MODULE 4

STATEMENT OF CASH FLOWS

Intended Learning Outcomes

After the end of this module, you should be able to:

1. state the significance of the information presented in statement of cash flows;
2. classify cash flow activities under operating, investing and financing
activities;
3. prepare a statement of cash flows using the direct method;
4. prepare a statement of cash flows using the indirect method.

CASH VERSUS ACCRUAL BASIS OF ACCOUNTING

The cash basis of accounting recognizes revenue when cash is received; and recognizes
expenses when cash is paid. For example, under the cash basis, services rendered in 2017 for which
cash is collected in 2018 would be treated as 2018 revenues. Similarly, under the cash basis,
expenses incurred in 2017 for which cash for which cash is disbursed in 2018 are a 2018 expense.
Because of these improper assignments of revenues and expenses, the cash basis of accounting is
generally considered unacceptable. There is no need for adjusting entries under the cash basis of
accounting.

The accrual basis of accounting recognizes revenues when sales are made or services are
performed, regardless of when cash is received. It also recognizes expenses as incurred, whether
or not cash is paid out. For instance, when services are performed for a customer on account, the
revenue is recorded at that time even though cash has not been received. Later, when they receive
cash no revenue is recorded because it has already been recorded. Under the accrual basis,
adjusting entries are used to bring the accounts up-to-date for economic activity that has taken
place but has not yet been recorded.

STATEMENT OF CASH FLOWS

The Statement of Cash Flows is a financial statement that provides information about the
causes of a change in company’s cash balance from the beginning to the end of specific period. In
addition to providing information about a company’s receipts and cash payments during a specific
period, the Statement of Cash Flows helps investors, creditors, and other external parties to
a. Assess a company’s ability to generate future net cash flows.
b. Assess a company’s need for external financing and its ability to pay its debts.
c. Reconcile the difference between net income and change in cash.

The Statement of Cash Flows discloses exactly what caused the cash balance to change
from the beginning of the period to the end of the period. This statement is organized around the
three major types of business activities, namely:
1. Operating
2. Investing
3. Financing

The total effect of these three categories of activities results in either a net increase or
decrease in cash.

Cash Inflows (Outflows) from Operating Activities

Operating activities result in cash inflows and outflows generated from the normal course
or day to day business transactions of the company.

These activities generally involve providing services, and producing and delivering goods.
Cash flows from operating activities generally the cash effects of transactions and other events that

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enter into the determination of profit or loss. This cash flow can be presented using either the direct
or indirect method. Examples of the business transactions that either generate of use cash that will
be reporting in this section are:
1. Cash inflows
a. Receipts from sale of goods and performance of services
b. Receipts from fees, commissions and other revenues
2. Cash outflows
a. Payments to suppliers of goods and services
b. Payment to employees
c. Payment for taxes
d. Payments for interest expense
e. Payments for other operating expense such as rents, insurance and supplies.

Using the direct method, the entity’s net cash provided by (used in) operating activities
obtained by adding the individual operating cash inflows and then subtracting individual operating
cash outflows. Below is an example of the operating activities section of the statement of cash
flows:

Cash received from sale of goods and performance of services P XX

Cash received from fees, commissions and other revenues XX
Cash paid to suppliers of goods and services (XX)
Cash paid to employees (XX)
Cash paid for other operating expense (XX)
Cash paid for taxes (XX)
Cash paid for interest (XX)
Net cash inflow (outflow) from operating activities P XX
The indirect method derives the net cash provided by (used in) operating activities by
adjusting the profit for income and expense items not resulting from cash transactions.
Net income P XX
Adjustments for:
Depreciation XX
Bad debts expense XX
Gain on sale (XX)
Loss on sale XX
Increase in Current Asset Accounts (XX)
Increase in Current Liability Accounts XX
Decrease in Current Asset Accounts XX
Decrease in Current Liability Accounts (XX)
Net cash inflow (outflow) from operating activities P XX
For example, increase in accounts receivable from sale of services or goods represented
increase in profit without corresponding increase in cash- for it is still a receivable. Since these
revenues are already included in the computation of net income, the increase in accounts receivable
should be deducted from the net income figure. To illustrate further, assume that the salaries
payable increased. Increase in salaries payable meant that the entity did not pay the full amount of
salaries expense for the period. The expense in the income statement, for cash purposes, is
overstated with the amount of the unpaid salaries. If expense is overstated, then profit is
understated by the same amount; hence, increase in salaries payable is added to the profit.
Per Philippine Accounting Standards (PAS) No. 7, enterprises are encouraged to report
cash flows from operating activities using the direct method but the indirect method is acceptable.

Cash Inflows (Outflows) from Investing Activities

Investing activities are those centered in support of the operations. This support may take
the form either of purchase of productive assets (i.e. equipment, furniture, land) that a business
needs in its operations or investments outside the company to wisely use any excess funds.
Examples of the business transactions that either generate of use cash that will be reporting in this
section are:

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 1. Cash inflows
a. Receipts from sale of property, plant and equipment
b. Receipts from collections of non-current receivables
2. Cash outflows
a. Payments to acquire property, plant and equipment
b. Payments to make loans to others generally in the form of non-current receivables.

Cash Inflows (Outflows) from Financing Activities

Financing activities deal only with external financing while internal financing is
accomplished through operating activities. These include obtaining resources from additional
investment from the owner and obtaining loans from banks or other lenders. Examples of the
business transactions that either generate of use cash that will be reporting in this section are:
1. Cash inflows
a. Receipts from investment by owners
b. Receipts from issuance of notes payable (non-trade) or other long-term borrowings
2. Cash outflows
a. Payments to owners in the form of withdrawal
b. Payments to settle notes payable (non-trade) or other long-term borrowings

Illustrative Problem. Below is the comparative financial statements (in Php) of Love By Chance
Emporium and the changes in the Statement of Financial Position.

LOVE BY CHANCE EMPORIUM

Comparative Statements of Financial Position
As of December 31

ASSETS
Increase
Current Assets 2017 2016 (Decrease)
Cash 85,000 67,500 17,500
Accounts receivable 25,000 13,000 12,000
Inventory 70,750 60,000 10,750
Supplies 4,500 1,700 2,800
Total Current Assets 185,250 142,200
Non-Current Assets
Cars 250,000 250,000
Accumulated depreciation- Cars (60,000) (30,000) 30,000
Equipment 45,000 30,000 15,000
Accumulated depreciation- Equipment (3,500) (1,000) 2,500
Furniture and Fixtures 25,000 25,000
Accumulated depreciation- Furniture and Fixtures (3,000) (1,500) 1,500
Total Non-Current Assets 253,500 272,500
TOTAL ASSETS 438,750 414,700

LIABILITIES AND CAPITAL

Current Liabilities
Accounts payable 11,000 15,000 (4,000)
Rent payable 10,000 10,000
Utilities payable 7,500 5,500 2,000
Total Current Liabilities 28,500 20,500
Non-current Liability
Loan Payable 125,000 150,000 (25,000)
Total Liabilities 153,500 170,500
AePete, Capital 285,250 244,200 41,050
TOTAL LIABILITIES AND CAPITAL 438,750 414,700

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 LOVE BY CHANCE EMPORIUM
Comparative Income Statements
For the year ended December 31

2017 2016
Sales 652,250 564,200
Less: Cost of Goods Sold 227,500 188,600
Gross Profit 424,750 375,600
Less: Operating Expenses
Rent expense 108,750 94,500
Salaries expense 90,000 76,000
Gas and Oil expense 46,520 35,500
Depreciation expense 34,000 32,500
Utilities expense 19,000 15,500
Repair expense 11,500 10,000
Supplies expense 4,330 7,500
Total 314,100 271,500
Operating Profit 110,650 104,100
Less: Interest expense 11,250 13,500
NET INCOME 99,400 90,600

The Statement of Cash Flows using the direct method in the 2017 is as follows:

LOVE BY CHANCE EMPORIUM

Statement of Cash Flows
For the year ended December 31, 2017

Cashflows from operating activities:

Cash received from customers (Schedule 1) 640,250
Cash paid to suppliers of merchandise (Schedule 2) (242,250)
Cash paid for gas and oil (46,520)
Cash paid for rent (Schedule 3) (98,750)
Cash paid for repairs (11,500)
Cash paid for salaries (90,000)
Cash paid for supplies (Schedule 4) (7,130)
Cash paid for utilities (Schedule 5) (17,000)
Cash paid for interest (11,250)
Net cash inflow from operating activities 115,850

Cash flow from investing activities

Purchase of equipment (15,000)

Cash flow from financing activities

Payment of loans 25,000
Cash withdrawn by the owner (Schedule 6) 58,350
Net cash outflow from financing activities (83,350)
Increase in cash for the year 17,500
Cash balance, December 31, 2016 67,500
Cash balance, December 31, 2017 85,000

Schedule 1
Sales 652,250
Less: Increase in accounts receivable 12,000
Cash received from customers 640,250

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Schedule 2
Cost of Goods Sold 227,500
Increase in merchandise inventory 10,750
Total Purchases 238,250
Decrease in Accounts Payable 4,000
Cash paid to suppliers of merchandise 242,250

Schedule 3
Rent expense 108,750
Less: Increase in rent payable 10,000
Cash paid for rent 98,750

Schedule 4
Supplies expense 4,330
Increase in supplies 2,800
Cash paid for supplies 7,130

Schedule 5
Utilities expense 19,000
Less: Increase in utilities payable 2,000
Cash paid for utilities 17,000

Schedule 6
Capital, Dec. 31, 2016 244,200
Net income for 2017 99,400
Capital, Dec. 31, 2017 285,250
Cash withdrawn by the owner 58,350

In the preparation of the above statement of cash flows, the following are the procedures:
1. For operating activities, start with the income statement and pick up the revenues one by
one. To determine the portion collected in cash, increase in accounts receivable should be
deducted as this has not been collected yet or decrease in accounts receivable should be
added as this represents additional collection aside from the sales.
2. For payment of merchandise to suppliers, pick up the cost of goods sold in the income
statement and add the increase in inventory in the statement of financial position to arrive
at total purchases. Then deduct increase in accounts payable representing non-payment to
arrive at the payment of merchandise.
3. Pick up the expenses, one by one, from the income statement and relate these to the accrued
expenses accounts. An increase in accrued expense such as Utilities Payable represents
non-payment and should be deducted to arrive at total payments made.
4. For investing activities, determine the changes in property, plant and equipment. An
increase means acquisition representing cash outflow and decrease means a sale
representing a cash inflow. See if there is a related payable for the acquisition which means
non-payment and should be deducted. Or a receivable from the sale which means non-
collection and should be deducted.
5. For financing activities, determine the changes in loan payable and capital accounts. An
increase in the payable or in capital means that the company received cash from creditor
or from the owner (except when the increase is due to the net income). A decrease in loan
payable or in the capital account means that the firm paid cash to creditor or the owner
made a cash withdrawal, unless again this is due to a net loss from operations or that the
withdrawal is in the form of non-cash. Unless other stated, withdrawal are presented as
cash withdrawal.

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A summary of typical computation:

Accrual Basis Adjustment Required Cash Basis

+ Accounts receivable, beg
Net sales - Accounts receivable, end Cash receipts from customers
+ Inventory, end
- Inventory, beg
+ Accounts payable, beg
Cost of Goods Sold - Accounts payable, end Cash paid to suppliers
+Prepaid expense, end
+ Accrued expense, beg
- Prepaid expense, beg
Operating expenses - Accrued expense, end Cash paid for operating expenses
+ Unearned revenue, end,
+ Accrued revenue, beg
- Unearned revenue, beg
Other income - Accrued income, end Cash received from other income
+ Interest payable, beg
Interest expense - Interest payable, end Cash paid for interest
+ Income tax payable, beg
Income tax expense - Income tax payable, end Cash paid for income tax

The Statement of Cash Flows using the indirect method in the 2017 is as follows:

LOVE BY CHANCE EMPORIUM

Statement of Cash Flows
For the year ended December 31, 2017

Cashflows from operating activities:

Net income 99,400
Adjustments for non-cash transactions:
Depreciation expense 34,000
Increase in accounts receivable (12,000)
Increase in inventory (10,750)
Increase in supplies (2,800)
Decrease in accounts payable (4,000)
Increase in rent payable 10,000
Increase in utilities payable 2,000
Net cash inflow from operating activities 115,850

Cash flow from investing activities

Purchase of equipment (15,000)

Cash flow from financing activities

Payment of loans 25,000
Cash withdrawn by the owner 58,350
Net cash outflow from financing activities (83,350)
Increase in cash for the year 17,500
Cash balance, December 31, 2016 67,500
Cash balance, December 31, 2017 85,000

Note: That the net cash flow from operating activities should be the same whether you use the
direct method or indirect method.

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Common Adjustments to Net Income

Items to Appear As Explanation Adjustment

Adjustment
Depreciation Expense items that decrease Add to net income
profit but have no cash effect
Gain (loss) on sale of asset The gain increase (loss Deduct gain (add loss) to net
decreases) net income but the income
cash effect is shown in
investing activities section.
Increase in trade receivables Represents revenue Deduct from net income
recognized for the period
with no corresponding cash
receipts
Decrease in trade receivables Represents cash receipts Add to net income
from revenue of previous
period
Increase in inventory Portion of purchases for the Deduct to net income
period that does not form part
of the cost of goods sold;
hence net income us
increased.
Decrease in inventory Cost of goods sold includes Add to net income
goods purchased and paid in
prior years.
Increase in prepaid expenses Payment during this period Deduct from net income
exceed related expenses
shown in profit or loss
Decrease in prepaid expenses Expenses recognized this Add to net income
period exceeds the payments
for the goods or services
Increase in trade payables and Expenses exceed related Add to net income
accrued expense payments to suppliers and
others.
Decrease in trade payables and Cash payments to suppliers Deduct from net income
accrued expense and others exceed related
expenses.

---END OF DISCUSSION---

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 EXERCISES

Problem 1
Categorize each cash flow as (O) for operating, (I) for investing or (F) for financing.
1 Cash received from sale of a building
2 Cash paid for salaries
3 Cash received for interest on a trade notes receivable
4 Cash paid to acquire a new truck
5 Cash loaned out to a customer in form of a long-term note
6 Cash received for services rendered
7 Cash paid for interest
8 Cash paid for insurance on equipment
9 Cash received from a debtor representing payments of principal
10 Cash paid out to acquire a building

Problem 2
The Ae Company reported the following condense profit or loss for 2017:
Sales P1,000,000
Less: Cost of Goods Sold 580,000
Gross Profit P 420,000
Less: Operating expenses
Depreciation expense P 80,000
Salaries Expense 120,000 200,000
Profit P 220,000

During 2017, the following changes occurred in the company’s current assets and current
liabilities:
Increase (Decrease)
Cash 37,000
Accounts receivable (50,000)
Inventories 89,000
Accounts payable (trade) (46,000)
Salaries payable 24,000

Instruction: Prepare the operating activities section of Ae Company’s Statement of Cash Flows
for the year ended 2017 using (a) indirect method and (b) direct method.

Problem 3
The following information was obtained from analysis of selected accounts of Pete Co. for the
year ended December 31, 2017:
Withdrawal by the owner 1,000,000
Proceeds of bank loan 5,000,000
Interest expense 875,000
Depreciation expense-Building 1,000,000
Depreciation expense-Furniture and Fixtures 500,000
Loss on sale of equipment 300,000
Gain on sale of land 200,000
Additional cash investment by owner 4,500,000
Purchase of equipment 1,000,000
Proceeds on sale of land 1,800,000
Payment of bank loan 2,000,000
Profit 5,950,000
Increase in accounts receivable 2,000,000
Decrease in inventory 2,400,000
Increase in trade payables 4,200,000
Increase in income tax payable 1,300,000
Decrease in interest payable 700,000

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 Depreciation expense- equipment 300,000

The balance of cash at January 1, 2017 was P2,000,000.

Instruction: Compute the cash balance on December 31, 2017.

Problem 4
The profit or loss section of the statement of comprehensive income of TinCan Corp for the year
ended December 31, 2017 is reproduced below:
Sales P6,100,000
Cost of Goods Sold (3,700,000)
Gross Profit P2,400,000
Gain on sale of equipment 100,000
Salaries expense (820,000)
Insurance expense (380,000)
Depreciation expense (220,000)
Profit before interest and income tax P1,080,000
Interest expense (120,000)
Profit before income tax P 960,000
Income tax expense (288,000)
Profit P 672,000
The following are also available info:
Decrease in accounts receivable P120,000
Increase in inventory 280,000
Decrease in accounts payable 160,000
Increase in salaries payable 100,000
Increase in prepaid insurance 180,000
Decrease in interest payable 30,000
Increase in income tax payable 18,000

Instruction: Prepare the operating activities section of TinCan Corp’s Statement of Cash Flows
for the year ended 2017 using (a) indirect method and (b) direct method.

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