 15 2, 3 2,3 $2,45 $ $ $ 15 2, 3 2,3 $2,45 Statement of Flows For the Four Months Ended April 3, 216 Increase in inventory Increase in supplies Increase in Accounts payable provided (used) in operating activities Investing Activities Investment by owner Net increase in cash at the beginning of the month at April 3, 216 $ 3 (2) (15) , 2,1 $2,1 For personal use by the original purchaser only. Copyright AccountingCoach.com. 16

17 Let s review the statement of cash flows for the four months ended April 3: The operating activities section of the cash flow statement starts with the net income of $3 for the four-month period. The increase in is not good for cash, as shown by the negative $2. Similarly, the increase in Supplies is not good for cash and it is reported as a negative $15. The increase in Accounts Payable is good for cash (since some bills were not paid) so the increase in the liability account is a positive $15. Combining the amounts, the net change in cash that is explained by operating activities is a positive $1. There were no changes in long-term assets, hence no cash was involved in investing activities. There were no changes in long-term liabilities. There was a change in owner s equity since December 31, and as a result the financing activities section reports the owner s investment in Combining the operating, investing, and financing activities, the cash flow statement reports a change in cash of $2,1. This agrees with the change in the account from $ on December 31, 215 to $2,1 on April 3, 216. May Transactions and Financial Statements On May 3 Good Deal pays its accounts payable of $15. On May 31 Good Deal purchases office equipment (a new computer and printer) that will be used exclusively in the business. The cost of the office equipment is $1,1 and is paid for in cash. The equipment is put into service on May 31. There were no other transactions in May. Income Statement For the Month Ended May 31, 216 Revenues Expenses $ $ Income Statement For the Five Months Ended May 31, 216 Revenues Expenses $ 8 5 $ 3 For personal use by the original purchaser only. Copyright AccountingCoach.com. 17

18 Balance Sheet May 31, 216 ASSETS LIABILITIES & OWNER S EQUITY Accounts receivable Supplies Office equipment $ ,1 $2,3 Accounts payable Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total owner s equity Total liabilities & owner s equity $ 2, 3 2,3 $2,3 A balance sheet comparing May 31 to April 3 and the resulting differences or changes is shown below: Balance Sheets May 31 and April 3, 216 Assets Accounts receivable Supplies Office equipment $ ,1 $2, $2, $2,45 Change $(1,25) 1,1 $ (15) & Owner s Equity Accounts payable Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total owner s equity Total liabilities & owner s equity $ 2, 3 2,3 $2,3 $ 15 2, 3 2,3 $2,45 $ (15) $ (15) Statement of Flows For the Month Ended May 31, 216 Decrease in accounts payable provided (used) in operating activities Investing Activities Purchase of office equipment Net increase in cash at the beginning of the month at the end of the month $ (15) (15) (1,1) (1,25) 2,1 $ 85 For personal use by the original purchaser only. Copyright AccountingCoach.com. 18

19 Balance Sheets May 31, 216 and December 31, 215 Assets Accounts receivable Supplies Office equipment $ ,1 $2, $ $ Change $ ,1 $2,3 & Owner s Equity Accounts payable Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total owner s equity Total liabilities & owner s Equity $ 2, 3 2,3 $2,3 $ $ $ 2, 3 $ 2,3 $2,3 Statement of Flows For the Five Months Ended May 31, 216 Increase in inventory Increase in supplies provided (used) in operating activities Investing Activities Purchase of office equipment Investment by owner Net increase in cash at the beginning of the year at May 31, 216 $ 3 (2) (15) (5) (1,1) 2, 85 $ 85 Let s review the cash flow statement for the five months ended May 31: The operating activities section starts with the net income of $3 for the five-month period. The increase in is not good for cash, as shown by the negative $2. Similarly, the increase in Supplies is not good for cash and it is reported as a negative $15. Combining the amounts, the net change in cash that is explained by operating activities is a negative $5. The increase in long-term assets is reported under investing activities. There were no changes in long-term liabilities. There was a change in owner s equity since December 31, and as a result the financing activities section of the cash flow statement reports the owner s investment into the Combining the operating, investing, and financing activities, the statement of cash flows reports an increase in cash of $85. This agrees with the change in the account as shown on the balance sheets from December 31, 215 (or January 1, 216) and May 31, 216. For personal use by the original purchaser only. Copyright AccountingCoach.com. 19

20 Depreciation Expense Depreciation moves the cost of an asset to Depreciation Expense during the asset s useful life. The accounts involved in recording depreciation are Depreciation Expense and Accumulated Depreciation. As you can see, cash is not involved. In other words, depreciation reduces net income on the income statement, but it does not reduce the account on the balance sheet. Because we begin preparing the statement of cash flows using the net income figure taken from the income statement, we need to adjust the net income figure so that it is not reduced by Depreciation Expense. To do this, we add back the amount of the Depreciation Expense. Depletion Expense and Amortization Expense are accounts similar to Depreciation Expense, as all three involve allocating the cost of a long-term asset to an expense over the useful life of the asset. There is no cash involved. Here s a Tip In the operating activities section of the cash flow statement, add back expenses that did not require the use of cash. Examples are depreciation, depletion, and amortization expense. Let s illustrate how a depreciation expense is handled by continuing with the June Transactions and Financial Statements The only transaction recorded by Good Deal during June was the depreciation on the office equipment. Recall that on May 31 Good Deal purchased the office equipment (a new computer and printer) for $1,1 and it was put into service on the same day. Let s assume that a depreciation expense of $2 per month is recorded by Good Deal. As a result, Good Deal s financial statements at June 3 will be as follows: Income Statement For the Month Ended June 3, 216 Revenues Expenses Depreciation Expense $ 2 $ (2) Income Statement For the Six Months Ended June 3, 216 Revenues Expenses Cost of goods sold Depreciation expense Total expense $ $ 28 For personal use by the original purchaser only. Copyright AccountingCoach.com. 2

21 Balance Sheet June 3, 216 ASSETS LIABILITIES & OWNER S EQUITY Accounts receivable Supplies Office equipment Less: Accumulated depreciation $ ,1 (2) $2,28 Accounts payable Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total Matt Jones, capital Total liabilities & owner s equity $ 2, 28 2,28 $2,28 A balance sheet comparing June 3 to May 31 and the resulting differences or changes is shown below: Balance Sheets June 3 and May 31, 216 Assets Accounts receivable Supplies Office equipment Less: Accumulated depreciation $ ,1 (2) $2, $ ,1 $ 2,3 Change $ (2) $ (2) & Owner s Equity Accounts payable Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total Matt Jones, capital Total liabilities & owner s equity $ 2, 28 2,28 $2,28 $ 2, 3 2,3 $2,3 $ (2) (2) $(2) (If you are wondering why June 3 is shown before May 31, it is because accountants usually place the most current amounts closest to the account names. This is a courtesy to the reader in that these are assumed to be the more important amounts and will be easier to read if placed closest to the words.) For personal use by the original purchaser only. Copyright AccountingCoach.com. 21

22 Statement of Flows For the Month Ended June 3, 216 Add: Depreciation expense provided (used) in operating activities Investing Activities Net increase in cash at the beginning of the month at the end of the month $ (2) 2 85 $ 85 The cash flow statement for the month of June illustrates why depreciation expense needs to be added back to net income. Good Deal did not spend any cash in June, however, the entry in the Depreciation Expense account resulted in a net loss on the income statement. To convert the bottom line of the income statement (a loss of $2) to the amount of cash provided or used in operating activities ($) we need to add back or remove the depreciation expense amount. Balance Sheets June 3, 216 and December 31, 215 Assets Accounts receivable Supplies Office equipment Less: Accumulated depreciation $ ,1 (2) $2, $ $ Change $ ,1 (2) $2,28 & Owner s Equity Accounts payable Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total Matt Jones, capital Total liabilities & owner s equity $ 2, 28 2,28 $2,28 $ $ $ 2, 28 2,28 $2,28 For personal use by the original purchaser only. Copyright AccountingCoach.com. 22

23 Statement of Flows For the Six Months Ended June 3, 216 Add back: Depreciation expense Increase in inventory Increase in supplies provided (used) in operating activities Investing Activities Increase in office equipment Investment by owner Net increase in cash at the beginning of the year at June 3, 216 $ 28 2 (2) (15) (5) (1,1) 2, 85 $ 85 Let s review the cash flow statement for the six months ended June 3: The operating activities section starts with the net income of $28 for the six-month period. Depreciation expense is added back to net income because it was a noncash transaction (net income was reduced, but there was no cash spent on depreciation). The increase in the account is not good for cash, as shown by the negative $2. Similarly, the increase in Supplies is not good for cash and it is reported as a negative $15. Combining the amounts, the net change in cash that is explained by operating activities is a negative $5. The increase in long-term assets caused a cash outflow of $1,1 which is reported in the investing activities section. There were no changes in long-term liabilities. There was a change in owner s equity since December 31, and as a result the financing activities section reports the owner s $2, investment into the Combining the operating, investing, and financing activities, the statement of cash flows reports an increase in cash of $85. This agrees with the change in the account as shown on the balance sheets from December 31, 215 and June 3, 216. Disposal of Assets If a company disposes of (sells) a long-term asset for an amount different from its recorded amount in the company s accounting records (its book value), an adjustment must be made to net income on the cash flow statement. For example, let s say a company sells one of its delivery trucks for $3,. That truck is shown on the company records at its original cost of $2, less accumulated depreciation of $18,. When these two amounts are combined ( netted together ) the net amount is known as the book value (or the carrying value) of the asset. In the example, the book value of the truck is $2, ($2, - $18,). Because the proceeds from the sale of the truck are $3, and the book value is $2, the difference of $1, is recorded in the account Gain on Sale of Truck an income statement For personal use by the original purchaser only. Copyright AccountingCoach.com. 23

24 account. The transaction has the effect of increasing the company s net income. If the truck had sold for $1,5 ($5 less than its $2, book value), the difference of $5 would be reported in the account Loss on Sale of Truck and would reduce the company s net income. One of the rules in preparing a statement of cash flows is that the entire proceeds received from the sale of a long-term asset must be reported in the second section of the statement, the investing activities section. This presents a problem because any gain or loss on the sale of an asset is also included in the company s net income which is reported in the first section operating activities. To avoid double counting, each gain is deducted from net income and each loss is added to net income in the operating activities section of the cash flow statement. Let s illustrate this by returning to s activities. July Transactions and Financial Statements On July 1 Matt decides that his company no longer needs its office equipment. Good Deal used the equipment for one month (May 31 through June 3) and had recorded one month s depreciation of $2. This means the book value of the equipment is $1,8 (the original cost of $1,1 less the $2 of accumulated depreciation). On July 1 Good Deal sells the equipment for $9 in cash and records a loss of $18 in the account Loss on Sale of Equipment on its income statement. There were no other transactions in July. The income statement and the statement of cash flows for the month of July illustrate how the disposal of the equipment is reported: Income Statement For the Month Ended July 31, 216 Revenues Expenses Loss on sale of equipment $ 18 $(18) Income Statement For the Seven Months Ended July 31, 216 Revenues Expenses Cost of goods sold Depreciation expense Loss on sale of equipment Total expense $ $1 For personal use by the original purchaser only. Copyright AccountingCoach.com. 24

25 Balance Sheets July 31, 216 and June 3, 216 Assets Accounts receivable Supplies Office equipment Less: Accumulated depreciation $ 1, $ 2, $ ,1 (2) $2,28 Change $ 9 (1,1) 2 $ (18) & Owner s Equity Accounts payable Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total Matt Jones, capital Total liabilities & owner s equity $ 2, 1 2,1 $ 2,1 $ 2, 28 2,28 $2,28 $ (18) (18) $ (18) Statement of Flows For the Month Ended July 31, 216 Add back: Depreciation expense Add back: Loss on sale of equipment provided (used) in operating activities Investing Activities Proceeds from sale of office equipment Net increase in cash at the beginning of the month at the end of the month $ (18) $1,75 Let s review the cash flow statement for the month of July 216: for July was a net loss of $18. There were no revenues, expenses, or gains, but there was an entry of $18 in the account Loss on Sale of Equipment. There was no depreciation expense in July, and current assets and current liabilities did not change in July, so cash was not affected. (We could have omitted the line Depreciation Expense.) There was no cash provided or used by operating activities. Good Deal received $9 from the sale of its office equipment. There was no change in long-term liabilities or owner s equity during July (other than the $18 Loss on Sale of Equipment. For personal use by the original purchaser only. Copyright AccountingCoach.com. 25

26 The summation of the amounts on the cash flow statement is a positive cash inflow of $9. This amount agrees to our check figure the increase in the account balance from June 3 to July 31. Balance Sheets July 31, 216 and December 31, 215 Assets Accounts receivable Supplies Office equipment Less: Accumulated depreciation $ 1, $ 2, $ $ Change $ 1, $ 2,1 & Owner s Equity Accounts payable Matt Jones, capital (excl. net inc.) Matt Jones, curr yr. net income Total Matt Jones, capital Total liabilities & owner s equity $ 2, 1 2,1 $ 2,1 $ $ 2, 1 2,1 $ 2,1 Statement of Flows For the Seven Months Ended July 31, 216 Add back: Depreciation expense Add back: Loss on sale of equipment Increase in inventory Increase in supplies provided (used) in operating activities Investing Activities Purchase of office equipment Proceeds from sale of office equipment provided (used) for investing activities Investment by owner Net increase in cash at the beginning of the year at July 31, 216 $ (2) (15) (5) (1,1) 9 (2) 2, 1,75 $1,75 Let s review the cash flow statement for the seven months of January through July 216: for the seven months is $1. This is the bottom line of the income statement. Included in the net income for the seven months is $2 of depreciation expense. This expense reduced net income but did not reduce the account; therefore we add the $2 depreciation expense to the net income. For personal use by the original purchaser only. Copyright AccountingCoach.com. 26

27 Also included in net income is the $18 entry into the Loss on Sale of Equipment account. This loss was reported on the income statement thereby reducing net income but not reducing cash. (The cash received from the sale of the equipment appears in its entirety under the investing activities section of the cash flow statement.) on July 31 is $2 (4 calculators at a cost of $5 each). Since the company began with no inventory, this increase in the account means that $2 of cash was used to increase inventory. Supplies increased from none to $15. The increase in the Supplies account is assumed to have had a negative effect of $15 on the account. Combining the amounts so far, we see that the cash from operating activities is a negative $5. In other words, rather than providing cash, the operating activities used $5 of cash. There is cash outflow (or payment) of $1,1 to purchase the office equipment on May 31 and the $9 of cash inflow (or receipt) from the sale of the office equipment on July 1. Combining these two amounts results in the net outflow ( cash used in investing activities ) of $2. There was an owner s investment of $2, made on January 2. The statement of cash flow s bottom line amount of $1,75 results from combining the amount totals of the previous three sections operating, investing, and financing activities. This $1,75 agrees to the check figure the difference in the account balance from the beginning of January to July 31. Conclusion Because the material covered here is considered an introduction to this topic, many complexities have been omitted. You should always consult with an accounting professional for assistance with your own specific circumstances. For personal use by the original purchaser only. Copyright AccountingCoach.com. 27

28 Attached Practice Answers 1. The account increases and because of the double entry system, the owner s equity account Mary Smith, Capital also increases. 2. The account decreases, and because of the double entry system, the asset account increases. 3. The account increases, and because of the double entry system, the liability account Notes Payable increases. 4. It is assumed that the company pays the dividend and therefore the account decreases. Because of the double entry system, the stockholders equity account Retained Earnings also decreases. 5. The account decreases, and because of the double entry system, the liability account Accounts Payable is decreased. 6. The account decreases, and because of the double entry system, the asset account Prepaid Insurance increases. 7. There is no effect on the account. The transaction does, however, result in a debit to the asset account Accounts Receivable and a credit to the income statement account Sales, which has the effect of increasing sales and net income on the income statement. The transaction changes nothing on the statement of cash flows since there is no cash involved at this time (the cash will be received in 3 days). 8. On the day the cash is received, the account increases, and because of the double-entry system, the asset account Accounts Receivable is decreased. (Be aware that this transaction has no effect on the income statement there is no increase in Sales and no increase in net income.) 9. If Accounts Payable decreased, we assume that the company paid some of its bills, therefore we assume that the account also decreased. 1. If the asset account Prepaid Insurance increased, we assume that the company paid an insurance premium that covered more than the current month. Therefore, we assume that the account decreased. Consider the general journal entry for this transaction: Prepaid Insurance xxx xxx 11. If the asset account Land increased, we assume that the company paid cash to purchase the land, therefore, the account decreased. Consider the general journal entry for this transaction: Land xxx xxx 12. The account increased because we assume that the company receives cash from the sale of any and all assets. Consider the general journal entry for this transaction: xxx Land xxx Gain on Sale of Land xxx 13. The account increases because we assume the company receives cash when it issues bonds. 14. The account decreases because we assume that the company used cash or paid cash to repurchase/redeem/reduce its bonds that are outstanding. For personal use by the original purchaser only. Copyright AccountingCoach.com. 28

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