AccountingCoach.com Cash Flow Statement

AccountingCoach.com Cash Flow Statement All underlined words are defined in the attached Glossary (Pages 40 46). Introduction to the 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, 2006" or "The Fiscal Year Ended September 30, 2006". 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. Copyright 2003-2007 AccountingCoach.com. 1

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 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. 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 (questions and answers appear on pages 37-39). As you formulate your response you will be learning to think about cash flows the way an accountant does. 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 Cash account decreases. When an asset (other than cash) decreases, the Cash account increases. When a liability increases, the Cash account increases. Copyright 2003-2007 AccountingCoach.com. 2

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. Here's a Tip 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 equity--the 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 activities 2. Cash involving investing activities 3. Cash 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 2006, the balance sheet accounts at December 31, 2006 will be compared to the balance sheet accounts at December 31, 2005. 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. 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 of current asset and current liability accounts, such as: Copyright 2003-2007 AccountingCoach.com. 3

Accounts Receivable Inventory Supplies Prepaid Insurance Other Current Assets Notes Payable (generally due within one year) Accounts Payable Wages Payable Payroll Taxes Payable Interest Payable Income Taxes Payable Unearned Revenues Other Current Liabilities In addition to using the changes in current assets and current liabilities, depreciation and the gains/losses on the sale of long-term assets are removed so that the income statement net income is converted from the accrual basis to cash. 2. Cash 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. Cash Provided From or Used By Financing Activities 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 Copyright 2003-2007 AccountingCoach.com. 4

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 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. 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 Liabilities Long-term Assets Long-term Liabilities Stockholders' Equity...is reported in this section of the cash flow statement Operating Activities Operating Activities Investing Activities Financing Activities Financing Activities *This refers to current assets other than Cash. Copyright 2003-2007 AccountingCoach.com. 5

Adjustments Within The Operating Activities 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. A Story To Illustrate Matt is a college student who enjoys buying and selling merchandise using the Internet. On January 2, 2007, 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 Statements On January 2, 2007 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 calculator--this 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, 2007: Good Deal Co. Income Statement For the Month Ended January 31, 2007 Revenues $ 0 Expenses 0 Net Income $ 0 Copyright 2003-2007 AccountingCoach.com. 6

Good Deal Co. Balance Sheet January 31, 2007 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 Liabilities & Owner's Equity $2,000 Good Deal Co. Statement of Cash Flows For the Month Ended January 31, 2007 Operating Activities 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 0 Cash 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 in Matt 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 Copyright 2003-2007 AccountingCoach.com. 7

and on the balance sheet. There was a $0 cash at January 1, but at January 31, the Cash balance is $1,300. Here s A Tip For a change in assets (other than cash)--the change in the Cash account is in the opposite direction. Recall that when Inventory increased by $700, Cash decreased by $700. For a change in liabilities and owner's equity--the change in the Cash account is in the same direction. Recall that when the owner invested cash in the company Cash increased and owner equity increased. February Transactions and Financial Statements On February 25, 2007, 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, 2007: Good Deal Co. Income Statement For the Month Ended February, 2007 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 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 $500) 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 $300 of net income even though there was no cash inflow or cash outflow during February. Copyright 2003-2007 AccountingCoach.com. 8

Good Deal Co. Statement of Cash Flows For the Month Ended February 28, 2007 Operating Activities Net Income $ 300 Increase in Accounts Receivable (800) Decrease in Inventory 500 Cash Provided (Used) in Operating Activities 0 Investing Activities 0 Financing Activities 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 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. Good Deal Co. Income Statement For the Two Months Ended February 28, 2007 Revenues $800 Expenses 500 Net Income $300 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, Capital on the balance sheet. Matt Jones, Capital has increased from $2,000 to $2,300. Copyright 2003-2007 AccountingCoach.com. 9

Good Deal Co. Balance Sheet February 28, 2007 Assets Liabilities & Owner's Equity 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 Good Deal Co. Statement of Cash Flows For the Two Months Ended February 28, 2007 Operating Activities Net Income $ 300 Increase in Accounts Receivable (800) Increase in Inventory (200) 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 year 0 Cash at February 28, 2007 $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 is a negative $700. Recall that Good Deal Copyright 2003-2007 AccountingCoach.com. 10

has not received any money yet from its operations (buying and selling merchandise) and it paid 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 sheet none on January 1 but $1,300 on February 28. March Transactions and Financial Statements 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 Statement For the Month Ended March 31, 2007 Revenues $ 0 Expenses 0 Net Income $ 0 Good Deal Co. Income Statement For the Three Months Ended March 31, 2007 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. Copyright 2003-2007 AccountingCoach.com. 11

Good Deal Co. Balance Sheet March 31, 2007 Assets Liabilities & Owner's Equity Cash $2,100 Liabilities $ 0 Accounts Receivable 0 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 Good Deal Co. Statement of Cash Flows For the Three Months Ended March 31, 2007 Operating Activities Net Income $ 300 Increase in Accounts Receivable 0 Increase in Inventory (200) Cash Provided (Used) in Operating Activities 100 Investing Activities 0 Financing Activities Investment by Owner $2,000 Net Increase in Cash 2,100 Cash at the beginning of year 0 Cash at March 31, 2007 $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, 2007 was $2,100. Copyright 2003-2007 AccountingCoach.com. 12

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, 2007. Let's look at how the statement of cash flows would be prepared for just one month--march 2007. 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, 2007 and March 31, 2007. The differences 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, 2007 Assets 3-31-07 2-28-07 Change Cash $2,100 $1,300 $ 800 Accounts Receivable -0-800 (800) Inventory 200 200-0- Total Assets $2,300 $2,300 $ -0- 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 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.) Copyright 2003-2007 AccountingCoach.com. 13

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 provides the other information we need for the one month of March: Good Deal Co. Statement of Cash Flows For the Month Ended March 31, 2007 Operating Activities Net Income $ 0 Decrease in Accounts Receivable 800 Change in Inventory 0 Cash Provided (Used) in Operating Activities 800 Investing Activities 0 Financing Activities 0 Net Increase in Cash 800 Cash at the beginning of year 1,300 Cash at end of month $2,100 Let's review the cash flow statement for the month of March 2007: 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. Inventory did not change, so Cash 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 stockholders' equity; hence, nothing is reported in the financing activities section. Copyright 2003-2007 AccountingCoach.com. 14

The summation of the amounts on the statement of cash flows is a positive $800. This amount agrees to the increase in the Cash account balance from $1,300 on February 28 to $2,100 on March 31. April Transactions and Financial Statements On 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: Good Deal Co. Income Statement For the Month Ended April 30, 2007 Revenues $ 0 Expenses 0 Net Income $ 0 Since no supplies were used in April, there is no change to the Supplies Expense account. The $150 is reported on the balance sheet in the asset account Supplies. Good Deal Co. Income Statement For the Fourth Months Ended April 30, 2007 Revenues $800 Expenses 500 Net Income $300 Copyright 2003-2007 AccountingCoach.com. 15

Good Deal Co. Balance Sheet April 30, 2007 Assets Liabilities & Owner's Equity Cash $2,100 Liabilities Accounts Receivable 0 Accounts Payable $ 150 Inventory 200 Owner's Equity Supplies 150 Matt Jones, Capital (excl. net inc.) 2,000 Matt Jones, Curr Yr. Net Income 300 Total Owner's Equity 2,300 Total Assets $2,450 Total Liabilities & Owner's Equity $2,450 As you can see from the balance sheet the company added assets of $150 (Supplies) and added its first liability of $150 (Accounts Payable). A balance sheet comparing April 30 to March 31 and the resulting differences or changes is shown below: Copyright 2003-2007 AccountingCoach.com. 16

Good Deal Co. Balance Sheets April 30 and March 31, 2007 Assets 4-30-07 3-31-07 Change 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 & Owner's Equity Liabilities Accounts Payable $ 150 $ 0 $150 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 $2,450 $2,300 $150 (If you are wondering why April 30 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.) Copyright 2003-2007 AccountingCoach.com. 17

Good Deal Co. Statement of Cash Flows For the Month Ended April 30, 2007 Operating Activities Net Income $ 0 Increase in Supplies (150) Increase in Accounts Payable 150 Cash Provided (Used) in Operating Activities 0 Investing Activities 0 Financing Activities Investment by Owner 0 Net Increase in Cash 0 Cash at the beginning of month 2,100 Cash at end of the month $2,100 The cash flow statement for the one 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. 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). Copyright 2003-2007 AccountingCoach.com. 18

Good Deal Co. Balance Sheets April 30, 2007 and December 31, 2006 Assets 4-30-07 12-31-06 Change Cash $2,100 $ 0 $2,100 Accounts Receivable 0 0 0 Inventory 200 0 200 Supplies 150 0 150 Total Assets $2,450 $ 0 $2,450 Liabilities & Owner's Equity Liabilities Accounts Payable $ 150 $ 0 $ 150 Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000 0 2,000 Matt Jones, Curr Yr. Net Income 300 0 300 Total Owner's Equity 2,300 0 2,300 Total Liabilities & Owner's Equity $2,450 $ 0 $2,450 Good Deal Co. Statement of Cash Flows For the Four Months Ended April 30, 2007 Operating Activities Net Income $ 300 Increase in Inventory (200) Increase in Supplies (150) Increase in Accounts Payable 150 Cash Provided (Used) in Operating Activities 100 Investing Activities 0 Financing Activities Investment by Owner 2,000 Net Increase in Cash 2,100 Cash at the beginning of year 0 Cash at April 30, 2007 $2,100 Copyright 2003-2007 AccountingCoach.com. 19

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 shown by the negative $200. Similarly, the increase in Supplies is not good for cash and it is reported as a negative $150. 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 $150. Combining the amounts, the net change in cash that is explained by operating activities is a positive $100. 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 into Good Deal Co. Combining the operating, investing, and financing activities, the cash flow statement reports a change in cash of $2,100. This agrees with the change in the Cash account from $0 on December 31, 2006 to $2,100 on April 30, 2007. May Transactions and Financial Statements On May 30 Good Deal pays its account 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 on May 31. There were no other transactions in May. Good Deal Co. Income Statement For the Month Ended May 31, 2007 Revenues $ 0 Expenses 0 Net Income $ 0 Copyright 2003-2007 AccountingCoach.com. 20

Good Deal Co. Income Statement For the Five Months Ended May 31, 2007 Revenues $800 Expenses 500 Net Income $300 Good Deal Co. Balance Sheet May 31, 2007 Assets Liabilities & Owner's Equity Cash $ 850 Liabilities Accounts Receivable 0 Accounts Payable $ 0 Inventory 200 Owner's Equity Supplies 150 Matt Jones, Capital (excl. net inc.) 2,000 Office Equipment 1,100 Matt Jones, Curr Yr. Net Income 300 Total Owner's Equity 2,300 Total Assets $2,300 Total Liabilities & Owner's Equity $2,300 A balance sheet comparing May 31 to April 30 and the resulting differences or changes is shown below: Copyright 2003-2007 AccountingCoach.com. 21

Good Deal Co. Balance Sheets May 31 and April 30, 2007 Assets 5-31-07 4-30-07 Change Cash $ 850 $2,100 $(1,250) Accounts Receivable 0 0 0 Inventory 200 200 0 Supplies 150 150 0 Office Equipment 1,100 0 1,100 Total Assets $2,300 $2,450 $ (150) Liabilities & Owner's Equity Liabilities Accounts Payable $ 0 $ 150 $ 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 $2,450 $ (150) Good Deal Co. Statement of Cash Flows For the Month Ended May 31, 2007 Operating Activities Net Income $ 0 Decrease in Accounts Payable (150) Cash Provided (Used) in Operating Activities (150) Investing Activities Purchase of Office Equipment (1,100) Financing Activities 0 Net Increase in Cash (1,250) Cash at the beginning of year 2,100 Cash at end of month $ 850 Copyright 2003-2007 AccountingCoach.com. 22

Good Deal Co. Balance Sheets May 31, 2007 and December 31, 2006 Assets 5-31-07 12-31-06 Change Cash $ 850 $ 0 $ 850 Accounts Receivable 0 0 0 Inventory 200 0 200 Supplies 150 0 150 Office Equipment 1,100 0 1,100 Total Assets $2,300 $ 0 $2,300 Liabilities & Owner's Equity Liabilities Accounts Payable $ 0 $ 0 $ 0 Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000 0 2,000 Matt Jones, Curr Yr. Net Income 300 0 300 Total Owner's Equity 2,300 0 $2,300 Total Liabilities & Owner's Equity $2,300 $ 0 $2,300 Good Deal Co. Statement of Cash Flows For the Five Months Ended May 31, 2007 Operating Activities Net Income $ 300 Increase in Inventory (200) Increase in Supplies (150) Cash Provided (Used) in Operating Activities (50) Investing Activities Purchase of Office Equipment (1,100) Financing Activities Investment by Owner 2,000 Net Increase in Cash 850 Cash at the beginning of year 0 Cash at May 31, 2007 $ 850 Copyright 2003-2007 AccountingCoach.com. 23

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 fivemonth period. 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 operating activities 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 flow statement 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 as shown on the balance sheets from December 31, 2006 (or January 1, 2007) and May 31, 2007. 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 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 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. Copyright 2003-2007 AccountingCoach.com. 24

Let's illustrate how a depreciation expense is handled by continuing with the Good Deal Co. 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 $1,100 and it was put into service on the same day. Let's assume 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: Good Deal Co. Income Statement For the Month Ended June 30, 2007 Revenues $ 0 Expenses Depreciation Expense 20 Net Income $(20) Good Deal Co. Income Statement For the Six Months Ended June 30, 2007 Revenues $800 Expenses Cost of Goods Sold 500 Depreciation Expense 20 Total Expense 520 Net Income $280 Copyright 2003-2007 AccountingCoach.com. 25

Good Deal Co. Balance Sheet June 30, 2007 Assets Liabilities & Owner's Equity Cash $ 850 Liabilities Accounts Receivable 0 Accounts Payable $ 0 Inventory 200 Owner's Equity Supplies 150 Matt Jones, Capital (excl. net inc.) 2,000 Office Equipment 1,100 Matt Jones, Curr Yr. Net Income 280 Less: Accumulated Depreciation (20) Total Matt Jones, Capital 2,280 Total Assets $2,280 Total Liabilities & Owner's Equity $2,280 A balance sheet comparing June 30 to May 31 and the resulting differences or changes is shown below: Copyright 2003-2007 AccountingCoach.com. 26

Good Deal Co. Balance Sheets June 30 and May 31, 2007 Assets 6-30-07 5-31-07 Change Cash $ 850 $ 850 $ 0 Accounts Receivable 0 0 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 Liabilities Accounts Payable $ 0 $ 0 $ 0 Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000 2,000 0 Matt Jones, Curr Yr. Net Income 280 300 0 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 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.) Copyright 2003-2007 AccountingCoach.com. 27

Good Deal Co. Statement of Cash Flows For the Month Ended June 30, 2007 Operating Activities Net Income $ (20) Add: Depreciation Expense 20 Cash Provided (Used) in Operating Activities 0 Investing Activities 0 Financing Activities 0 Net Increase in Cash 0 Cash at the beginning of month 850 Cash at end of month $850 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 $20) to the amount of cash provided or used in operating activities ($0) we need to add back or remove the depreciation expense amount. Copyright 2003-2007 AccountingCoach.com. 28

Good Deal Co. Balance Sheets June 30, 2007 and December 31, 2006 Assets 6-30-07 12-31-06 Change Cash $ 850 $ 0 $ 850 Accounts Receivable 0 0 0 Inventory 200 0 200 Supplies 150 0 150 Office Equipment 1,100 0 1,100 Less: Accumulated Depreciation (20) 0 (20) Total Assets $2,280 $ 0 $2,280 Liabilities & Owner's Equity Liabilities Accounts Payable $ 0 $ 0 $ 0 Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000 0 2,000 Matt Jones, Curr Yr. Net Income 280 0 280 Total Matt Jones, Capital 2,280 0 2,280 Total Liabilities & Owner's Equity $2,280 $ 0 $2,280 Copyright 2003-2007 AccountingCoach.com. 29

Good Deal Co. Statement of Cash Flows For the Six Months Ended June 30, 2007 Operating Activities Net Income $ 280 Add back: Depreciation Expense 20 Increase in Inventory (200) Increase in Supplies (150) Cash Provided (Used) in Operating Activities (50) Investing Activities Increase in Office Equipment (1,100) Financing Activities Investment by Owner 2,000 Net Increase in Cash 850 Cash at the beginning of year 0 Cash at June 30, 2007 $ 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 sixmonth 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 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 operating activities is a negative $50. The increase in long-term assets caused a cash outflow of $1,100 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 $2,000 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 as shown on the balance sheets from December 31, 2006 and June 30, 2007. Copyright 2003-2007 AccountingCoach.com. 30

Gain or Loss on 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 $3,000. 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 account Gain of Sale of Truck--an 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 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 Good Deal Co.'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 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 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: Copyright 2003-2007 AccountingCoach.com. 31

Good Deal Co. Income Statement For the Month Ended July 31, 2007 Revenues $ 0 Expenses Loss on Sale of Equipment 180 Net Income $(180) Good Deal Co. Income Statement For the Seven Months Ended July 31, 2007 Revenues $800 Expenses Cost of Goods Sold 500 Depreciation Expense 20 Loss on Sale of Equipment 180 Total Expense 700 Net Income $100 Copyright 2003-2007 AccountingCoach.com. 32

Good Deal Co. Balance Sheets July 31, 2007 and June 30, 2007 Assets 7-31-07 6-30-07 Change Cash $1,750 $ 850 $ 900 Accounts Receivable 0 0 0 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) Liabilities & Owner's Equity Liabilities Accounts Payable $ 0 $ 0 $ 0 Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000 2,000 0 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) Good Deal Co. Statement of Cash Flows For the Month Ended July 31, 2007 Operating Activities Net Income $ (180) Add back: Depreciation Expense 0 Add back: Loss on Sale of Equipment 180 Cash Provided (Used) in Operating Activities 0 Investing Activities Proceeds from sale of Office Equipment 900 Financing Activities 0 Net Increase in Cash 900 Cash at the beginning of month 850 Cash at end of month $1,750 Copyright 2003-2007 AccountingCoach.com. 33

Let's review the cash flow statement for the month of July 2007: 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 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 $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 figure--the increase in the Cash account balance from June 30 to July 31. Good Deal Co. Balance Sheets July 31, 2007 and December 31, 2006 Assets 7-31-07 12-31-06 Change Cash $1,750 $ 0 $1,750 Accounts Receivable 0 0 0 Inventory 200 0 200 Supplies 150 0 150 Office Equipment 0 0 0 Less: Accumulated Depreciation 0 0 0 Total Assets $2,100 $ 0 $2,100 Liabilities & Owner's Equity Liabilities Accounts Payable $ 0 $ 0 $ 0 Owner's Equity Matt Jones, Capital (excl. net inc.) 2,000 0 2,000 Matt Jones, Curr Yr. Net Income 100 0 100 Total Matt Jones, Capital 2,100 0 2,100 Total Liabilities & Owner's Equity $2,100 $ 0 $2,100 Copyright 2003-2007 AccountingCoach.com. 34

Good Deal Co. Statement of Cash Flows For the Seven Months Ended July 31, 2007 Operating Activities 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 Purchase of Office Equipment (1,100) Proceeds from sale of Office Equipment 900 Cash Provided (Used) in Investing Activities (200) Financing Activities Investment by owner 2,000 Net Increase in Cash 1,750 Cash at the beginning of year 0 Cash at July 31, 2007 $1,750 Let's review the cash flow statement for the seven months of January through July 2007: Net income for the seven months is $100. This includes revenues, gains, expenses, and losses. Included in the net income for the seven months is $20 of depreciation expense. This expense 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 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.) Inventory on July 31 is $200 (4 calculators at a cost of $50 each). Since the company began with no inventory, this increase in the Inventory account means that $200 of cash was used to increase inventory. Copyright 2003-2007 AccountingCoach.com. 35

Supplies increased from none to $150. The increase in the Supplies account is assumed to 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 a negative $50. In other words, rather than providing cash, the operating activities used $50 of cash. There is cash outflow (or payment) of $1,100 to purchase the office equipment on May 31 and 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 investing activities") 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 sections--operating, investing, and financing activities. This $1,750 agrees to the check figure--the difference in the Cash account balance from the beginning of January to July 31. Conclusion Because the material covered here is considered an introduction to the topic of cash flow statement, there are many complexities not presented. You should always consult with an accounting professional for assistance with your own specific circumstances. Copyright 2003-2007 AccountingCoach.com. 36

Attached Practice Questions 1. When Mary Smith invests her personal money into her new company, what will happen to her company's Cash account 2. When a company purchases inventory (merchandise purchased in order to be resold) what will happen to its Cash account? 3. What happens to the company's Cash account if it borrows money from the bank by signing a note payable? 4. What happens to a company's Cash account if it declares a dividend on its shares of stock? Answer 5. What is the effect on its Cash account when a company pays some of its Accounts Payable? 6. What is the effect on its Cash account when a company prepays a 6-month insurance premium? 7. What is the effect on its Cash account when a company sells merchandise, but allows the customer to pay in 30 days? 8. What is the effect on its Cash account when a company receives payment from one of its customers 30 days after the sale was recorded? 9. If a company's Accounts Payable account decreased, what is the likely effect this will have on Cash? 10. If the asset account Prepaid Insurance increased, what is the likely effect on Cash? 11. If the asset account Land increased, what's the likely effect on Cash? 12. If the asset account Land decreased, what's the likely effect on Cash? 13. If the liability account Bonds Payable increases, what is the likely effect on Cash? 14. If the liability account Bonds Payable decreases, what is the likely effect on Cash? Copyright 2003-2007 AccountingCoach.com. 37

Attached Practice Answers 1. The Cash account increases and because of the double entry system, the owner's equity account Mary Smith, Capital also increases. 2. The Cash account decreases, and because of the double entry system, the asset account Inventory increases. 3. The Cash 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 Cash account decreases. Because of the double entry system, the stockholders' equity account Retained Earnings also decreases. 5. The Cash account decreases, and because of the double entry system, the liability account Accounts Payable is decreases. 6. The Cash account decreases, and because of the double entry system, the asset account Prepaid Insurance increases. 7. There is no effect on the Cash 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 30 days). 8. On the day the cash is received, the Cash account increases, and because of double entry system, the asset account Accounts Receivable decreases. (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 Cash account also decreased. 10.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 Cash account decreased. Consider the general journal entry for this transaction: Prepaid Insurance Cash xxx xxx Copyright 2003-2007 AccountingCoach.com. 38

11.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 this transaction: Land Cash xxx xxx 12.The Cash 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: Land Cash Gain on Sale of Land xxx xxx xxx 13.The Cash account increases because we assume that company receives cash when it issues bonds. 14.The Cash account decreases because we assume that the company uses cash or paid cash to repurchase/redeem/reduce its bonds that are outstanding. Copyright 2003-2007 AccountingCoach.com. 39

Glossary accounts payable This current liability account will show the amount a company owes for items or services purchased on credit and for which there was not a promissory note. This account is often referred to as trade payables (as opposed to notes payable, interest payable, etc.) accounts receivable A current asset resulting from selling goods or services on credit (on account). Invoice terms such as (a) net 30 days or (b) 2/10, n/30 signify that a sale was made on account and was not a cash sale. accumulated depreciation The amount of a long term asset's cost that has been allocated to Depreciation Expense since the time that the asset was acquired. Accumulated Depreciation is a long-term contra asset account (an asset account with a credit balance) that is reported on the balance sheet under the heading Property, Plant, and Equipment. amortization expense The allocation to expenses of the cost of an intangible asset such as a patent, goodwill, bond issue costs, etc. bonds payable Generally a long term liability account containing the face amount, par amount, or maturity amount of the bonds issued by a company that are outstanding as of the balance sheet date. book value The book value of an asset is the amount of cost in its asset account less the accumulated depreciation applicable to the asset. The book value of a company is the amount of owner's or stockholders' equity. buildings Buildings is a noncurrent or long-term asset account which shows the cost of a building (excluding the cost of the land). Buildings will be depreciated over their useful lives by debiting the income statement account Depreciation Expense and crediting the balance sheet account Accumulated Depreciation. Copyright 2003-2007 AccountingCoach.com. 40