4405 Principles of Accounting
4405 Principles of Accounting
4405 Principles of Accounting
Principles of accounting
Lecture 4a
Fulbright Economics Teaching Program Ho Chi Minh City, Vietnam Academic Year: 2005-2006
Principles of Accounting
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Lecture Notes 4a
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Principles of accounting
Lecture 4a
The statement of cash flows concerns with the net cash flow generated from business activities
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Notes: During 2004, the firm liquidated some fixed assets for book values and received 10 in cash; it also paid dividends of 19
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Principles of accounting
Lecture 4a
Direct Method
Bo Ho Company Income Statement ($1000) December 31, 2004 Revenue Expenses: Cost of Goods Sold Salaries Expense Depreciation Expense Interest Expense Total Expenses Earnings Before Tax Corporate Income Tax Net Income
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Direct Method
Bo Ho Company Statement of Cash Flows ($1000) December 31, 2004 CASH FLOW FROM OPERATING: Receipts from Customers Payments Suppliers Salaries Interest Taxes Total Payments Net Cash Flow from Operating (I)
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$ 180 $ 72 15 4 20 (111) $ 69
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Principles of accounting
Lecture 4a
Direct Method
Bo Ho Company Statement of Cash Flows ($1000) December 31, 2004 (cont.) CASH FLOW FROM INVESTING: Payments for Purchases of Fixed Assets Collections from Liquidation of Fixed Assets Net Cash Flow from Investing (II) $(287) 10 (277)
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Direct Method
Bo Ho Company Statement of Cash Flows ($1000) December 31, 2004 (cont.) CASH FLOW FROM FINANCING: Long term Borrowing Stock Issue Dividends Paid Net Cash Flow from Financing (III) TOTAL NET CASH FLOW = I+II+III (decrease) Cash Balance, December 31, 2003 Cash Balance, December 31, 2004
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Principles of accounting
Lecture 4a
Direct Method
Step 1: Look at the change in the balance from the beginning to the end of period
These numbers are often shown at the end of the cash flow statement
Total net cash flow + the beginning cash balance = the ending cash balance Or, the ending cash balance the beginning cash balance = total net cash flow
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Direct Method
In our example, cash balance reduces by $9,000
Operating activity during period provides $69,000 Investing activity uses $277,000 Financing activity generates $199,000
($69,000 + 199,000 277,000 = - $9,000)
It tells us, the firm shows a profit but its cash is decreasing
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Principles of accounting
Lecture 4a
or
Cash = Liabilities + OE Non-cash Assets
Any change () in non-cash items (liabilities, owners equity, or assets) must be accompanied by a change in cash to keep the equation balance
If a non-cash asset changes, how will it affect cash?
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Principles of accounting
Lecture 4a
Cash Equation
Assets = Liabilities + Owners Equity Current Assets + Fixed Assets = Liabilities + Owners Equity Cash + Receivables + Inventory = Liabilities + Owners Equity Fixed Assets Cash = Liabilities + OE FA Receivables Inventory
A change in Liabilities or Owners Equity leads to a positive change in Cash A change in Assets leads to a negative change in Cash
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Principles of accounting
Lecture 4a
From Amounts on the Income Statement to Items on the Statement of Cash Flows Accountants often calculate cash flows from income statement items
Some accountants use the balance sheet with their experiences and additional information to determine changes in the balance sheet and calculate cash flow items However, most of corporate accounting systems cannot provide detailed information to follow this way
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From Amounts on the Income Statement to Items on the Statement of Cash Flows (cont.)
In our example, $180,000 is collected from customers. This amount is determined as follows:
(+) (=) (-) (=)
Or
Revenue Beginning Receivables Total Receivables Ending Receivables Collections during Period
$200,000 25,000 $225,000 45,000 $180,000 ======= $200,000 (20,000) $180,000 =======
Principles of accounting
Lecture 4a
From Amounts on the Income Statement to Items on the Statement of Cash Flows (cont.)
The difference between the cost of goods sold and the amount paid to suppliers can be determined by looking at inventory and payables
(+) (=) (-) (=) Ending Inventory Cost of Goods Sold Merchandise during Period Beginning Inventory Merchandise Purchased during Period $100,000 100,000 $200,000 (60,000) $140,000 ======= 6,000 140,000 $146,000 (74,000) $ 72,000 ======= $
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From Amounts on the Income Statement to Items on the Statement of Cash Flows (cont.)
Calculations on the previous slide for the amount paid to suppliers can be summarized as follows: Cost of Goods Sold Increase (Decrease) in Inventory Decrease (Increase) in Payables Amount Paid to Suppliers $100,000 40,000 (68,000) $72,000
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From Amounts on the Income Statement to Items on the Statement of Cash Flows (cont.)
The salaries paid can be determined by salaries expense and salaries payable Beginning Salaries Payable (+) Salaries Expense during Period (=) Total Salaries Payable (-) Ending Salaries Payable (=) Salaries Paid Or, Salaries Expense during Period Decrease (Increase) in Salaries Payable Salaries Paid
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From Amounts on the Income Statement to Items on the Statement of Cash Flows (cont.)
Note that in our example, both interest payable and corporate tax payable have a zero balance at the beginning and the ending of period
It means the total interest expense and tax have been accrued and paid off, so the cash flow equals the expenses, namely, $4,000 interest paid, and $20,000 tax paid
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Principles of accounting
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The balance sheet approach is based on the net income, then adjusted for changes in the balance sheet accounts
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Comparing the Income Statement and the Statement of Cash Flows (cont.)
Summary of the balance sheet approach:
Changes in Non-cash Assets Less Increase or Plus Decrease Negative Impact Changes in Liabilities & Owners Equity
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Principles of accounting
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Comparing the Income Statement and the Statement of Cash Flows (cont.)
Remember, regardless plus or minus an increase or a decrease, any change in non-cash assets, liabilities, or owners equity is always accompanied by a change in cash to keep the accounting equation balance Cash = Liabilities + Owners Equity Non-cash Assets
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Comparing the Income Statement and the Statement of Cash Flows (cont.)
The common adjustments to transfer the amounts on the income statement into cash flow items:
Income Statement Revenue Cost of Goods Sold Salaries Expense Rental Expense Insurance Expense Depreciation Expense Amortization Expense Non-cash Assets Receivables Purchases during Period Prepaid Salaries Prepaid Rental Prepaid Insurance Fixed Assets Intangible Assets Liabilities Deferred Revenue Payables Salaries Payable Rental Payable Insurance Payable
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The main idea of investing and financing activities is the position of investments in fixed assets, and the position of fund mobilization and repayment
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Calculating Cash Flows from Investing and Financing Activities (cont.) Analyze items on balance sheet for investing and financing activities:
An increase in cash (an inflow) from:
An increase in liabilities or owners equity A decrease in non-cash assets
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Adjusting Net Income to Account the Net Cash Flow from Operating The indirect method starts with net income
Plus and minus changes in current assets and current debt (which make net income and net cash flow different)
If a firm uses the direct method, the national accounting standard commission often asks for an additional use of indirect method
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Adjusting Net Income to Account the Net Cash Flow from Operating (cont.)
Adjustments include
Depreciation is added back to net income because it reduces income on the income statement, but cash is not actually disbursed An increase in current (non-cash) assets leads to a decrease in cash from operating, so it is adjusted by subtracting from net income A decrease in current (non-cash) assets leads to an increase in cash from operating, so it is adjusted by adding to net income
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Adjusting Net Income to Account the Net Cash Flow from Operating (cont.)
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Lecture 4a
Adjusting Net Income to Account the Net Cash Flow from Operating (cont.)
The general principle of addition and subtraction to adjust net income in the indirect method is as same as in the direct method, namely, to adjust line by line on the income statement Remember the cash equation Cash = Liabilities + Owners Equity Non-cash Assets
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Adjusting Net Income to Account the Net Cash Flow from Operating (cont.)
Calculating cash flow from operating for Bo Ho Company Net Income $23 Adjustments for net income to calculate cash flow from operating Depreciation Increase in Accounts Receivable Increase in Inventory Increase in Accounts Payable Increase in Salaries Payable Net Impact (increase and decrease) Net Cash Flow from Operating
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$ 17 (20) (40) 68 21 46 $ 69
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Principles of accounting
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Adjusting Net Income to Account the Net Cash Flow from Operating (cont.)
As discussed, depreciation is the allocation of the historical cost over the future accounting periods Depreciation is not a disbursement flow; it is a noncash expense Depreciation is added back to net income to account the net cash flow from operating, simply because it has been subtracted when we calculating net income on the income statement. Deprecation is also not a cash receipt flow
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Adjustments
Addition of non-cash losses (or expenses)
Depreciation (for fixed assets), amortization (for intangible assets), depletion (for natural resources) Losses from non-operating activity
Adjustments for changes in current assets and current debt (generally called working capital) related to operating
Changes in current assets # Less Increase # Plus Decrease Changes in current debt @ Plus Increase @ Less Decrease
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Adjustments (cont.)
Profits (losses) from non-cash operating do not belong to the firms main operating activity, but are shown on the income statement, and hence, affect the net income These profits (losses) should be subtracted from (added to) net income, because they have been recorded in the other activity (investing and financing)
These profits (losses) are reflected in the other activities (investing or financing), so they should be adjusted to avoid from being double recorded on the same statement of cash flows
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Adjustments (cont.)
Ben Thanh Company sells a piece of land for 50 million in cash; its acquisition cost is 75 million; the firm has a loss of 25 million How does this loss affect the cash flow from operating on the statement of cash flow?
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Adjustments (cont.)
The firms net income has included the 25 million loss, but this is not an operating activity The cash flow of 50 million (with the loss imbedded) is shown in the category of cash flow from investing The 25 million loss should be added back to net income as an adjustment, to avoid double recording on the statement of cash flow
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Profits or losses from sales of fixed assets (investing) Profits or losses from debt payment before due (financing)
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A change in liabilities and owners equity, or a decrease in assets generates cash A decrease in liabilities and owners equity, or an increase in assets uses cash
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Transactions are recorded on the basis of double-entry accounting, hence, the cash sources and uses always equal
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Nothing to worry about the cash flow statement. It is only the matter of the two operations
Subtraction! Addition!!
Addition! Subtraction!!
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References
Horngren Sundem Elliott
Introduction to Financial Accounting, 8th Edition, Prentice Hall, 2002.
Stickney Weil
Financial Accounting, 8th Edition, The Dryden Press, 1997.
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