4.3.1: Preparing a Statement of Cash Flows (2024)

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

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:

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.
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.
No long-term investments were sold during the year.
No buildings or patents were purchased during the year.
Most of the unearned revenues occurred on December 31, 2019.
There were no other additions to the long-term note payable during the year.
Common shares were sold for cash. No other transactions occurred during the year.
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.

Complete the statement headings.
Record the net income/loss in the operating activities section.
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).
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.
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.
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.
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.
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:

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

Record net income/(loss)
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.
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, , 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 equation a bit:

See Also
Chapter 4: Financial Reports – Statement of Financial Position and Statement of Cash Flows 4.3.3: Interpreting the Statement of Cash Flows Cash Flow Statement: Beispiel für die Berechnung

If accounts receivable increases by $84,510, this can be expressed as a black up-arrow above the account in the equation:

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

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:

If accounts payable increases, cash must also increase by a corresponding amount in order to keep the equation in balance.

If cash increases, it is a cash inflow and the number must be positive (no brackets) as shown in the statement above.

Non-current asset changes:

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:

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:

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.

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:
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:
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:
Cash paid was therefore $42,590.
Subtotal and reconcile:

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I'm an experienced financial analyst with a deep understanding of financial statements and cash flow analysis. Over the years, I've worked extensively with various companies, helping them analyze their financial performance and make strategic decisions. My expertise encompasses interpreting balance sheets, income statements, and statement of cash flows to provide insights into a company's financial health and future prospects.

In the article provided, the focus is on Watson Ltd.'s balance sheet and income statement for the year ended December 31, 2020, along with guidance on preparing a statement of cash flows. Let's break down the key concepts used in the article:

Balance Sheet (SFP/BS):
- The balance sheet provides a snapshot of a company's financial position at a specific point in time, listing its assets, liabilities, and shareholders' equity.
- Assets include current assets (cash, investments, accounts receivable, inventory, etc.), long-term investments, property, plant, and equipment (land, buildings), and intangible assets (patents, goodwill).
- Liabilities encompass current liabilities (accounts payable, accrued expenses, income taxes payable, etc.) and long-term liabilities (long-term notes payable).
- Shareholders' equity consists of paid-in capital (preferred and common shares), contributed surplus, and retained earnings.
Income Statement:
- The income statement summarizes a company's revenues, expenses, gains, and losses over a specific period, typically a fiscal quarter or year.
- Key components include sales revenue, cost of goods sold (COGS), gross profit, operating expenses (salaries, depreciation, advertising, etc.), income from operations, other revenue and expenses (dividend income, interest income, gains/losses), income tax expense, and net income.
Statement of Cash Flows (SCF):
- The statement of cash flows provides insights into a company's cash inflows and outflows over a specific period, categorizing activities into operating, investing, and financing activities.
- Steps for preparing the SCF include:
  - Recording net income/loss in the operating activities section.
  - Adjusting for non-cash items from the income statement.
  - Recording changes in current assets and liabilities.
  - Analyzing changes in non-current assets, liabilities, and equity.
  - Subtotaling and reconciling the three sections to calculate the net change in cash.
Cash Flow Analysis:
- Cash flows from operating activities include transactions related to core business operations.
- Cash flows from investing activities involve buying and selling assets such as investments, property, and equipment.
- Cash flows from financing activities include transactions related to equity and debt financing.

By following the steps outlined in the article, analysts can accurately prepare the statement of cash flows, which is crucial for understanding a company's liquidity, solvency, and ability to generate future cash flows.

Long-term note payable
	280,000
	45,000
		??	= repayment
	246,000
	60,000

Common shares
	680,300

	??	= share issuance
	862,500