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STATEMENT OF CASH FLOWS

The official name for the cash flow statement is the statement of cash flows. We will use
both names throughout.

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, 2007" or "The Fiscal Year Ended September 30, 2008".

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 the accrual basis of accounting to cash.
2. Investing activities – reports the purchase and sale of long-term
investments and property, plant and equipment.
3. Financing activities – reports the issuance and repurchase of the
company's own bonds and stock and the payment of dividends.
4. Supplemental information – reports the exchange of significant items that
did not involve cash and reports the amount of income taxes paid and interest paid.

What Can The Statement of 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.

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Here are a few ways the statement of cash flows is used.
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.
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.
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. As you formulate your response you will be learning
to think about cash flows the way an accountant does.
1. When Azhar Shah invests her personal money into her new company, what will
happen to her company's Cash account? Answer
2. When a company purchases inventory (merchandise purchased in order to be
resold) what will happen to its Cash account? Answer
3. What happens to the company's Cash account if it borrows money from the bank
by signing a note payable? Answer
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? Answer
6. What is the effect on its Cash account when a company prepays a 6-month
insurance premium? Answer
7. What is the effect on its Cash account when a company sells merchandise, but
allows the customer to pay in 30 days? Answer
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? Answer
9. If a company's Accounts Payable account decreased, what is the likely effect this
will have on Cash? Answer
10. If the asset account Prepaid Insurance increased, what is the likely effect on Cash?
Answer
11. If the asset account Land increased, what's the likely effect on Cash?
Answer
12. If the asset account Land decreased, what's the likely effect on Cash?
Answer
13. If the liability account Bonds Payable increases, what is the likely effect on Cash?
Answer

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

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 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.
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.

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:

Cash involving operating activities


Cash involving investing activities
Cash involving financing activities
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 2007, the balance sheet accounts at December 31, 2007 will be
compared to the balance sheet accounts at December 31, 2006. The changes—or
differences—in these account balances will likely be entered in one of the sections of the
statement of cash flows.

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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:
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, 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

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.

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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
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 ...is reported in this section


balance sheet category of 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 than Cash.

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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 in Part 3.

A Story To Illustrate:-
Azhar Shah is a college student who enjoys buying and selling merchandise using the
Internet. On January 2, 2008, 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, 2008 Azhar Shah invests Rs.2,000 of his personal money into his sole
proprietorship, Good Deal Co. On January 20, Good Deal buys 14 graphing calculators
for Rs.50 per calculator—this is about 50% less than the selling price Azhar Shah has
observed at the retail stores. The total cost to Good Deal for all 14 calculators is Rs.700.
Good Deal has no other transactions during January.

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Good Deal Co.
Income Statement
For the Month Ended January 31, 2008

Revenues Rs. 0
Expenses 0
Net Income Rs. 0

Good Deal Co.


Balance Sheet
January 31, 2008

Assets Liabilities & Owner's Equity


Cash Rs.1,300 Liabilities Rs. 0
Inventory 700 Owner's Equity
Azhar Shah, Capital 2,000
Total Assets Rs.2,000 Total Liabilities & Owner's Equity Rs.2,000

Good Deal Co.


Statement of Cash Flows
For the Month Ended January 31, 2008

Operating Activities
Net Income Rs. 0
Increase in Inventory (700)
Cash Provided (Used) in Operating
(700)
Activities
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 Rs.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

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operating activities resulted in a decrease in cash of Rs.700. The decrease in cash
occurred because the company increased its inventory by Rs.700 during January. The
financing activities section shows an increase in cash of Rs.2,000 which corresponds to
the increase in Azhar Shah’s Capital (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 Rs.1,300.

This net change of a positive Rs.1,300 is verified at the bottom of the cash flow statement
and on the balance sheet. There was a Rs.0 cash at January 1, but at January 31, the Cash
balance is Rs.1,300.

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 Rs.700, Cash decreased by
Rs.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's Equity increased.

February Transactions and Financial Statements:-


On February 25, 2008, Good Deal sells 10 calculators to a nearby high school for Rs.80
each. Azhar Shah delivers the calculators on February 25 and gives the school an Rs.800
invoice due by March 10. Azhar Shah receives Rs.800 from the school on March 8.

Azhar Shah prepared financial statements for his new business as of February 29, 2008:

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Good Deal Co.
Income Statement
For the Month Ended Feb. 29, 2008

Revenues Rs.800
Expenses 500
Net Income Rs.300

The income statement for the month of February shows revenues (or sales) of Rs.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 Rs.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 Rs.300 of net
income even though there was no cash inflow or cash outflow during February.

Good Deal Co.


Statement of Cash Flows
For the Month Ended February 29, 2008

Operating Activities
Net Income Rs. 300
Increase in Accounts Receivable (800)
Decrease in Inventory 500
Cash Provided (Used) in Operating
0
Activities
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 Rs.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
Rs.1,300 on January 31 and will show Rs.1,300 on February 29.

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Good Deal Co.
Income Statement
For the Two Months Ended February 29, 2008

Revenues Rs.800
Expenses 500
Net Income Rs.300

The year-to-date net income of Rs.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 Azhar Shah, Capital on the balance sheet. Azhar Shah, Capital has
increased from Rs.2,000 to Rs.2,300.

Good Deal Co.


Balance Sheet
February 29, 2008

Assets Liabilities & Owner's Equity


Cash Rs.1,300 Liabilities Rs. 0
Accounts Receivable 800 Owner's Equity
Inventory 200 Azhar Shah, Capital (excl. net inc.) 2,000
Azhar Shah, Curr Yr. Net Income 300
Total Owner's Equity 2,300
Total Assets Rs.2,300 Total Liabilities & Owner's Equity Rs.2,300

Good Deal Co.


Statement of Cash Flows
For the Two Months Ended February 29, 2008

Operating Activities
Net Income Rs. 300
Increase in Accounts Receivable (800)
Increase in Inventory (200)
Cash Provided (Used) in Operating
(700)
Activities
Investing Activities 0
Financing Activities

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Investment by Owner Rs.2,000

Net Increase in Cash 1,300


Cash at the beginning of the year 0
Cash at February 29, 2008 Rs.1,300

Good Deal's income statement for the first two months shows a positive net income of
Rs.300. However, the fact that the company's Accounts Receivable increased by Rs.800
means the company did not collect the cash from its sales. And because Inventory
increased by Rs.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 Rs.700. Recall that Good Deal has not
received any money yet from its operations (buying and selling merchandise) and it paid
out Rs.700 for the 14 calculators it purchased.

The cash flow statement also shows Rs.2,000 of financing by the owner. When this is
combined with the negative Rs.700 from operating activities, the net change in cash for
the first two months is a positive Rs.1,300. This agrees to the change in cash on the
balance sheet—none on January 1 but Rs.1,300 on February 29.

March Transactions and Financial Statements


On March 8 Good Deal receives Rs.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, 2008

Revenues Rs. 0
Expenses 0
Net Income Rs. 0

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Good Deal Co.
Income Statement
For the Three Months Ended March 31, 2008

Revenues Rs.800
Expenses 500
Net Income Rs.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 Rs.2,000 to Rs.2,300.

Good Deal Co.


Balance Sheet
March 31, 2008

Assets Liabilities & Owner's Equity


Cash Rs.2,100 Liabilities Rs. 0
Accounts Receivable 0 Owner's Equity
Inventory 200 Azhar Shah, Capital (excl. net inc.) 2,000
Azhar Shah, Curr Yr. Net Income 300
Total Owner's Equity 2,300
Total Assets Rs.2,300 Total Liabilities & Owner's Equity Rs.2,300

Good Deal Co.


Statement of Cash Flows
For the Three Months Ended March 31, 2008

Operating Activities
Net Income Rs. 300
Increase in Accounts Receivable 0
Increase in Inventory (200)
Cash Provided (Used) in Operating
100
Activities
Investing Activities 0
Financing Activities
Investment by Owner Rs.2,000

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Net Increase in Cash 2,100
Cash at the beginning of the year 0
Cash at March 31, 2008 Rs.2,100

The income statement for the first three months of the business shows a net income of
Rs.300. The operating activities section of the statement of cash flows begins with the
Rs.300 in net income, but then shows that Rs.200 of cash was used to increase inventory.
As a result, only Rs.100 of cash was provided from operating activities.

The statement of cash flows also shows that Rs.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, 2008 was Rs.2,100.

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

The statement of cash flows presented above was for the three months ended March 31,
2008. Let's look at how the statement of cash flows would be prepared for just one
month—March 2008.

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 29,
2008 and March 31, 2008. The differences in these account balances from February 29 to
March 31 will provide us with information we need on the activities in March.

Good Deal Co.


Balance Sheets
March 31 and February 29, 2008

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Assets 3-31-08 2-29-08 Change
Cash Rs.2,100 Rs.1,300 Rs. 800
Accounts Receivable -0- 800 (800)
Inventory 200 200 -0-
Total Assets Rs.2,300 Rs.2,300 Rs. -0-

Liabilities & Owner's Equity


Liabilities Rs. -0- Rs. -0- Rs. -0-
Owner's Equity
Azhar Shah, Capital (excl. net inc.) 2,000 2,000 -0-
Azhar Shah, Curr Yr. Net Income 300 300 -0-
Total Owner's Equity 2,300 2,300 -0-
Total Liabilities & Owner's Equity Rs.2,300 Rs.2,300 Rs. -0-

(If you are wondering why March 31 is shown before February 29, it is because
accountants usually place the most current amounts closest to the account names.
This is a courtesy to the reader in that these are assumed to be the more important
amounts and will be easier to read if placed closest to the words.)

Focus on the "Change" column above. The first amount, a positive Rs.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 Rs.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 Rs.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 Rs.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:

Good Deal Co.


Statement of Cash Flows
For the Month Ended March 31, 2008

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Operating Activities
Net Income Rs. 0
Decrease in Accounts Receivable 800
Change in Inventory 0
Cash Provided (Used) in Operating
800
Activities
Investing Activities 0
Financing Activities 0

Net Increase in Cash 800


Cash at the beginning of the year 1,300
Cash at the end of the month Rs.2,100

Let's review the cash flow statement for the month of March 2008:

 Net income for March is Rs.0, since there were no revenues, gains, expenses, or
losses.
 Cash increased by Rs.800 because Rs.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 owner's equity; hence, nothing is
reported in the financing activities section.
 The summation of the amounts on the statement of cash flows is a positive
Rs.800. This amount agrees to the increase in the Cash account balance from
Rs.1,300 on February 29 to Rs.2,100 on March 31.

April Transactions and Financial Statements


On April 28 Good Deal orders Rs.150 of supplies on account. The supplies arrive on
April 30 along with an invoice showing that the full Rs.150 is due by May 30. None of
the supplies were used in April. This was the only transaction during April.

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

Good Deal Co.


Income Statement
For the Month Ended April 30, 2008

Revenues Rs. 0
Expenses 0
Net Income Rs. 0

Since no supplies were used in April, there is no change to the Supplies Expense
account. The Rs.150 is reported on the balance sheet in the asset account Supplies.

Good Deal Co.


Income Statement
For the Four Months Ended April 30, 2008

Revenues Rs.800
Expenses 500
Net Income Rs.300

Good Deal Co.


Balance Sheet
April 30, 2008

Assets Liabilities & Owner's Equity


Cash Rs.2,100 Liabilities
Accounts Receivable 0 Accounts Payable Rs. 150
Inventory 200 Owner's Equity
Supplies 150 Azhar Shah, Capital (excl. net inc.) 2,000
Azhar Shah, Curr Yr. Net Income 300
Total Owner's Equity 2,300
Total Assets Rs.2,450 Total Liabilities & Owner's Equity Rs.2,450

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As you can see from the balance sheet the company added assets of Rs.150 (Supplies)
and added its first liability of Rs.150 (Accounts Payable).

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

Good Deal Co.


Balance Sheets
April 30 and March 31, 2008

Assets 4-30-08 3-31-08 Change


Cash Rs.2,100 Rs.2,100 Rs. 0
Accounts Receivable 0 0 0
Inventory 200 200 0
Supplies 150 Rs. 0 Rs.150
Total Assets Rs.2,450 Rs.2,300 Rs.150

Liabilities & Owner's Equity


Liabilities
Accounts Payable Rs. 150 Rs. 0 Rs.150
Owner's Equity
Azhar Shah, Capital (excl. net inc.) 2,000 2,000 0
Azhar Shah, Curr Yr. Net Income 300 300 0
Total Owner's Equity 2,300 2,300 0
Total Liabilities & Owner's Equity Rs.2,450 Rs.2,300 Rs.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.)

Good Deal Co.


Statement of Cash Flows

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For the Month Ended April 30, 2008

Operating Activities
Net Income Rs. 0
Increase in Supplies (150)
Increase in Accounts Payable 150
Cash Provided (Used) in Operating
0
Activities
Investing Activities 0
Financing Activities
Investment by Owner 0

Net Increase in Cash 0


Cash at the beginning of the month 2,100
Cash at the end of the month Rs.2,100

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.

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).

Good Deal Co.


Balance Sheets
April 30, 2008 and December 31, 2007

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Assets 4-30-08 12-31-07 Change
Cash Rs.2,100 Rs. 0 Rs.2,100
Accounts Receivable 0 0 0
Inventory 200 0 200
Supplies 150 0 150
Total Assets Rs.2,450 Rs. 0 Rs.2,450

Liabilities & Owner's Equity


Liabilities
Accounts Payable Rs. 150 Rs. 0 Rs. 150
Owner's Equity
Azhar Shah, Capital (excl. net inc.) 2,000 0 2,000
Azhar Shah, Curr Yr. Net Income 300 0 300
Total Owner's Equity 2,300 0 2,300
Total Liabilities & Owner's Equity Rs.2,450 Rs. 0 Rs.2,450

Good Deal Co.


Statement of Cash Flows
For the Four Months Ended April 30, 2008

Operating Activities
Net Income Rs. 300
Increase in Inventory (200)
Increase in Supplies (150)
Increase in Accounts Payable 150
Cash Provided (Used) in Operating
100
Activities
Investing Activities 0
Financing Activities
Investment by Owner 2,000

Net Increase in Cash 2,100


Cash at the beginning of the year 0
Cash at April 30, 2008 Rs.2,100

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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 Rs.300 for the four-month period. The increase in Inventory is not
good for cash, as shown by the negative Rs.200. Similarly, the increase in
Supplies is not good for cash and it is reported as a negative Rs.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 Rs.150. Combining the amounts, the
net change in cash that is explained by operating activities is a positive Rs.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 in Good Deal Co.
 Combining the operating, investing, and financing activities, the cash flow
statement reports a change in cash of Rs.2,100. This agrees with the change in the
Cash account from Rs.0 on December 31, 2007 to Rs.2,100 on April 30, 2008.

May Transactions and Financial Statements


On May 30 Good Deal pays its accounts payable of Rs.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 Rs.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, 2008

Revenues Rs. 0
Expenses 0
Net Income Rs. 0

Good Deal Co.


Income Statement
For the Five Months Ended May 31, 2008

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Revenues Rs.800
Expenses 500
Net Income Rs.300

Good Deal Co.


Balance Sheet
May 31, 2008

Assets Liabilities & Owner's Equity


Cash Rs. 850 Liabilities
Accounts Receivable 0 Accounts Payable Rs. 0
Inventory 200 Owner's Equity
Supplies 150 Azhar Shah, Capital (excl. net inc.) 2,000
Office Equipment 1,100 Azhar Shah, Curr Yr. Net Income 300
Total Owner's Equity 2,300
Total Assets Rs.2,300 Total Liabilities & Owner's Equity Rs.2,300

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

Good Deal Co.


Balance Sheets
May 31 and April 30, 2008

Assets 5-31-08 4-30-08 Change


Cash Rs. 850 Rs.2,100 Rs.(1,250)
Accounts Receivable 0 0 0
Inventory 200 200 0
Supplies 150 150 0
Office Equipment 1,100 0 1,100
Total Assets Rs.2,300 Rs.2,450 Rs. (150)

Liabilities & Owner's Equity


Liabilities

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Accounts Payable Rs. 0 Rs. 150 Rs. (150)
Owner's Equity
Azhar Shah, Capital (excl. net inc.) 2,000 2,000 0
Azhar Shah, Curr Yr. Net Income 300 300 0
Total Owner's Equity 2,300 2,300 0
Total Liabilities & Owner's Equity Rs.2,300 Rs.2,450 Rs. (150)

Good Deal Co.


Statement of Cash Flows
For the Month Ended May 31, 2008

Operating Activities
Net Income Rs. 0
Decrease in Accounts Payable (150)
Cash Provided (Used) in Operating
(150)
Activities
Investing Activities
Purchase of Office Equipment (1,100)
Financing Activities 0

Net Increase in Cash (1,250)


Cash at the beginning of the month 2,100
Cash at the end of the month Rs. 850

Good Deal Co.


Balance Sheets
May 31, 2008 and December 31, 2007

Assets 5-31-08 12-31-07 Change


Cash Rs. 850 Rs. 0 Rs. 850
Accounts Receivable 0 0 0
Inventory 200 0 200
Supplies 150 0 150
Office Equipment 1,100 0 1,100
Total Assets Rs.2,300 Rs. 0 Rs.2,300

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Liabilities & Owner's Equity
Liabilities
Accounts Payable Rs. 0 Rs. 0 Rs. 0
Owner's Equity
Azhar Shah, Capital (excl. net inc.) 2,000 0 2,000
Azhar Shah, Curr Yr. Net Income 300 0 300
Total Owner's Equity 2,300 0 Rs.2,300
Total Liabilities & Owner's Equity Rs.2,300 Rs. 0 Rs.2,300

Good Deal Co.


Statement of Cash Flows
For the Five Months Ended May 31, 2008

Operating Activities
Net Income Rs. 300
Increase in Inventory (200)
Increase in Supplies (150)
Cash Provided (Used) in Operating
(50)
Activities
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 the year 0
Cash at May 31, 2008 Rs. 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 Rs.300 for the five-
month period. The increase in Inventory is not good for cash, as shown by the
negative Rs.200. Similarly, the increase in Supplies is not good for cash and it is
reported as a negative Rs.150. Combining the amounts, the net change in cash that
is explained by operating activities is a negative Rs.50.
 The increase in long-term assets is reported under investing activities.

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 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 Rs.850. This agrees with the change in the
Cash account as shown on the balance sheets from December 31, 2007 (or
January 1, 2008) and May 31, 2008.

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.

In the operating activities section of the cash flow statement, add back expenses that did
not require the use of cash. Examples are depreciation, depletion, and amortization
expense.

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

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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 Rs.1,100 and it was put into service on the same day. Let's
assume that a depreciation expense of Rs.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, 2008

Revenues Rs. 0
Expenses
Depreciation Expense 20
Net Income Rs.(20)

Good Deal Co.


Income Statement
For the Six Months Ended June 30, 2008

Revenues Rs.800
Expenses
Cost of Goods Sold 500
Depreciation Expense 20
Total Expense 520
Net Income Rs.280

Good Deal Co.


Balance Sheet
June 30, 2008

Assets Liabilities & Owner's Equity


Cash Rs. 850 Liabilities
Accounts Receivable 0 Accounts Payable Rs. 0
Inventory 200 Owner's Equity
Supplies 150 Azhar Shah, Capital (excl. net inc.) 2,000
Office Equipment 1,100 Azhar Shah, Curr Yr. Net Income 280

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Less: Accumulated Depreciation (20) Total Azhar Shah, Capital 2,280
Total Assets Rs.2,280 Total Liabilities & Owner's Equity Rs.2,280

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

Good Deal Co.


Balance Sheets
June 30 and May 31, 2008

Assets 6-30-08 5-31-08 Change


Cash Rs. 850 Rs. 850 Rs. 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 Rs.2,280 Rs.2,300 Rs.(20)

Liabilities & Owner's Equity


Liabilities
Accounts Payable Rs. 0 Rs. 0 Rs. 0
Owner's Equity
Azhar Shah, Capital (excl. net inc.) 2,000 2,000 0
Azhar Shah, Curr Yr. Net Income 280 300 0
Total Azhar Shah, Capital 2,280 2,300 (20)
Total Liabilities & Owner's Equity Rs.2,280 Rs.2,300 Rs.(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.)

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Good Deal Co.
Statement of Cash Flows
For the Month Ended June 30, 2008

Operating Activities
Net Income Rs. (20)
Add: Depreciation Expense 20
Cash Provided (Used) in Operating
0
Activities
Investing Activities 0
Financing Activities 0

Net Increase in Cash 0


Cash at the beginning of the month 850
Cash at the end of the month Rs.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 Rs.20) to the amount of
cash provided or used in operating activities (Rs.0) we need to add back or remove the
depreciation expense amount.

Good Deal Co.


Balance Sheets
June 30, 2008 and December 31, 2007

Assets 6-30-08 12-31-07 Change


Cash Rs. 850 Rs. 0 Rs. 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 Rs.2,280 Rs. 0 Rs.2,280

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Liabilities & Owner's Equity
Liabilities
Accounts Payable Rs. 0 Rs. 0 Rs. 0
Owner's Equity
Azhar Shah, Capital (excl. net inc.) 2,000 0 2,000
Azhar Shah, Curr Yr. Net Income 280 0 280
Total Azhar Shah, Capital 2,280 0 2,280
Total Liabilities & Owner's Equity Rs.2,280 Rs. 0 Rs.2,280

Good Deal Co.


Statement of Cash Flows
For the Six Months Ended June 30, 2008

Operating Activities
Net Income Rs. 280
Add back: Depreciation Expense 20
Increase in Inventory (200)
Increase in Supplies (150)
Cash Provided (Used) in Operating
(50)
Activities
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 the year 0
Cash at June 30, 2008 Rs. 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 Rs.280 for the six-
month period. Depreciation expense is added back to net income because it was a
noncash transaction (net income was reduced, but there was no cash spent on
depreciation). The increase in the Inventory account is not good for cash, as
shown by the negative Rs.200. Similarly, the increase in Supplies is not good for
cash and it is reported as a negative Rs.150. Combining the amounts, the net
change in cash that is explained by operating activities is a negative Rs.50.

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 The increase in long-term assets caused a cash outflow of Rs.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 Rs.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 Rs.850. This agrees with the change in the
Cash account as shown on the balance sheets from December 31, 2007 and June
30, 2008.

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 Rs.3,000. That truck
is shown on the company records at its original cost of Rs.20,000 less accumulated
depreciation of Rs.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 Rs.2,000 (Rs.20,000 - Rs.18,000).

Because the proceeds from the sale of the truck are Rs.3,000 and the book value is
Rs.2,000 the difference of Rs.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 Rs.1,500 (Rs.500 less than its Rs.2,000 book value),
the difference of Rs.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.

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

July Transactions and Financial Statements


On July 1 Azhar Shah 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 Rs.20. This means the book value of the equipment
is Rs.1,080 (the original cost of Rs.1,100 less the Rs.20 of accumulated depreciation). On
July 1 Good Deal sells the equipment for Rs.900 in cash and records a loss of Rs.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:

Good Deal Co.


Income Statement
For the Month Ended July 31, 2008

Revenues Rs. 0
Expenses
Loss on Sale of Equipment 180
Net Income Rs.(180)

Good Deal Co.


Income Statement
For the Seven Months Ended July 31, 2008

Revenues Rs.800
Expenses
Cost of Goods Sold 500
Depreciation Expense 20

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Loss on Sale of Equipment 180
Total Expense 700
Net Income Rs.100

Good Deal Co.


Balance Sheets
July 31, 2008 and June 30, 2008

Assets 7-31-08 6-30-08 Change


Cash Rs.1,750 Rs. 850 Rs. 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 Rs.2,100 Rs.2,280 Rs. (180)

Liabilities & Owner's Equity


Liabilities
Accounts Payable Rs. 0 Rs. 0 Rs. 0
Owner's Equity
Azhar Shah, Capital (excl. net inc.) 2,000 2,000 0
Azhar Shah, Curr Yr. Net Income 100 280 (180)
Total Azhar Shah, Capital 2,100 2,280 (180)
Total Liabilities & Owner's Equity Rs.2,100 Rs.2,280 Rs. (180)

Good Deal Co.


Statement of Cash Flows
For the Month Ended July 31, 2008

Operating Activities
Net Income Rs. (180)
Add back: Depreciation Expense 0
Add back: Loss on Sale of Equipment 180

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Cash Provided (Used) in Operating
0
Activities
Investing Activities
Proceeds from sale of Office Equipment 900
Financing Activities 0

Net Increase in Cash 900


Cash at the beginning of the month 850
Cash at the end of the month Rs.1,750

Let's review the cash flow statement for the month of July 2008:

 Net income for July was a net loss of Rs.180. There were no revenues, expenses,
or gains, but there was an entry of Rs.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 Rs.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
Rs.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, 2008 and December 31, 2007

Assets 7-31-08 12-31-07 Change


Cash Rs.1,750 Rs. 0 Rs.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 Rs.2,100 Rs. 0 Rs.2,100

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Liabilities & Owner's Equity
Liabilities
Accounts Payable Rs. 0 Rs. 0 Rs. 0
Owner's Equity
Azhar Shah, Capital (excl. net inc.) 2,000 0 2,000
Azhar Shah, Curr Yr. Net Income 100 0 100
Total Azhar Shah, Capital 2,100 0 2,100
Total Liabilities & Owner's Equity Rs.2,100 Rs. 0 Rs.2,100

Good Deal Co.


Statement of Cash Flows
For the Seven Months Ended July 31, 2008

Operating Activities
Net Income Rs. 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
(50)
Activities
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 the year 0
Cash at July 31, 2008 Rs.1,750

Let's review the cash flow statement for the seven months of January through July 2008:

 Net income for the seven months is Rs.100. This includes revenues, gains,
expenses, and losses.

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 Included in the net income for the seven months is Rs.20 of depreciation expense.
This expense reduced net income but did not reduce the Cash account; therefore
we add the Rs.20 depreciation expense to the net income.
 Also included in net income is the Rs.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 Rs.200 (4 calculators at a cost of Rs.50 each). Since the
company began with no inventory, this increase in the Inventory account means
that Rs.200 of cash was used to increase inventory.
 Supplies increased from none to Rs.150. The increase in the Supplies account is
assumed to have had a negative effect of Rs.150 on the Cash account.
 Combining the amounts so far, we see that the cash from operating activities is a
negative Rs.50. In other words, rather than providing cash, the operating activities
used Rs.50 of cash.
 There is cash outflow (or payment) of Rs.1,100 to purchase the office equipment
on May 31 and the Rs.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 Rs.200.
 There was an owner's investment of Rs.2,000 made on January 2.

The statement of cash flow's bottom line amount of Rs.1,750 results from combining the
amount totals of the previous three sections—operating, investing, and financing
activities. This Rs.1,750 agrees to the check figure—the difference in the Cash account
balance from the beginning of January to July 31.

Additional Information and Resources

Because the material covered here is considered an introduction to this topic, many
complexities have been omitted. You should always consult with an accounting
professional for assistance with your own specific circumstances.

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