Preparing A Cash Flow

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THE CONCEPTUAL FRAMEWORK UNDERLYING
THE PREPARATION OF THE STATEMENT OF CASH FLOW
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The objective of the statement of cash flow is to facilitate an understanding of the
financial consequences of business activities by providing detail pertaining to the sources and
uses of a companys cash. While the income statement and balance sheet are based on accrual
accounting, the statement of cash flow is intended to represent the cash-flow consequences of
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business activities. Most of the challenge in preparing, and ultimately understanding, the
statement of cash flow is due to a failure to appreciate the relation between the statement of cash
flow and other financial statements. The purpose of this note is to discuss the conceptual
framework underlying the preparation of the statement of cash flow that is based on that relation.
Overview
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The statement of cash flow contains three sections: operating, investing, and financing,
each of which present detail related to cash flow from these activities. Under U.S. GAAP
(Generally Accepted Accounting Principles), there are two acceptable methods of presentation of
the statement of cash flow: (1) the indirect method and (2) the direct method. The difference in
these two methods lies only with the presentation of the operating-activities section of the
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statement. Specifically, the direct method directly lists cash receipts and disbursements related to
operations to arrive at cash flow from operating activities (CFO); the indirect method begins with
net income taken from the income statement, which is determined by using accrual accounting,
and adjusts it for items that reflect differences in net income and actual operating cash flows.
Both methods result in identical CFO amounts.
No
A company may choose to use either the indirect or the direct method in presenting its
statement of cash flow. A company choosing to use the direct method, however, must also
provide as a supplement the same detail that would have been included using the indirect method
(i.e., the reconciliation of net income with cash flow from operations).1 In essence then, all
1
See paragraph 20 of Statement of Financial Accounting Standards No. 95. Of 600 companies surveyed by the
AICPA in 1996, only 11 used the direct method of reporting (Accounting Trends and Techniques, 1997).
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This technical note was prepared by Luann J. Lynch and Paul J. Simko, Associate Professors of Business
Administration. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling
of an administrative situation. Copyright 2006 by the University of Virginia Darden School Foundation,
Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenbusinesspublishing.com.
No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in
any form or by any meanselectronic, mechanical, photocopying, recording, or otherwisewithout the permission
of the Darden School Foundation.
This document is authorized for educator review use only by Melani Machinea, at Universidad Torcuato di Tella (UTDT) until August 2015. Copying or posting is an infringement of copyright.
Permissions@hbsp.harvard.edu or 617.783.7860
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companies must present information required by the indirect method. Therefore, the primary
focus of this note will be on the preparation of the statement of cash flow using the indirect
method.
In general, you will observe two types of adjustments that convert net income into CFO
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under the indirect method:
1. Noncash revenues and expenses included under accrual accounting in the determination
of net income (i.e., depreciation expense, amortization expense, gains or losses on
investment sales, and noncash restructuring charges).
2. Changes in operating assets and operating liabilities. With some exceptions, operating
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assets and liabilities are typically those classified as current assets and current liabilities.
Examples include, but are not limited to, accounts receivable, inventory, accounts
payable, and taxes payable. Exceptions include investments in marketable securities and
short-term debt, as those items relate to investing and financing activities, respectively.
It is worth emphasizing again that, despite the difference in format of the operating
section of the statement of cash flow, the direct and indirect methods of preparing the statement
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of cash flow both lead to the same cash flow from operating activities (CFO), cash flow from
investing activities (CFI), and cash flow from financing activities (CFF).
On the following page is a comparison of the indirect and direct methods of presenting
the statement of cash flow.
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No
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Indirect Method Direct Method
Operating Activities: Operating Activities:

Net income
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+ Depreciation [Directly lists cash receipts from
+/ Loss/gain on sales customers, cash payments to
. suppliers, etc.]
. .
+/ Decrease/increase in operating assets .
+/ Increase/decrease in operating liabilities .
. .
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_____________________________________ __________________________________
CFO (cash flow from operating activities) CFO (cash flow from operating activities)
Investing Activities: Investing Activities:

Cash in from sale of investments
Cash out from purchase of investments [Same as Indirect Method]
.
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_____________________________________ __________________________________
CFI (cash flow from investing activities) CFI (cash flow from investing activities)
Financing Activities: Financing Activities:

Cash in from stock issues
Cash in from borrowing [Same as Indirect Method]
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Cash out from retirement of debt

Cash out from stock repurchase
Dividends paid
_____________________________________ __________________________________
CFF (cash flow from financing activities) CFF (cash flow from financing activities)
Cash at end of period Cash at end of period

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less: Cash at start of period less: Cash at start of period

_____________________________________ __________________________________
Net Change in Cash = CFO + CFI + CFF Net Change in Cash = CFO + CFI + CFF
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A Conceptual Understanding
Lets focus on the preparation of the statement of cash flow using the indirect method.
Recall the following: (1) the indirect method of presentation for the statement of cash flow starts
with net income, and (2) the accrual-accounting income statement ends with net income.
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Envision an income statement sitting above the statement of cash flow, providing the net-income
value that is the necessary starting point for the statement of cash flow under the indirect method:
Revenues $ xxx
less:
COGS xxx
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Income
Statement Wage expense xxx
Depreciation expense xxx
Gain/loss on sale xxx
Etc. xxx
Operating Activities:
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Net income $ xxx
:
:
Accounts receivable xxx
:
CFO $ xxx
Statement of
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Cash Flow Investing Activities:

: xxx
CFI $ xxx
Financing Activities:
: xxx
CFF $ xxx
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Cash=CFO+CFI+CFF $ xxx
With the indirect method, the adjustments made to net income to yield CFO are simply
adjustments made for differences in the timing of accrual-accounting-based entries and actual
cash receipts or outlays, for each line item on the income statement. Take revenues, for example.
Assume ABC Company records revenues of $10,000 during the period. Further assume that
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ABC has no sales on account (i.e., all sales are cash sales). The following entry records revenue
for the period:
Cash (A) (inc) $10,000

Retained earnings (OE) (Revenues) (inc) $10,000
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From this entry, we can see that all $10,000 of the revenues represent a cash inflow during the
period (cash receipts from customers). Thus, in constructing the statement of cash flow, the
entire $10,000 in revenues should be represented as a cash inflow in the operating activities
section.
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If we are preparing a statement of cash flow using the direct method, we simply list the
$10,000 as cash receipts from customers in the operating activities section. If we are preparing a
statement of cash flow using the indirect method, the logic for reporting the $10,000 cash inflow
is as follows. Revenues increase by $10,000, and net income includes the effect of the entire
$10,000 in revenues. Since the $10,000 cash inflow from customers is captured in net income,
with which we start the statement of cash flow, we have no need to list a line item such as cash
receipts from customers, and no need to adjust net income to get to CFO.
Revenues
COGS
Wage expense yo
Depreciation expense
$ 10,000
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Gain/loss on sale
Operating activities:
Net Income $ 10,000
:
:
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Accounts Receivable xxx

:
CFO $ 10,000
Investing activities:
:
CFI $0
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Financing activities:
:
CFF $0
Cash=CFO+CFI+CFF $ 10,000
As a modification to the above scenario, assume that ABC Company records revenues of
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$10,000 during the period, 60% of which are on account. The following entry records revenues
for the period:
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Cash (A) (inc) $4,000
Accounts Receivable (A) (inc) $6,000
Retained earnings (OE) (Revenues) (inc) $10,000
Assume the companys balance sheets show that the beginning and ending balances in
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the accounts receivable account are $500 and $1,600, respectively. Given these balances, the
company must have collected $4,900 from customers on account. This is illustrated by the
following analysis of transactions affecting the accounts receivable account:
Accounts Receivable (A)

(given) beg. bal. 500
(given) credit sales 6,000 4,900 collections
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(given) end bal. 1,600
The following entry records the collections from customers on account for the period:
Cash (A) (inc) $4,900

Accounts Receivable (A) (dec) $4,900
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From the two entries above, we see that total cash receipts from customers during the
period are $8,900. Why is the $10,000 in revenue different from the $8,900 cash receipts from
customers? (1) because $6,000 of the $10,000 in revenues were not cash sales, and (2) because
the company collected $4,900 from customers that had purchased on account. Together this
difference is $1,100 ($6,000 $4,900); the increase in accounts receivable captures the different
rates at which customers buy on account and pay their bills.
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Cash receipts from customers = cash sales + collections from customers on account
= ($10,000 $6,000) + $4,900
= $4,000 + $4,900
= $8,900
It is this $8,900 cash receipts from customers that must be represented as a cash inflow in CFO.
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If we were preparing a statement of cash flow using the direct method, we would simply
list the $8,900 as cash receipts from customers in the operating activities section. Note, however,
that preparing the statement of cash flow using the indirect method is less straightforward.
Because we begin with net income, and net income includes the effect of the entire $10,000 in
revenue for the period, it must be adjusted for the increase in the balance in the accounts
receivable account during the period (i.e., $1,100).
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Revenues $ 10,000
COGS
Wage expense
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Gain/loss on sale
Net Income $ 10,000
:
:
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in accounts receivable (1,100)
:
CFO $ 8,900
:
CFI $0
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:
CFF $0
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An Illustration
Below we use six examples to illustrate the application of the conceptual framework
underlying the preparation of the statement of cash flow using the indirect method. We will start
by treating each of items 1 through 6 independently. Specifically, for any item that affects cash
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flow from operations (CFO), we will reconcile what would be reported in net income on the
income statement to what would be reported as CFO on the statement of cash flow. For any item
that affects cash flow from investing or financing, we will compute the cash amount collected or
disbursed and list it in its proper place on the statement. Once we have addressed each item
separately, we will combine all of the items into a single, aggregated, final statement of cash
flow.
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1. Revenue recognized on the income statement for the period totaled $200,000; 25% of
sales were on account. The beginning and ending accounts receivable balances found on
the balance sheets were $25,000 and $20,000, respectively.
2. Cost of goods sold for the period was $135,000. The balance in the inventory account on
the balance sheet at the beginning of the period was $40,000. Of the $145,000 total
inventory purchased during the period, $29,000 was on account. A liability was booked
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directly to accounts payable, an account that related only to inventory transactions. Its
beginning balance on the balance sheet was $5,000, and its ending balance was $14,000.
3. Wage expense for the period was $50,000. The beginning and ending balances in the
wages payable account on the balance sheets were $10,000 and $5,000, respectively.
4. Stock investments, purchased in a prior period for $2,000, were sold during the period for
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$3,000. The total beginning balance in the investment account on the balance sheet was
$20,000.
5. The company purchased equipment during the period for $5,000 cash. Including the
depreciation on this new equipment, the company recording $6,000 in depreciation
expense during the period. The company sold no equipment during the period. The
beginning and ending balances in the equipment account on the balance sheets were
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$18,000 and $17,000, respectively.

6. During the period the company issued stock for $10,000 cash, paid $3,000 in dividends,
and borrowed $2,500 for three years from the bank (on the last day of the year). The
beginning balances in the common stock account, retained earnings account, and long-
term debt account on the balance sheet were $50,000, $100,000, and $0, respectively.
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1. Revenue recognized on the income statement for the period totaled $200,000; 25% of sales
were on account. The beginning and ending accounts receivable balances found on the
balance sheets were $25,000 and $20,000, respectively.
Of $200,000 in sales for the period, $150,000 were cash sales. Also, from an analysis of
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transactions affecting the A/R account, we see that the company collected $55,000 from
customers on account:
Accounts Receivable (A)

beg. bal. 25,000
credit sales 50,000 55,000 collections
end bal. 20,000
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[Change in accounts receivable = of 5,000]
Thus, total cash receipts from customers during the period are $205,000:
Cash receipts from customers = cash sales + collections from customers on account
= 150,000 + 55,000
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= 205,000
Why is the $200,000 in revenue different from the $205,000 in cash receipts from customers?
(1) because $50,000 of the $200,000 in revenues were not cash sales, and (2) because the
company collected $55,000 from customers that had purchased on account. Together this
difference is $5,000; the decrease in A/R captures the different rates at which customers buy
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on account and pay their bills.
This $205,000 cash receipts from customers must be represented as a cash inflow in CFO.
The statement of cash flow begins with net income, in this case $200,000 in revenues.
Therefore, the $5,000 decrease in A/R that occurred during the period must be added to net
income to determine CFO, resulting in $205,000 in cash receipts from customers during the
period being included in CFO.
No
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Translated to SCF format:
Revenues $ 200,000
COGS
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Wage expense
Gain/loss on sale
Net Income $ 200,000

:
:
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in accounts receivable 5,000
:
CFO $ 205,000
Investing
:
CFI $0
Financing
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:
CFF $0
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2. Cost of goods sold for the period was $135,000. The balance in the inventory account on the
balance sheet at the beginning of the period was $40,000. Of the $145,000 total inventory
purchased during the period, $29,000 was on account. A liability was booked directly to
accounts payable, an account that related only to inventory transactions. Its beginning
balance on the balance sheet was $5,000, and its ending balance was $14,000.
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Of the $145,000 in inventory purchases for the period, $116,000 were paid in cash. In
addition, from the following analyses of transactions affecting the inventory and accounts
payable accounts, we can see that the company made payments of $20,000 to suppliers on
account:
Inventory (A)
beg. bal. 40,000
purchases 145,000 135,000 cost of goods sold (COGS)
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end bal. 50,000
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Accounts Payable (L)
5,000 beg. bal.
payments 20,000 29,000 credit purchases
14,000 end bal.
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[Change in inventory = of 10,000]
[Change in accounts payable = of 9,000]
Thus, total cash payments to suppliers during the period are $136,000:
Cash paid for inventory = cash purchases + payments to suppliers on account

= ($145,000 $29,000) + $20,000
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= $136,000
Why is the $135,000 in cost of goods sold (COGS) different from the $136,000 in cash
payments to suppliers? (1) because $10,000 of the purchases remained in inventory at the end
of the period and didnt affect COGS, (2) because $29,000 of the $145,000 in purchases were
not cash purchases, (3) because the company paid some suppliers on account, in the amount
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of $20,000. Together this difference is $1,000.
It is this $136,000 cash payment to suppliers that must be represented as a cash outflow in
CFO. The statement of cash flow begins with net income, which was reduced during the
period by $135,000 due to COGS. To determine CFO, we must adjust net income for the
increase in inventory of $10,000 and the increase in accounts payable of $9,000. Notice that
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these two adjustments have opposite impacts on CFO. These adjustments to net income result
in $136,000 in cash payments to suppliers during the period being included in CFO.
No
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Revenues
COGS (135,000)
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Wage expense
Gain/loss on sale
Net Income $ (135,000)

:
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:
in inventory (10,000)
in accounts payable 9,000
:
CFO $ (136,000)
Investing
:
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CFI $0
Financing
:
CFF $0
Cash=CFO+CFI+CFF $ (136,000)
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3. Wage expense for the period was $50,000. The beginning and ending balances in the wages
payable account on the balance sheets were $10,000 and $5,000, respectively.
From the following analysis of transactions affecting the wages payable account, we see that
although $50,000 of wage expense was incurred during the period, the company paid
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employees $55,000 in cash payments:
Wages Payable (L)

10,000 Beg. bal.
wage payments 55,000 50,000 wage expense
5,000 End bal.
[Change in wages payable = of 5,000]

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Why is the $50,000 in wage expense different from the $55,000 in cash payments to
employees? Because $5,000 of the $55,000 in payments to employees was for work
performed (and expensed) in the prior period.
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It is the $55,000 cash payments to employees that must be represented as a cash outflow in
CFO. The statement of cash flow begins with net income, which was reduced by $50,000 for
current period wage expense. In determining CFO, net income must be adjusted for the
decrease in wages payable of $5,000. This adjustment results in $55,000 in cash payments to
employees during the period being included in CFO.
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Revenues
COGS
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Wage expense (50,000)
Gain/loss on sale

:
:
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in wages payable (5,000)
:
CFO $ (55,000)
Investing
:
CFI $0
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Financing
:
CFF $0
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4. Stock investments, purchased in a prior period for $2,000, were sold during the period for
$3,000. The total beginning balance in the investment account on the balance sheet was
$20,000.
Because we are dealing with investments the company has made in the common stock of
other businesses, any related transactions should be classified as investing activities. It is the
$3,000 cash proceeds from the sale of investments that should be represented as a cash
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inflow in CFI. However, because the statement of cash flow begins with net income, which
included the $1,000 gain on the investment sale, we must remove that gain from the CFO
section to avoid double counting the $1,000 on the statement of cash flow.
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Revenues
COGS
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Wage expense
Gain/loss on sale 1,000
Net Income $ 1,000

:
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:
gain on sale (1,000)
:
CFO $0
Investing
:
Sale of investment 3,000
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:
CFI $ 3,000
Financing
:
CFF $0
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5. The company purchased equipment during the period for $5,000 cash. Including the
depreciation on this new equipment, the company recording $6,000 in depreciation expense
during the period. The company sold no equipment during the period. The beginning and
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ending balances in the equipment account on the balance sheets were $18,000 and $17,000,
respectively.
Because we are dealing with investments the company has made in property, plant, and
equipment, any related transactions should be classified as investing activities. It is the
$5,000 cash payment for equipment that should be represented as a cash outflow in CFI.
However, the statement of cash flow begins with net income, which includes $6,000 of
depreciation expense. Because this expense was a noncash expense, it must be added back to
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convert the accrual accounting based net income to a cash flow amount to be included in
CFO.
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Revenues
COGS
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Wage expense
Depreciation expense (6,000)
Gain/loss on sale
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:
:
+ depreciation expense 6,000
:
CFO $0
Investing
:
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Purchase of equipment (5,000)
:
CFI $ (5,000)
Financing
:
CFF $0
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6. During the period the company issued stock for $10,000 cash, paid $3,000 in dividends, and
borrowed $2,500 for three years from the bank (on the last day of the year). The beginning
balances in the common stock account, retained earnings account, and long-term debt
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account on the balance sheet were $50,000, $100,000, and $0, respectively.
Because the issuance of additional capital stock, the payment of dividends, and the long-term
borrowing from the bank are all financing transactions, they should be presented in the
statement of cash flow as financing activities.
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Revenues
COGS
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Wage expense
Gain/loss on sale
Net Income $0
:
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:
:
CFO $0
Investing
:
CFI $0
Financing
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:
Issue of stock 10,000
New borrowings 2,500
Dividends paid (3,000)
:
CFF $ 9,500
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Items 1 through 6 Combined

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Thus far, we have treated items 1 through 6 independently. Now, lets treat them
comprehensively. All financial statements are just composites of many individual events, and the
statement of cash flow is no exception.
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We can aggregate all six of these items into one statement of cash flow presented using the
Indirect Method, as follows:
Indirect Method: Transaction

Number
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Revenues 200,000 #1
COGS (135,000) #2
Wage expense (50,000) #3

Depreciation expense (6,000) #5
Gain/loss on sale 1,000 #4
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Net Income 10,000
+ depreciation 6,000 #5
gain on sale (1,000) #4
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in accounts receivable 5,000 #1
in inventory (10,000) #2
in accounts payable 9,000 #2
in wages payable (5,000) #3
CFO $ 14,000
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Sale of investment 3,000 #4

Purchase of equipment (5,000) #5
CFI $ (2,000)
No
:
Issue of stock 10,000 #6
New borrowings 2,500 #6
Dividends paid (3,000) #6
:
CFF $ 9,500
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Note that the analogous presentation under the direct method must yield the same cash flow from
operating, investing, and financing subtotals, but the reconciliation of net income to cash from
operations is not necessary. The direct method of presentation would be as follows:
Direct method: Transaction
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Number
Cash receipts from customers 205,000 #1

Cash payments to suppliers (136,000) #2
Cash payments to employees (55,000) #3
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CFO $ 14,000
Sale of investment 3,000 #4

Purchase of equipment (5,000) #5
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CFI $ (2,000)
:
Issue of stock 10,000 #6
New borrowings 2,500 #6
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Dividends paid (3,000) #6

:
CFF $ 9,500
No
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The information contained in items 1 through 6 can be represented in the following comparative
balance sheet:
Balance Sheet
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Beginning of period End of period
Assets:
Cash $ 62,000 $ 83,500
Accounts receivable 25,000 20,000
Inventory 40,000 50,000
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Investments 20,000 18,000
Equipment 18,000 17,000
Total assets 165,000 188,500
Liabilities:
Accounts payable 5,000 14,000
Wages payable 10,000 5,000
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Long-term debt 0 2,500
Total liabilities: 15,000 21,500
Owners equity:
Common stock 50,000 60,000
Retained earnings 100,000 107,000
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Total owners equity $150,000 $167,000

No
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Operating Activities: Operating Activities:

Investing Activities: Investing Activities:

Financing Activities: Financing Activities:

Cash out from retirement of debt

Cash at end of period Cash at end of period

less: Cash at start of period less: Cash at start of period

Cash Flow Investing Activities:

Cash (A) (inc) $10,000

Accounts Receivable xxx

Accounts Receivable (A)

Cash (A) (inc) $4,900

$18,000 and $17,000, respectively.

Accounts Receivable (A)

on account and pay their bills.

Net Income $ 200,000

end bal. 50,000

Cash paid for inventory = cash purchases + payments to suppliers on account

Net Income $ (135,000)

employees $55,000 in cash payments:

Wages Payable (L)

[Change in wages payable = of 5,000]

Net Income $ (50,000)

Net Income $ 1,000

Net Income $ (6,000)

Items 1 through 6 Combined

Indirect Method: Transaction

Wage expense (50,000) #3

Net Income 10,000

Sale of investment 3,000 #4

Direct method: Transaction

Cash receipts from customers 205,000 #1

Sale of investment 3,000 #4

Dividends paid (3,000) #6

Total assets 165,000 188,500

Total liabilities: 15,000 21,500

Total owners equity $150,000 $167,000

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