Financial Reports – Statement of Financial Posi- Posi-tion and Statement of Cash Flows
Chapter 4 Learning Objectives
4.3 Statement of Cash Flows (SCF)
4.3.1 Preparing a Statement of Cash Flows
Presented below is the SFP/BS and income statement for Watson Ltd.
4.3. Statement of Cash Flows (SCF) 99
Watson Ltd.
Balance Sheet As at December 31, 2020
2020 2019
Assets
Current assets
Cash $ 307,500 $ 250,000
Investments (trading, at fair value through net income) 12,000 10,000
Accounts receivable (net) 249,510 165,000
Notes receivable 18,450 22,000
Inventory (at lower of FIFO cost and NRV) 708,970 650,000
Prepaid insurance expenses 18,450 15,000
Total current assets 1,314,880 1,112,000
Long term investments (at amortized cost) 30,750 0
Property, plant, and equipment
Land 92,250 92,250
Building (net) 232,000 325,000
324,250 417,250
Intangible assets (net) 110,700 125,000
Total assets $1,780,580 $1,654,250
Liabilities and Shareholders’ Equity Current liabilities
Accounts payable $ 221,000 $ 78,000
Accrued interest payable 24,600 33,000
Income taxes payable 54,120 60,000
Unearned revenue 25,000 225,000
Current portion of long-term notes payable 60,000 45,000
Total current liabilities 384,720 441,000
Long-term notes payable (due June 30, 2025) 246,000 280,000
Total liabilities 630,720 721,000
Shareholders’ equity Paid in capital
Preferred, ($2, cumulative, participating – authorized
issued and outstanding, 15,000 shares) 184,500 184,500 Common (authorized, 400,000 shares; issued and
outstanding (2020: 250,000 shares);
(2019: 200,000 shares) 862,500 680,300
Contributed surplus 18,450 18,450
1,065,450 883,250
Retained earnings 84,410 50,000
1,149,860 933,250 Total liabilities and shareholders’ equity $1,780,580 $1,654,250
Watson Ltd.
Income Statement
For the Year Ended December 31, 2020
Sales $3,500,000
Cost of goods sold 2,100,000
Gross profit 1,400,000
Operating expenses
Salaries and benefits expense 800,000
Depreciation expense 43,000
Travel and entertainment expense 134,000
Advertising expense 35,000
Freight-out expenses 50,000
Supplies and postage expense 12,000
Telephone and internet expense 125,000
Legal and professional expenses 48,000
Insurance expense 50,000
1,297,000
Income from operations 103,000
Other revenue and expenses
Dividend income 3,000
Interest income from investments 2,000
Gain from sale of building 5,000
Interest expense (3,000)
7,000 Income from continuing operations before income tax 110,000
Income tax expense 33,000
Net income $ 77,000
Additional information:
1. The trading investment does not meet the criteria to be classified as a cash equivalent and no purchases or sales took place in the current year.
2. An examination of the intangible assets sub-ledger revealed that a patent had been sold in the current year. The intangible assets have an indefinite life.
3. No long-term investments were sold during the year.
4. No buildings or patents were purchased during the year.
5. Most of the unearned revenues occurred on December 31, 2019.
6. There were no other additions to the long-term note payable during the year.
7. Common shares were sold for cash. No other transactions occurred during the year.
8. Cash dividends were declared and paid.
4.3. Statement of Cash Flows (SCF) 101
The statement of cash flows can be challenging to prepare. This is because preparing the entries requires analyses of the accounts as well as an understanding of the types of trans-actions that affect each account. Preparing a statement of cash flows is made much easier if specific steps in a sequence are followed. Below is a summary of those steps.
1. Complete the statementheadings.
2. Record thenet income/lossin the operating activities section.
3. Adjust for any non-cash line items reported in the income statement to restate net income/loss from an accrual to a cash basis (i.e., depreciation expense, amortization expense and any non-cash gains or losses).
4. Record the description and change amount as cash inflows or outflows foreach current asset and current liability (working capital accounts) except for the “current portion of long-term debt” line item, since it is not a working capital account. Subtotal the operating activities section.
5. In the investment activities section, using T-accounts or other techniques, determine the change for each non-current (long-term) asset account. Analyze and determine the reasons for the change. Record a description and the change amount(s) as cash inflows or outflows.
6. In the financing activities section, add back to long-term debt any current portion identi-fied in the SFP/BS for both years, if any. Using T-accounts or other techniques, determine the change for each non-current liability and equity account. Analyze and determine the reason for the change(s). Record a description and the change amount(s) as cash inflows or outflows.
7. Subtotalthe three sections and record as the net change in cash. Record theopening and closing cash and cash equivalents balances. Sum the opening balance, the new change in cash subtotal, and the closing balance. This should to reconcile with the ending cash and cash equivalent balances from the SFP/BS.
8. Complete anyrequired disclosures.
To summarize the steps above into a few key words and phrases to remember:
Headings
Record net income/(loss)
Adjustout non-cash income statement items Currentassets and current liabilities changes Non-current asset accountschanges
Non-current (long-term) liabilities and equityaccounts changes Subtotal and reconcile
Disclosures
Applying the Steps:
1. Headings:
Watson Ltd.
Statement of Cash Flows For the Year Ended December 31, 2020 Cash flows from operating activities
Net income (loss)
Non-cash items (adjusted from net income):
Net cash from operating activities Cash flows from investing activities
Net cash from investing activities Cash flows from financing activities
Net cash from financing activities Net increase (decrease) in cash Cash, January 1
Cash, December 31
2. Record net income/(loss) As illustrated in step 3 below.
3. Adjustments:
4.3. Statement of Cash Flows (SCF) 103
Watson Ltd.
Income Statement
For the Year Ended December 31, 2020
Sales $3,500,000
Cost of goods sold 2,100,000
Gross profit 1,400,000
Operating expenses
Salaries and benefits expense 800,000
Depreciation expense 43,000
Travel and entertainment expense 134,000
Advertising expense 35,000
Freight-out expenses 50,000
Supplies and postage expense 12,000
Telephone and internet expense 125,000
Legal and professional expenses 48,000
Insurance expense 50,000
1,297,000
Income from operations 103,000
Other revenue and expenses
Dividend income 3,000
Interest income from investments 2,000
Gain from sale of building 5,000
Interest expense (3,000)
7,000 Income from continuing operations before income tax 110,000
Income tax expense 33,000
Net income $ 77,000
Watson Ltd.
Statement of Cash Flows For the Year Ended December 31, 2020 Cash flows from operating activities
Net income (loss) $ 77,000
Non-cash items (adjusted from net income):
Depreciation expense 43,000
Gain from sale of equipment (5,000)
Enter the amount of the net income/(loss) as the first amount in the operating activities section. Next, review the income statement and select the non-cash items. Look for items such as depreciation, depletion, amortization, and gain/loss on sale/disposal of assets. In this case, there are two non-cash items to adjust. Record them as adjustments to net income in the statement of cash flows.
4. Current assets and liabilities:
Calculate and record the change for each current asset and current liability (except the current portion of long-term notes payable, which is to be included with its corresponding long-term notes payable account) as shown in the financing activities section below:
Watson Ltd.
Statement of Cash Flows for the year ended December 31, 2020 Cash flows from operating activities
Net income (loss) $ 77,000
Non-cash items (adjusted from net income):
Depreciation expense 43,000
Gain from sale of building (5,000)
Cash in (out) from operating working capital:
Increase in trading investments (2,000) Increase in accounts receivable (84,510)
Decrease in notes receivable 3,550
Increase in inventory (58,970)
Increase in prepaid expenses (3,450)
Increase in accounts payable 143,000
Decrease in interest payable (8,400)
Decrease in income taxes payable (5,880) Decrease in unearned revenue (200,000) Net cash from operating activities (101,660) Cash flows from investing activities
Accounting Equation:
A = L + E MUST ALWAYS BALANCE!
Assets = Liabilities + Equity
Cash + (all other) Assets = Liabilities + Equity
Cash + Assets = Liabilities + Equity
Cash + Assets = Liabilities + Equity
Cash + Assets = Liabilities + Equity
Cash inflows are reported as positive numbers, while cash outflows are reported as negative numbers. To determine if the amount is a positive or negative number, a simple method is to use the accounting equation to determine whether cash is increasing as a positive number or decreasing as a negative number.
Recall that theaccounting equation, Assets = Liabilities + Equity, must always remain in balance. This concept can be applied when analyzing the various accounts and recording the changes. For example, accounts receivable has increased from $165,000 to $249,510 for a total change of $84,510. Using the accounting equation, this can be expressed as:
Expanding the A= L + E equation a bit:
Cash + accounts receivable + all other assets = Liabilities + Equity
If accounts receivable increases by $84,510, this can be expressed as a black up-arrow above the account in the equation:
Cash + accounts receivable + all other assets = Liabilities + Equity
If accounts receivableincreases, its effect on the cash account must be a corresponding decreaseto keep the equation balanced:
4.3. Statement of Cash Flows (SCF) 105
Cash + accounts receivable + all other assets = Liabilities + Equity
If cashdecreases, it is a cash outflow, and the number must be negative (bracketed) as shown in the statement above.
The same technique can be used when analyzing liability or equity accounts. For example, an increase in account payable (liability) of $143,000 will affect the equation as follows:
Cash + all other assets = Liabilities + Equity
If accounts payable increases, cash must also increase by a corresponding amount in order to keep the equation in balance.
Cash + all other assets = Liabilities + Equity
If cashincreases, it is a cash inflow and the number must be positive (no brackets) as shown in the statement above.
5. Non-current asset changes:
The next section is the investing activities section. The analysis of all the non-current asset accounts must also take into account whether there have been any current year purchases or disposals/sales (or both) as part of the analysis. The use of T-accounts for this type of analysis provides a useful visual tool to help understand the changes that occurred in the account.
Cash flows from investing activities
Investments (trading, FVNI) (30,750) Sales proceeds from sale of building 55,000 Sales proceeds from sale of patent 14,300 Net cash from investing activities 38,550 Cash flows from financing activities
Cash + Assets = Liabilities + Equity
Cash + Assets = Liabilities + Equity
There are four non-current asset accounts: long-term investments, land, buildings, and intangible assets. The land account had no change so there were no purchases or sales of land. Analyzing the investment account results in the following cash flows:
Long-term investment –
?? = purchase of investment
30,750
Since the additional information presented above stated that there were no sales of long-term investments during the year, the entry would have been for a purchase:
General Journal
Date Account/Explanation PR Debit Credit
Long term investments (at amortized cost) . . . . . 30,750
Cash . . . . 30,750
Cash paid for the investment was therefore $30,750.
Analysis of the buildings account is a bit more complex because of the effects of the contra account for accumulated depreciation. In this case, the building account and its contra account must be merged since the SFP/BS reports only the net carrying amount.
Analyzing the buildings account results in the following cash flows:
Building (net of accum. depr.) 325,000
43,000 current year accum. depr.
?? = sale of building 232,000
Building (net of accum. depr.) 325,000
43,000
50,000 = X
232,000
Since there was a gain from the sale of buildings, the entry would have been:
General Journal
Date Account/Explanation PR Debit Credit
Cash . . . . 55,000
Gain on sale of building . . . . 5,000 Buildings (net) . . . . 50,000
Cash proceeds were therefore $55,000.
The sale of the patent is straightforward since there were no other sales or purchases in the current year.
4.3. Statement of Cash Flows (SCF) 107
6. Non-current liabilities and equity changes:
Net cash from investing activities 38,550 Cash flows from financing activities
Repayment of long-term note (19,000) Proceeds from shares issuance 182,200
Dividends paid (42,590)
Net cash from financing activities 120,610
Cash + Assets = Liabilities + Equity
Cash + Assets = Liabilities + Equity
There are five long-term liability and equity accounts: long-term notes payable, preferred shares, common shares, contributed surplus, and retained earnings. The preferred shares and contributed surplus accounts had no changes to report. Analyzing the long-term note payable account results in the following cash flows:
Long-term note payable 280,000
45,000
?? = repayment
246,000 60,000
Since there were no other transactions stated in the additional information above, the entry would have been:
General Journal
Date Account/Explanation PR Debit Credit
LT note payable . . . . 19,000
Cash . . . . 19,000
Cash paid was therefore $19,000.
Note how the current portion of long-term debt has been included in the analysis of the long-term note payable. The current portion line item is a reporting requirement regard-ing the principal amount owregard-ing one year after the reportregard-ing date, but it is not actually a working capital account, so it is omitted from the operating section and included with its corresponding long-term liability account in the financing activities section as shown above.
The common shares and retained earnings accounts are straightforward and the analy-sis of each are shown below.
Common shares 680,300
?? = share issuance
862,500
Since there were no other transactions stated in the additional information above, the entry would have been:
General Journal
Date Account/Explanation PR Debit Credit
Cash . . . . 182,200
Common shares . . . . 182,200
Cash received was therefore $182,200.
Retained earnings 50,000
77,000 net income
?? = dividends paid
84,410
The additional information stated that cash dividends were declared and paid, so the entry would have been:
General Journal
Date Account/Explanation PR Debit Credit
Retained earnings . . . . 42,590
Cash . . . . 42,590
Cash paid was therefore $42,590.
7. Subtotal and reconcile:
The three activities total a net increase in cash of $57,500. When added to the opening cash balance of $250,000, the resulting total of $307,500 is equal to the ending cash bal-ance, December 31, 2020 in the SFP/BS. This can be seen in the completed statement below.
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4.3. Statement of Cash Flows (SCF) 109