4.3.1: Preparing a Statement of Cash Flows

Presented below is the SFP/BS and income statement for Watson Ltd.

Watson Ltd.
Balance Sheet
As of 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.

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 transactions 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 statement headings.
2. Record the net income/loss in 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 for each 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 identified 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. Subtotal the three sections and record as the net change in cash. Record the opening 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 any required disclosures.

To summarize the steps above into a few key words and phrases to remember:

Headings

Record net income/(loss)

Adjust out non-cash income statement items

Current assets and current liabilities changes

Non-current asset accounts changes

Non-current (long-term) liabilities and equity accounts changes

Subtotal and reconcile

Disclosures

 Applying the Steps:

1. Headings:

    Watson Ltd.
   Income Statement
   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)
3. Adjustments:

   
   
   
   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:

   

   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 the accounting 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 receivable increases, its effect on the cash account must be a corresponding decrease to keep the equation balanced:

                              
Cash + accounts receivable + all other assets = Liabilities + Equity

If cash decreases, 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 cash increases, 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.

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:

\[
\begin{array}{l}
\text { Long-term investment }\\
\begin{array}{r|l}
\hline- & \\
? ? & \\
\hline & \\30,750 &
\end{array} \text { purchase of investment }
\end{array} \notag
\] 

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). . . . Cash . . . . . . . . . . . . . . . . . . . . .		30,750	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.

1. Non-current liabilities and equity changes:

   

   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 . . . . . . . . . . . . . . . . . .  Cash . . . . . . . . . . . . . . . . . . . . . . . . . .		19,000	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 regarding the principal amount owing one year after the reporting 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 analysis 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 . . . . . . . . . . . . . . . . . . . . . . . . . .  Common shares . . . . . . . . . . . . . . . . . .		182,200	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. . . . . . . . . . . . . . . . .  Cash . . . . . . . . . . . . . . . . . . . . . . . . . .		42,590	42,590

   Cash paid was therefore $42,590.

    

2. Subtotal and reconcile:

Problem data file to accompany the video

 

Problem data file to accompany the video