introduction to cash flow statement g

7/29/2019 Introduction to Cash Flow Statement G

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Introduction to Cash 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, 2010" or "The Fiscal Year

Ended September 30, 2010".

The cash flow statement organizes and reports the cash generated and used in the following

categories:

1. Operating activities converts the items reported on the income statement from theaccrual basis of accounting to cash.

2. Investing activities reports the purchase and sale of long-term investments andproperty, plant and equipment.

3. Financing activities reports the issuance and repurchase of the company's own bondsand stock and the payment of dividends.

4. Supplementalinformation

reports the exchange of significant items that did not involve cashand reports the amount of income taxes paid and interest paid.

What Can The Statement of Cash 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 statementmight 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 cashfrom operating activities is consistently greater than the net income, the company's netincome or earnings are said to be of a "high quality". If the cash from operating activitiesis less than net income, a red flag is raised as to why the reported net income is notturning into cash.

2. Some investors believe that "cash is king". The cash flow statement identifies the cashthat is flowing in and out of the company. If a company is consistently generating morecash than it is using, the company will be able to increase its dividend, buy back some ofits stock, reduce debt, or acquire another company. All of these are perceived to be goodfor stockholder value.

3. Some financial models are based upon cash flow.


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Understanding The Changes In Cash

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. 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 Cash account?

The Cash account increases, and because of double entry system, the owners equityMary Smith, capital also increase.

2. When a company purchases inventory (merchandise purchased in order to be resold) what willhappen to its Cash account?

The Cash account decreases, and because of double entry system, the assetst accountinventory increases.

3. What happens to the company's Cash account if it borrows money from the bank by signing anote payable?

The cash account increases, and because of double entry system, the liability

account Notes payable increase.

4. What happens to a company's Cash account if it declares a dividend on its shares of stock?

It is assumed that the company pays the dividend and therefore the cash accountdecreases, because of double entry system, the Stockholders equity account Retained

Earnings also decreases.

5. What is the effect on its Cash account when a company pays some of itsAccounts Payable?

The cash account decreases, and because of double entry system, the liability

account Accounts Payable is decreased.

6. What is the effect on its Cash account when a company prepays a 6-month insurancepremium?

The Cash account decreases, and because of double entry system, the assets accountPrepaid Insurance increases.

7. What is the effect on its Cash account when a company sells merchandise, but allows thecustomer to pay in 30 days?

There is no effect on cash account. The transaction does, however, result in a debit toasset account Accounts Receivable and a credit to income statement account Sales, which hasthe effect of increasing sales and net income on the income statement. The transaction changesnothing on the statement of cash flow since there is no cash involved at this time ( the cash willbe received in 30 days ).

8. What is the effect on its Cash account when a company receives payment from one of itscustomers 30 days after the sale was recorded?
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On the day the cash is received, the cash account increases, and because of doubleentry system, the assets account Accounts Receivable decreases. ( Be aware that thistransaction has no effect on income statement there is no increase on sales and no increase onincome. )

9. If a company's Accounts Payable account decreased, what is the likely effect this will have onCash?

If Accounts Payable decreased, we assume that the company paid some of its bills,therefore assume that the cash account will also decreased.

10. If the asset account Prepaid Insuranceincreased, what is the likely effect on Cash?

If the assets account Prepaid Insurance increased, we assume that the company paid aninsurance premium that covered more than the current month. Therefore, we assume that thecash account decreased. Consider the General journal entry for this transaction.

Prepaid Insurance xxxxCash xxxx

11. If the asset account Land increased, what's the likely effect on Cash?

If the asset account Land increased, we assume that the company paid cash to purchase

the land, therefore, the cash account decreased. Consider the General journal entry for thistransaction.

Land xxxxCash xxxx

12. If the asset account Land decreased, what's the likely effect on Cash?

The cash account increase because we assume that the company receives cash fromthe sale of any and all assets. Consider the general journal entry for this transaction.

Cash xxxxLand xxxxGain on sale of Land xxxx

13. If the liability account Bonds Payableincreases, what is the likely effect on Cash?

The cash account increased because we assume that the company receives cash whenthey issue bonds.

14. If the liability account Bonds Payable decreases, what is the likely effect on Cash?

The cash account decreases because we assume that the company used cash or

paid cash to repurchase/redeem/reduce its bonds that are outstanding.

Much of what you learned in the practice questions above 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 thefollowing general assumptions:

When an asset (other than cash) increases, the Cash account decreases. When an asset (other than cash) decreases, the Cash account increases. When a liability increases, the Cash account increases. When a liability decreases, the Cash account decreases. When owner's equity increases, the Cash account increases. When owner's equity decreases, the Cash account decreases.
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For a change in assets (other than cash)the change in the Cash account is in

the opposite direction.

For a change in liabilities and owner's equitythe change in the Cash account is in

the same direction

Format of the Statement of Cash Flows

The statement of cash flows has four distinct sections:

1. Cash involving operating activities2. Cash involving investing activities3. Cash involving financing activities4. Supplemental information.

Assuming that the cash flow statement is being prepared using theindirect method(themethod used by most companies) thedifferencesin a company's balance sheet accountswill provide much of the needed information. For example, if the statement of cash flowsis for the year 2010, the balance sheet accounts at December 31, 2010 will be comparedto the balance sheet accounts at December 31, 2009. The changesor differencesinthese account balances will likely be entered in one of the sections of the statement ofcash flows.

Shown below is each of the four sections of the statement of cash flows, followed by alist of those balance sheet accounts which affect it.

1. Cash Provided From or Used By Operating Activities

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 ofcurrent

assetand current liabilityaccounts, such as:Accounts ReceivableInventorySuppliesPrepaid InsuranceOther Current AssetsNotes Payable(generally due within one year)Accounts PayableWages PayablePayroll Taxes PayableInterest PayableIncome Taxes PayableUnearned Revenues

Other Current Liabilities

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. Cash Provided From or Used By Investing Activities
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This section of the cash flow statement reports changes in the balances oflong-term

assetaccounts, such as:Long-term InvestmentsLandBuildingsEquipmentFurniture & FixturesVehicles

In short, investing activities involve the purchase and/or sale of long-term investments and

property, plant, and equipment.

3. Cash Provided From or Used By Financing Activities

This section of the cash flow statement reports changes in balances of the long-term

liabilityandstockholders' equityaccounts, such as:Notes Payable(generally due after one year)Bonds PayableDeferred Income Taxes

Preferred StockPaid-in Capital in Excess of Par-Preferred StockCommon StockPaid-in Capital in Excess of Par-Common StockPaid-in Capital from Treasury StockRetained EarningsTreasury Stock

In short, financing activities involve the issuance and/or the repurchase of a company's own

bonds or stock. 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 ChangesTake a look at the summary belowit shows where the changes in balance sheetaccounts should be entered on your statement of cash flows:

A change in thisbalance sheet category

...is reported in this sectionof the cash flow statement

Current Assets* Operating Activities

Current Liabilities Operating Activities

Long-term Assets Investing Activities

Long-term Liabilities Financing Activities

Stockholders' Equity Financing Activities

*This refers to current assets other thanCash.

Adjustments Within The Operating Activities Section
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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 paidout cash for all of its expenses, then net income would equal the cash from operatingactivities. However, since some of the revenues and expenses on the income statementwere 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 beillustrated in the hypothetical story presented in Part 3.

Story To Illustrate

Matt is a college student who enjoys buying and selling merchandise using the Internet. On

January 2, 2010, he decides to turn his hobby into a business called "Good Deal Co." 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-to-date period. The purpose is to show how these transactions are reported on

the cash flow statement.

January Transactions and Financial StatementsOn January 2, 2010 Matt invests $2,000 of his personal money into his sole proprietorship, Good

Deal Co. On January 20, Good Deal buys 14 graphing calculators for $50 per calculatorthis is

about 50% less than the selling price Matt has observed at the retail stores. The total cost to

Good Deal for all 14 calculators is $700. Good Deal has no other transactions during January.

Matt prepares financial statements for his new business as of January 31, 2010:

Good Deal Co.Income Statement

For the Month Ended January 31, 2010

Revenues $ 0

Expenses 0

Net Income $ 0

Good Deal Co.Balance Sheet

January 31, 2010

Assets Liabilities & Owner's Equity

Cash $1,300 Liabilities $ 0

Inventory 700 Owner's Equity

Matt Jones, Capital 2,000

Total Assets $2,000 Total Liab. & Owner's Equity $2,000

Good Deal Co.Statement of Cash Flows

For the Month Ended January 31, 2010

Operating Activities
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Net Income $ 0

Increase in Inventory (700)

Cash Provided (Used) in Operating Activities (700)

Investing Activities 0

Financing Activities

Investment by Owner 2,000

Net Increase in Cash 1,300

Cash at the beginning of the month 0Cash at the end of the month $1,300

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 $700. The decrease in cash occurred because the

company increased its inventory by $700 during January. The financing activities section shows

an increase in cash of $2,000 which corresponds to the increase inMatt Jones, Capital(Matt's

investment in the business). The net change in the Cash account from the owner's investment

and the cash outflow for inventory is a positive $1,300.

This net change of a positive $1,300 is verified at the bottom of the cash flow statement and on

the balance sheet. There was a $0 cash at January 1, but at January 31, the Cash balance is

$1,300.

For a change in assets (other than cash)the change in the Cashaccount is in

the opposite direction. Recall that whenInventoryincreased by $700, Cash decreased by $700.

For a change in liabilities and owner's equitythe change in the Cash account is in

the same direction. Recall that when the owner invested cash in the company Cash increased

and Owner's Equity increased.

February Transactions and Financial Statements

On February 25, 2010, Good Deal sells 10 calculators to a nearby high school for $80 each. Matt

delivers the calculators on February 25 and gives the school an $800 invoice due by March 10.

Matt receives $800 from the school on March 8.

Matt prepared financial statements for his new business as of February 28, 2010:


For the Month Ended Feb. 28, 2010
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Revenues $800

Expenses 500

Net Income $300

The income statement for the month of February shows revenues (or sales) of $800. Under the

accrual basis of accountingrevenue is recognized when title passes (at the time of shipment ortime of delivery), notwhen the money is received. Expenses (such as the cost of goods sold for

$500) appear on the income statement when they best match up with revenues, notwhen 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 $300 of net income even though there was no cash inflow or cash

outflow during February.


For the Month Ended February 28, 2010

Operating ActivitiesNet Income $ 300

Increase inAccounts Receivable (800)

Decrease in Inventory 500

Cash Provided (Used) in Operating Activities 0



Investment by Owner 0

Net Increase in Cash 0

Cash at the beginning of the month 1,300

Cash at the end of the month $1,300

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 Cash of $1,300 on January 31

and will show $1,300 on February 28.


For the Two Months Ended February 28, 2010

Revenues $800

Expenses 500

Net Income $300
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The year-to-date net income of $300 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, Capitalon the balance sheet. Matt Jones, Capital has increased from

$2,000 to $2,300.

Good Deal Co.Balance SheetFebruary 28, 2010


Cash $1,300 Liabilities $ 0

Accounts Receivable 800 Owner's Equity

Inventory 200 Matt Jones, Capital (excl. net inc.) 2,000

Matt Jones, Curr Yr. Net Income 300

Total Owner's Equity 2,300

Total Assets $2,300 Total Liabilities & Owner's Equity $2,300


For the Two Months Ended February 28, 2010


Net Income $ 300

Increase inAccounts Receivable (800)

Increase inInventory (200)



Financing ActivitiesInvestment by Owner $2,000


Cash at the beginning of the year 0

Cash at February 28, 2010 $1,300

Good Deal's income statement for the first two months shows a positive net income of $300.

However, the fact that the company's Accounts Receivable increased by $800 means the

company did not collect the cash from its sales. And because Inventory increased by $200, the

company's Cash had also decreased in order to pay for the Inventory increase. As a result, the

cash flows for the two-month period shows that Good Deal's cash from operating activities isa negative $700. Recall that Good Deal has not receivedany money yet from its operations

(buying and selling merchandise) and itpaid out$700 for the 14 calculators it purchased.

The cash flow statement also shows $2,000 of financing by the owner. When this is combined

with the negative $700 from operating activities, the net change in cash for the first two months is

a positive $1,300. This agrees to the change in cash on the balance sheetnone on January 1

but $1,300 on February 28.

March Transactions and Financial Statements
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On March 8 Good Deal receives $800 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:

Good Deal Co.Income StatementFor the Month Ended March 31, 2010

Revenues $ 0

Expenses 0

Net Income $ 0


For the Three Months Ended March 31, 2010

Revenues $800

Expenses 500

Net Income $300

Note that the year-to-date net income causes the amount in the owner's capital account (on the

balance sheet) to increase from $2,000 to $2,300.

Good Deal Co.Balance SheetMarch 31, 2010

Assets Liabilities & Owner's EquityCash $2,100 Liabilities $ 0

Accounts Receivable 0 Owner's Equity

Inventory 200 Matt Jones, Capital (excl. net inc.) 2,000




Good Deal Co.
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Statement of Cash FlowsFor the Three Months Ended March 31, 2010


Net Income $ 300

Increase inAccounts Receivable 0



Investing Activities 0Financing Activities

Investment by Owner $2,000



Cash at March 31, 2010 $2,100

The income statement for the first three months of the business shows a net income of $300. The

operating activities section of the statement of cash flows begins with the $300 in net income, but

then shows that $200 of cash was used to increase inventory. As a result, only $100 of cash was

provided from operating activities.

The statement of cash flows also shows that $2,000 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, 2010 was $2,100.

The figure of $2,100 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 $2,100 in the Cash account on March 31 and there was $0 on January 1.

The statement of cash flows presented above was for the three months ended March 31, 2010.

Let's look at how the statement of cash flows would be prepared for just one monthMarch 2010.

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, 2010 and March 31,

2010. Thedifferences in these account balances from February 28 to March 31 will provide us

with information we need on the activities in March.

Good Deal Co.Balance Sheets

March 31 and February 28, 2010

Assets 3-31-10 2-28-10 Change

Cash $2,100 $1,300 $ 800

Accounts Receivable -0- 800 (800)

Inventory 200 200 -0-

Total Assets $2,300 $2,300 $ -0-
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12/27

Liabilities & Owner's Equity

Liabilities $ -0- $ -0- $ -0-

Owner's Equity

Matt Jones, Capital(excl. net inc.) 2,000 2,000 -0-

Matt Jones, Curr Yr. Net Income 300 300 -0-

Total Owner's Equity 2,300 2,300 -0-

Total Liabilities & Owner's Equity $2,300 $2,300 $ -0-

(If you are wondering why March 31 is shown before February 28, it is because accountants usually placethe most current amounts closest to the account names. This is a courtesy to the reader inthat these are assumed to be the more important amounts and will be easier to read ifplaced closest to the words.)

Focus on the "Change" column above. The first amount, a positive $800 change in the Cash

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 $800

increase in the Cash account. The other amounts in the "Change" column will be used on the

statement of cash flows to identify the reasons for the $800 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 $0 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 the Month Ended March 31, 2010


Net Income $ 0

Decrease in Accounts Receivable 800

Change in Inventory 0



Financing Activities 0

Net Increase in Cash 800Cash at the beginning of the month 1,300


Let's review the cash flow statement for the month of March 2010:

Net income for March is $0, since there were no revenues, gains, expenses, or losses. Cash increased by $800 because $800 of accounts receivable were collected during

March.
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13/27

Inventory did not change, so Cash was not affected. (We could omit this line since it hadno effect on cash.)

There were no changes in long-term assets during March, so nothing is reported in theinvesting activities section.

There were no changes in long-term liabilities or owner's equity; hence, nothing isreported in the financing activities section.

The summation of the amounts on the statement of cash flows is a positive $800. Thisamount agrees to the increase in the Cash account balance from $1,300 on February 28to $2,100 on March 31.

April Transactions and Financial StatementsOn April 28 Good Deal orders $150 of supplies on account. The supplies arrive on April 30 along

with an invoice showing that the full $150 is due by May 30. None of the supplies were used in

April. This was the only transaction during April.

Matt prepared the following financial statements for Good Deal Co. as of April 30:


For the Month Ended April 30, 2010

Revenues $ 0

Expenses 0

Net Income $ 0

Since no supplies were usedin April, there is no change to the Supplies Expense account. The

$150 is reported on the balance sheet in the asset account Supplies.


For the Four Months Ended April 30, 2010

Revenues $800

Expenses 500

Net Income $300

Good Deal Co.Balance SheetApril 30, 2010


Cash $2,100 LiabilitiesAccounts Receivable 0 Accounts Payable $ 150


Supplies 150 Matt Jones, Capital (excl. net inc.) 2,000




As you can see from the balance sheet the company added assets of $150 (Supplies) and added

its first liability of $150 (Accounts Payable).
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14/27

A balance sheet comparing April 30 to March 31 and the resulting differences or changes is

shown below:


April 30 and March 31, 2010


Cash $2,100 $2,100 $ 0

Accounts Receivable 0 0 0

Inventory 200 200 0

Supplies 150 $ 0 $150

Total Assets $2,450 $2,300 $150


Liabilities

Accounts Payable $ 150 $ 0 $150

Owner's EquityMatt Jones, Capital(excl. net inc.) 2,000 2,000 0

Matt Jones, Curr Yr. Net Income 300 300 0

Total Owner's Equity 2,300 2,300 0

Total Liabilities & Owner's Equity $2,450 $2,300 $150

(If you are wondering why April 30 is shown before March 31, it is because accountants usually place themost current amounts closest to the account names. This is a courtesy to the reader in thatthese are assumed to be the more important amounts and will be easier to read if placedclosest to the words.)


For the Month Ended April 30, 2010


Net Income $ 0

Increase inSupplies (150)

Increase inAccounts Payable 150




Investment by Owner 0




The cash flow statement for the month of April reports that there was no change in the Cash

account from March 31 through April 30. The operating activities section reports the increase in

Supplies, but also reports the increase in Accounts Payable.
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15/27

On the statement of cash flows, think of the positive amounts (the numbers notin parentheses)

as goodfor 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 Payablewhich increases).

Think of the negative amounts (the numbers within parentheses) asnot goodfor 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).


April 30, 2010 and December 31, 2009


Cash $2,100 $ 0 $2,100


Inventory 200 0 200

Supplies 150 0 150

Total Assets $2,450 $ 0 $2,450


LiabilitiesAccounts Payable $ 150 $ 0 $ 150

Owner's Equity

Matt Jones, Capital(excl. net inc.) 2,000 0 2,000


Total Owner's Equity 2,300 0 2,300

Total Liabilities & Owner's Equity $2,450 $ 0 $2,450


For the Four Months Ended April 30, 2010


Net Income $ 300



Increase inAccounts Payable 150




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16/27



Cash at April 30, 2010 $2,100

Let's review the statement of cash flows for the four months ended April 30:

The operating activities section of the cash flow statement starts with the net income of$300 for the four-month period. The increase in Inventory is not good for cash, as shownby the negative $200. Similarly, the increase in Supplies is not good for cash and it isreported as a negative $150. The increase in Accounts Payable is good for cash (sincesome bills were not paid) so the increase in the liability account is a positive $150.Combining the amounts, the net change in cash that is explained by operating activities isa positive $100.

There were no changes in long-term assets, hence no cash was involved in investingactivities.

There were no changes in long-term liabilities. There was a change in owner's equitysince December 31, and as a result the financing activities section reports the owner'sinvestment in Good Deal Co.

Combining the operating, investing, and financing activities, the cash flow statementreports a change in cash of $2,100. This agrees with the change in the Cash accountfrom $0 on December 31, 2009 to $2,100 on April 30, 2010.

May Transactions and Financial StatementsOn May 30 Good Deal pays its accounts payable of $150. 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 $1,100 and is paid for in cash. The equipment is put into service onMay 31. There were no other transactions in May.


For the Month Ended May 31, 2010

Revenues $ 0

Expenses 0

Net Income $ 0


For the Five Months Ended May 31, 2010

Revenues $800

Expenses 500

Net Income $300


17/27

Good Deal Co.Balance SheetMay 31, 2010


Cash $ 850 Liabilities

Accounts Receivable 0 Accounts Payable $ 0



Office Equipment 1,100 Matt Jones, Curr Yr. Net Income 300



A balance sheet comparing May 31 to April 30 and the resulting differences or changes is shown

below:


May 31 and April 30, 2010


Cash $ 850 $2,100 $(1,250)


Inventory 200 200 0

Supplies 150 150 0

Office Equipment 1,100 0 1,100

Total Assets $2,300 $2,450 $ (150)


LiabilitiesAccounts Payable $ 0 $ 150 $ (150)

Owner's Equity

Matt Jones, Capital(excl. net inc.) 2,000 2,000 0


Total Owner's Equity 2,300 2,300 0

Total Liabilities & Owner's Equity $2,300 $2,450 $ (150)
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18/27


For the Month Ended May 31, 2010


Net Income $ 0

Decrease in Accounts Payable (150)


Investing Activities

Purchase ofOffice Equipment (1,100)


Net Increase in Cash (1,250)


Cash at the end of the month $ 850


May 31, 2010 and December 31, 2009


Cash $ 850 $ 0 $ 850


Inventory 200 0 200Supplies 150 0 150


Total Assets $2,300 $ 0 $2,300


Liabilities

Accounts Payable $ 0 $ 0 $ 0

Owner's Equity



Total Owner's Equity 2,300 0 $2,300Total Liabilities & Owner's Equity $2,300 $ 0 $2,300
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19/27


For the Five Months Ended May 31, 2010


Net Income $ 300



Cash Provided (Used) in Operating Activities (50)Investing Activities






Cash at May 31, 2010 $ 850

Let's review the cash flow statement for the five months ended May 31:

The operating activities section starts with the net income of $300 for the five-monthperiod. The increase in Inventory is not good for cash, as shown by the negative $200.Similarly, the increase in Supplies is not good for cash and it is reported as a negative$150. Combining the amounts, the net change in cash that is explained by operatingactivities is a negative $50.

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 flowstatement reports the owner's investment into the Good Deal Co.

Combining the operating, investing, and financing activities, the statement of cash flows

reports an increase in cash of $850. This agrees with the change in the Cash account asshown on the balance sheets from December 31, 2009 (or January 1, 2010) and May 31,2010.

Depreciation ExpensDepreciation 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 Cash 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 byDepreciation Expense. To do this, we add back the amount of the Depreciation Expense.

Depletion Expense and Amortization Expenseare 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.

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.
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20/27

Let's illustrate how a depreciation expense is handled by continuing with the Good DealCo.

June Transactions and Financial StatementsThe only transaction recorded by Good Deal during June was the depreciation on theoffice equipment. Recall that on May 31 Good Deal purchased the office equipment (anew computer and printer) for $1,100 and it was put into service on the same day. Let'sassume that a depreciation expense of $20 per month is recorded by Good Deal. As a

result, Good Deal's financial statements at June 30 will be as follows:


For the Month Ended June 30, 2010

Revenues $ 0

Expenses

Depreciation Expense 20

Net Income $(20)


For the Six Months Ended June 30, 2010

Revenues $800

Expenses

Cost of Goods Sold 500


Total Expense 520

Net Income $280

Good Deal Co.Balance SheetJune 30, 2010


Cash $ 850 Liabilities

Accounts Receivable 0 Accounts Payable $ 0



Office Equipment 1,100 Matt Jones, Curr Yr. Net Income 280

Less: Accum. Depreciation (20 ) Total Matt Jones, Capital 2,280


A balance sheet comparing June 30 to May 31 and the resulting differences or changes is shown

below:


June 30 and May 31, 2010
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21/27


Cash $ 850 $ 850 $ 0


Inventory 200 200 0

Supplies 150 150 0

Office Equipment 1,100 1,100 0

Less: Accumulated Depreciation (20 ) 0 (20 )

Total Assets $2,280 $2,300 $(20)


Liabilities


Owner's Equity


Matt Jones, Curr Yr. Net Income 280 300 (20 )

Total Matt Jones, Capital 2,280 2,300 (20 )

Total Liabilities & Owner's Equity $2,280 $2,300 $(20)

(If you are wondering why June 30 is shown before May 31, it is because accountants usually place themost current amounts closest to the account names. This is a courtesy to the reader in thatthese are assumed to be the more important amounts and will be easier to read if placedclosest to the words.)


For the Month Ended June 30, 2010


Net Income $ (20)

Add: Depreciation Expense 20





Cash at the beginning of the month 850

Cash at the end of the month $850

The cash flow statement for the month of June illustrates why depreciation expense needsto be added back to net income. Good Deal did not spend any cash in June, however, theentry 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 $20) to the amount of cashprovided or used in operating activities ($0) we need to add back or remove thedepreciation expense amount.
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22/27


June 30, 2010 and December 31, 2009


Cash $ 850 $ 0 $ 850

Accounts Receivable 0 0 0Inventory 200 0 200

Supplies 150 0 150


Less: Accumulated Depreciation (20 ) 0 (20 )

Total Assets $2,280 $ 0 $2,280


Liabilities


Owner's Equity

Matt Jones, Capital(excl. net inc.) 2,000 0 2,000Matt Jones, Curr Yr. Net Income 280 0 280

Total Matt Jones, Capital 2,280 0 2,280


Good Deal Co.Statement of Cash FlowsFor the Six Months Ended June 30, 2010


Net Income $ 280

Add back: Depreciation Expense 20


Increase inSupplies (150 )


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23/27

Increase inOffice Equipment (1,100)





Cash at June 30, 2010 $ 850

Let's review the cash flow statement for the six months ended June 30:

The operating activities section starts with the net income of $280 for the six-monthperiod. Depreciation expense is added back to net income because it was a noncashtransaction (net income was reduced, but there was no cash spent on depreciation). Theincrease in the Inventory account is not good for cash, as shown by the negative $200.Similarly, the increase in Supplies is not good for cash and it is reported as a negative$150. Combining the amounts, the net change in cash that is explained by operatingactivities is a negative $50.

The increase in long-term assets caused a cash outflow of $1,100 which is reported inthe investing activities section.

There were no changes in long-term liabilities. There was a change in owner's equitysince December 31, and as a result the financing activities section reports the owner's$2,000 investment into the Good Deal Co.

Combining the operating, investing, and financing activities, the statement of cash flowsreports an increase in cash of $850. This agrees with the change in the Cash account asshown on the balance sheets from December 31, 2009 and June 30, 2010.

Disposal of AssetsIf 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 $3,000. That truck is shown

on the company records at its original cost of $20,000 less accumulated depreciation of $18,000.

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 $2,000

($20,000 - $18,000).

Because the proceeds from the sale of the truck are $3,000 and the book value is $2,000 the

difference of $1,000 is recorded in the accountGain on Sale of Truckan income statement

account. The transaction has the effect of increasing the company's net income. If the truck had

sold for $1,500 ($500 less than its $2,000 book value), the difference of $500 would be reportedin 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 secondsection 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 isdeductedfrom net income and each

loss is addedto net income in the operating activities section of the cash flow statement.

Let's illustrate this by returning to Good Deal Co.'s activities.
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24/27

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 30) and had recorded one month's

depreciation of $20. This means the book value of the equipment is $1,080 (the original cost of

$1,100 less the $20 of accumulated depreciation). On July 1 Good Deal sells the equipment for

$900 in cash and records a loss of $180 in the account Loss on Sale of Equipmenton 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:


For the Month Ended July 31, 2010

Revenues $ 0

Expenses

Loss on Sale of Equipment 180

Net Income $(180)


For the Seven Months Ended July 31, 2010

Revenues $800

Expenses

Cost of Goods Sold 500


Loss on Sale of Equipment 180

Total Expense 700

Net Income $100


July 31, 2010 and June 30, 2010


Cash $1,750 $ 850 $ 900


Inventory 200 200 0

Supplies 150 150 0

Office Equipment 0 1,100 (1,100)

Less: Accumulated Depreciation 0 (20 ) 20

Total Assets $2,100 $2,280 $ (180)
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25/27


Liabilities


Owner's Equity


Matt Jones, Curr Yr. Net Income 100 280 (180 )

Total Matt Jones, Capital 2,100 2,280 (180 )Total Liabilities & Owner's Equity $2,100 $2,280 $ (180)


For the Month Ended July 31, 2010


Net Income $ (180)

Add back: Depreciation Expense 0Add back: Loss on Sale of Equipment 180



Proceeds from sale ofOffice Equipment 900



Cash at the beginning of the month 850


Let's review the cash flow statement for the month of July 2010:

Net income for July was a net loss of $180. There were no revenues, expenses, or gains,but there was an entry of $180 in the account Loss on Sale of Equipment.

There was no depreciation expense in July, and current assets and current liabilities didnot 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 $900 from the sale of its office equipment. There was no change in long-term liabilities or owner's equity during July.

The summation of the amounts on the cash flow statement is a positive cash inflow of $900. This

amount agrees to our check figurethe increase in the Cash account balance from June 30 to

July 31.


July 31, 2010 and December 31, 2009
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26/27


Cash $1,750 $ 0 $1,750


Inventory 200 0 200

Supplies 150 0 150

Office Equipment 0 0 0

Less: Accumulated Depreciation 0 0 0Total Assets $2,100 $ 0 $2,100


Liabilities


Owner's Equity



Total Matt Jones, Capital 2,100 0 2,100



For the Seven Months Ended July 31, 2010


Net Income $ 100

Add back: Depreciation Expense 20

Add back: Loss on Sale of Equipment 180

Increase in Inventory (200)

Increase in Supplies (150 )

Cash Provided (Used) in Operating Activities (50 )Investing Activities


Proceeds from sale ofOffice Equipment 900

Cash Provided (Used) in Investing Activities (200 )


Investment by owner 2,000


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27/27

Cash at July 31, 2010 $1,750

Let's review the cash flow statement for the seven months of January through July 2010:

Net income for the seven months is $100. This includes revenues, gains, expenses, andlosses.

Included in the net income for the seven months is $20 of depreciation expense. Thisexpense reduced net income but did not reduce the Cash account; therefore we add the$20 depreciation expense to the net income.

Also included in net income is the $180 entry into the Loss on Sale of Equipmentaccount. This loss was reported on the income statement thereby reducing net incomebut not reducing cash. (The cash received from the sale of the equipment appears in itsentirety under the investing activities section of the cash flow statement.)

Inventory on July 31 is $200 (4 calculators at a cost of $50 each). Since the companybegan with no inventory, this increase in the Inventory account means that $200 of cashwas used to increase inventory.

Supplies increased from none to $150. The increase in the Supplies account is assumedto have had a negative effect of $150 on the Cash account.

Combining the amounts so far, we see that the cash from operating activities is anegative $50. In other words, rather thanprovidingcash, the operatingactivities used$50 of cash.

There is cash outflow (or payment) of $1,100 to purchase the office equipment on May 31and the $900 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 investingactivities") of $200.

There was an owner's investment of $2,000 made on January 2.

The statement of cash flow's bottom line amount of $1,750 results from combining the amount

totals of the previous three sectionsoperating, investing, and financing activities. This $1,750

agrees to the check figurethe difference in the Cash account balance from the beginning of

January to July 31.

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introduction to cash flow statement g

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