FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2

CHAPTER 3: STATEMENT OF CASH FLOWS

Learning Competencies:
 Discuss the components and structures of a Cash Flow Statement and Prepare a Cash flow Statement

Importance of Cash Flow Statement

The International Financial Reporting Standards of the International Standards Board has its objective
to require the provision of information about the historical changes in cash and cash equivalents of an entity
by means of a cash flow statement.
The statement of cash flows is a basic financial statement. It provides information about cash receipts
and cash payments of an entity during a period. It classifies the information into operating, investing, and
financing activities. It reconciles the cash balance beginning with the cash balance ending.
The cash flow statement, when used with the income statement and balance sheet, provides information
on the effect on cash, of changes in the assets (other than cash), liabilities, and owner’s equity accounts of
the entity.
It provides the users
1. A basis to evaluate the ability if the entity to generate cash;
2. An information on how the entity generates cash from some or all of the following:
a. From operations
b. From borrowings
c. From investors
d. From sales of noncurrent assets
3. An information on how the entity uses cash which may be for some or all of the following:
a. For operations
b. For payment of borrowed money
c. For income to investors
d. Purchase of noncurrent assets
4. An information to determine the liquidity and solvency of the entity;
5. An information for estimating future cash inflow and cash outflow; and
6. An information for evaluating the relationship between cash flow and profitability.
The primary purpose of the statement of cash flows is to provide information about the cash receipts
and cash payments of an entity during a period. The secondary objective is to group the information as to
operating, investing, and financing. Use statement of cash flows to assess liquidity, solvency, and
profitability of an entity.
Liquidity is the ability to pay current obligations; solvency is the ability of a company to survive over a
long term; and profitability is the ability to generate reasonable return on investments.
High sales but low cash may include bad debts on sales on account. High sales with high cash indicates
profitable operation, where sales are more than cash outlays for operations.

Elements of Cash Flows

1. Cash flows from operating activities – These are cash flows that are directly related to earning the
net income or suffering the net loss.
2. Cash flows from investing activities – These are cash for the acquisition or disposition of plant,
equipment, and investment.
3. Cash flows from financing activities – These are cash flows for financing the entity through cash
receipts from and cash payments to investors or creditors other than to, or from suppliers.

Operating Activities are the principal revenue-producing activities of the entity and other activities that
are neither investing nor financing activities. Operating activities include the cash effects of transactions that
enter into the determination of net income.
Investing Activities are the acquisition and disposal of long-term assets and other investments.
Financing Activities are activities that result in changes in the size and composition of the equity
investments of owners and long-term liabilities of the entity.
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The inflow from operating activities comes from cash receipts from the sale of goods, services, as well
as other revenues. The outflows are for payment to suppliers of goods and services, taxes, and other
expenses.
The outflow for investing activities consists of payments for property, plant and equipment, intangibles,
and other long-term assets. The inflow from investing activities consists cash receipts from sale of property,
plant and equipment, intangibles, and other long-term assets.
The inflow from financing activities consists of cash from equity investors or owners of the entity
investors or owners of the entity and cash from borrowings. The outflow for financing activities consists of
cash back to equity investors or owners of the entity and cash for repayments of cash borrowed.

Accrual Basis of Accounting

Not all cash receipts are revenues and not all cash payments are expenses. It is also common to earn
revenue prior to receiving cash and to incur expenses prior to paying cash.
There are two methods of accounting: the cash basis of accounting and the accrual basis of accounting.
The cash basis of accounting recognizes revenue or income when cash is received and recognizes expenses
only when is paid. On the other hand, the accrual basis of accounting recognizes revenue or income in the
accounting period in which it is earned, whether or not cash has been received, and recognizes expenses in
the accounting period in which it is incurred, whether or not cash has been paid. Between the two method
methods, it is the accrual basis of accounting that is in accordance with generally accepted accounting
principles (GAAP). The objective of accounting is to fairly measure the results of the operation for a given
period of time, and the financial position as of a certain or specific date. The results of operation are shown
in the income statement, and the financial position is shown in the balance sheet or statement of financial
position. Rarely does the cash basis of accounting fairly measures result of operation and financial position,
thus its limited use. Whether the business is service, trading, or manufacturing, there is a need to always
employ a system of fair measurement. Fair measurement does not mean accurate measurement, but rather,
measurement within acceptable range. At the end of the accounting or reporting period, adjusting entries are
made to correct certain accounts.
The following are indications that the accrual basis of accounting is in use:
1. Recognition of accounts receivable
2. Recognition of accounts payable
3. Recognition of bad debts expense or uncollectible accounts receivable
4. Recognition of depreciation of property and plant and equipment
5. Recognition of prepaid expenses
6. Recognition of accrued expenses or expenses payable
7. Recognition of cash receipts for income not yet earned

Recognition of Accounts Receivables

When service or goods are delivered to customers, whether physically or constructively, it brings
revenue or income and the right to collect from the customer. The revenue or income is recognized as a
credit to sales or service income, and a debit to accounts receivable; sale is the account for trading business;
and service income for service business.
For such transaction, this is the journal entry.
Accounts Receivable PXXX
Sales or Service Income PXXX
To record income

This is an entry made when the sale is on account or on credit. At a later time, cash is collected from the
customer at which time the journal entry for collection is as follows:
Cash P XXX
Accounts Receivable PXXX
To record collection from customer

When cash is received on the date of sale of the product or service, this is the journal entry.
Cash PXXX
Sales or Service Income PXXX
To record sales on cash basis
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2

Recognition of Accounts Payable

When goods or supplies are bought, and the entity does not pay cash at the time of purchase, the entity
makes a promise to pay at a future date. The transaction, called a purchase on account or on credit, is
recorded as follows:
1. Purchase or Merchandise Inventory PXXX
Accounts Payable
To record purchase of goods on credit
2. Laboratory Supplies PXXX
Accounts Payable PXXX
To record supplies bought on credit
Payment of accounts payable is recorded as follows:
Accounts Payable PXXX
Cash PXXX
Purchase of goods and supplies on cash basis is recorded as follows:
1. Purchases or Merchandise Inventory PXXX
Cash PXXX
To record purchase of goods on cash
2. Laboratory Supplies PXXX
Cash PXXX
To record supplies bought on cash

Recognition of Bad Debts Expense

Before the income are prepared, there is a need to recognize that portion of the accounts receivable from
customers that may not be collected. These are called bad debts. The amounts due from customers are
recorded as gross amounts with the debits to accounts receivable. For varying reasons, the entity may not be
able to collect from all the customers, or a customer may not pay in full the amount collectible from them.
The entity will find the best way of determining the probable uncollectible amounts from customers.
The journal entry is as follows:
Bad Debts Expense PXXX
Allowance for Bad Debts PXXX
To adjust for estimated uncollectible accounts
The bad debts expense is one of those accounts listed as expenses in the income statement. The journal
entry recognizes bad debts or uncollectible accounts receivable. There is a credit allowance for bad debts or
allowance for uncollectible accounts. Either one of these two accounts is shown in the balance sheet as a
deduction from accounts receivable. Meanwhile, an allowance account is used to indicate that the non-
collectability is still an estimate. Once a particular or specific amount due from a customer becomes
definitely uncollectible, the same is written off the accounts receivable. To write off is to take out the bad
accounts receivable from the accounts receivable and from the allowance for bad debts.
The journal entry is as follows:
Allowance for Bad Debts PXXX
Accounts Receivable PXXX
To adjust for the written off receivables which are definitely uncollectible

Recognition of Depreciation of Plant and Equipment

Plant and Equipment are those assets with useful lives extending beyond the year when they were
purchased. They are assets with physical existence. Since the assets (plant and equipment) will help create
revenue over a period beyond the year they are acquired, the application their costs to revenue should also be
over a period beyond their year of acquisition. This is done through a process called depression accounting.
Depreciation accounting is the process of allocating the cost of plant and equipment to the years or periods
expected to benefit from their use. Examples of plant and equipment are building, furniture, office
equipment, laboratory equipment, and motor vehicles or transportation equipment.
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2

Land is also a long-lived asset. It is generally not subject to depreciation since it practically has
indefinite number of years of existence.
The depreciation expense is journalized this way:
Depreciation Expense PXXX
Accumulated Depreciation PXXX
To record depreciation
To compute for depreciation, determine the cost of the asset, its scrap value, and its estimated useful
life. The estimated useful life is based on physical wear and tear, obsolescence, and company policy on
repairs and replacements. The scrap value is the estimated selling price of the asset at the end of its useful
life. Depreciable cost is cost less scrap value. It is the cost of the plant and equipment that is allocated over a
period of time, in which allocated amounts are the debits to depreciation expense. A common method of
determining depreciation expense is the straight line method. The straight line method of depreciation
determines the cost of the asset, and from this cost, the scrap value is subtracted. The net, called
depreciation cost, is divided by its estimated useful life.
The formula is as follows:
Cost of Plant ∧Equipment−Scrap Value
Depreciation per year =
Estimated life∈ years
Example
Cost of Delivery Truck 1,250,000
Scrap Value 250,000
Estimated Life 5 years

1,250,000−250,000
Depreciation per year =
5 years
Depreciation per year =P 200,000
The journal entry is as follows:
Depreciation Expense – Delivery Truck P200,000
Accumulated Depreciation – Delivery Truck P200,000
To adjust depreciation for the year
Such is the formula as there is an increase in expense and a decrease in asset. According to the rules of
debits and credits, an increase in expense is a debit to an expense account, and a decrease in asset is a credit
to the asset account. In the case of the latter, instead of directly crediting Delivery Equipment, the credit is to
the contra-delivery equipment account, with the title, Accumulated Depreciation – Delivery Equipment. The
account Accumulated Depreciation – Delivery Equipment is a deduction from Delivery Equipment when
presented in the balance sheet these accounts will appear among the other assets, as follows:
Delivery Equipment P 1,250,000
Less: Accumulated Depreciation 200,000
Net P 1,050,000
When the depreciation cost of P 1,000,000 has been fully recorded as expense, no more expense is
recorded. If the estimate of the five-year life is close to reality, most likely the delivery equipment is no
longer serviceable to the seller, and therefore has to be sold as scrap. It is also possible to estimate zero scrap
value for certain depreciable assets.

Recognition of Prepaid Expenses

Certain expenses are paid in advance of actual use. There are two methods of recording such advance
payments: the asset method and the expense method. When the asset method is used, an asset account is
debited upon payment, and for the expense method, an expense account is debited. Under the asset method,
the adjusting entry at the end of the accounting period (or reporting period) is the recognition of the expense
portion by debiting the expense account for the increase in expense, and a credit to the asset account for the
decrease in asset. On the other hand, under the expense method, the end of period adjustment is a debit to the
asset account for the unused portion, and a credit to the expense account.

Examples
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2

A. The company paid a one-year comprehensive insurance on the company car. Payment on February
1, 20X1 is P12,000. The journal entries for the payment and the year-end adjustments are as
follows:
Asset Method Expense Method
20X1 20X1
Feb. 1 Prepaid Insurance 12,000 Feb. 1 Insurance Expense 12,000
Cash 12,000 Cash 12,000
To record payment of To record payment of
insurance premium. insurance premium.
20X1 20X1
Dec. 31 Insurance Expense 11,000 Dec. 31 Prepaid Insurance 11,000
Prepaid Insurance 11,000 Insurance Expense 11,000
To adjust for the 11-month To adjust for the one month
expense. unused insurance premium.

B. On December 16, 20X1, the company purchased office supplies from Goodwill Trading amounting
to P10,000. By December 31, 20X1, the consumed office supplies amounted to P4,000 leaving an
unused portion of P6,000.
Recording of the purchase and the year-end adjustment are as follows:

Asset Method Expense Method

20X1 20X1
Dec. 16 Unused Office Supplies 10,000 Feb. 1 Office Supplies Expense 10,000
Cash 12,000 Cash 10,000
To record purchase of office To record purchase of office
supplies. supplies.
20X1 20X1
Dec. 31 Office Supplies Expense 4,000 Dec. 31 Unused Office Supplies 6,000
Unused Office Supplies 4,000 Insurance Expense 6,000
To adjust for used office To adjust for the unused office
supplies. supplies.

Recognition of Accrued Expenses or Expenses Payable at the End of the Accounting Period
A company may have availed of or has incurred some expenses, payments for which have not been
made. The expenses that usually fall in this category are salaries to employees, professional fees to
contractors, electric bills, telephone bills, and water bills.
Example
On December 31, 20X1, the unpaid Meralco electric bill amounts to P20,000.

The following is a journal entry adjustment:

Dec. 31 Utilities Expense 20,000
Utilities Payable or Accrued Expense Payable 20,000
To adjust for unpaid electric bill for the month of Dec. 20X1
The debit to utilities expense is for the increase in the expense, and the credit to utilities payable or
accrued expenses payable is for the increase in liability to Meralco.

Recognition of Cash Received for Income Not Yet Earned

The company may receive cash for services that will, in turn, be rendered to the customers or client in
the future.
Example
Probiolab received P24,000 from client on December 1, 20X1 for medical retainership
for the months of December 20X1, January 20X2, and February 20X2. There are two ways
of recording this cash receipt: one as a liability and the other as an income.

The journal entries for cash receipts and year-end adjustment are as follows:
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2

Liability Method Income Method

20X1 20X1
Dec. 1 Cash 24,000 Dec. 1 Cash 24,000
Unearned Service 24,000 Service Income 24,000
To record advance receipt of To record advance receipt of
service fees service fees
20X1 20X1
Dec. 31 Unearned Service Income 8,000 Dec. 31 Service Income 16,000
Service Income 8,000 Unearned Service Income 16,000
To adjust for the earned income To adjust for unearned service
for December 20X1 income for January and
February 20X2
To summarize, the illustrated adjusting entries at the end of accounting or reporting period are for the
following:
 Bad Debts Expense or Estimated Uncollectible Accounts
 Depreciation Expense
 Prepaid Expenses
 Accrued Expenses
 Unearned Income
The cash flow statement reconciles the net change in the cash balance within the accounting period with
the changes in the other balance sheet accounts. The cash flows statement also explains why, for example, an
increase in cash of P1 million for the year is not the same as the net income for the year.

Direct Method Cash Flow Statement

The direct method reports cash receipts less cash payments to arrive at net cash from operating
activities. Direct method cash receipts and cash payments are obtained from the cash records. A list of all
cash receipts and all cash payments is made.
Total cash receipts less total cash payments is the net cash increase (receipts more than payments) or the
cash decrease (receipts less then payments).

Illustration of the Direct Method

A. Cash from operating activities
Cash Receipts
Cash received from customers P 2,500,000
Cash received from other income 100,000
2,600,000
Cash Payments
Cash paid to suppliers 900,000
Cash paid for salaries 600,000
Cash paid for utilities 360,000
Cash paid for various expenses 150,000 2,010,000

B. Cash investing activities

Cash paid for office computer (120,000)

C. Cash from financing activities

Additional investment of proprietor 200,000
Net increase in cash for the year 670,000
Add: Cash balance beginning 120,000
Cash balance ending P 790,000

Indirect Method Cash Flow Statement

Under the indirect method, the accrual basis net income is adjusted to net cash, provided by operating
activities. The indirect method accounts for the increase or decrease in the cash balance by the following:
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2

a. Computing net increase or decrease in cash, cash balance beginning of accounting period versus
cash balance end of period
b. Determining net results of operation or net income (NI); adjusting (increase or decrease) net income
for transactions that reduce the net income without cash payments, such as depreciation and other
adjustments on net income or net loss are made to convert the result of operation to cash basis
c. Identifying cash receipts from investing activities
d. Identifying cash payments for investing activities
e. Identifying cash receipts from financing activities
f. Identifying cash payments for financing activities
The net of a, b, c d, e, f shall equal the net increase or the net decrease in cash.

Demonstration Exercise
John Lee Company
Income Statement
For the Year Ended December 31, 2012
Revenues P 5,400,000
Cost of Sales P 3,000,000
Operating Expenses (excluding depreciation) 900,000
Depreciation Expense 200,000 4,100,000
Net Income P 1,300,000
The following balances are reported on December 31:
2011 2012
Cash P 450,000 P 1,170,000
Accounts receivable 1,010,000 1,300,000
Inventories 250,000 320,000
Accounts Payable 720,000 700,000
Additional cash transactions for 2012 are as follows:
1. The company bought a delivery truck for 2,000 cash
2. A long-term loan for 1,800,000 was obtained from the bank
3. The proprietor John Lee withdrew 200,000
Requirements
1. Prepare a statement of cash flows using the indirect method.
2. Prepare a statement of cash flows using the direct method.

Indirect Method
John Lee Company
Statement of Cash Flows
For the Year Ended December 31, 2012
Cash Flows from Operating Activities
Net Income P 1,300,000
Adjustment to reconcile net income to net cash
provided by operating activities
Depreciation 200,000
Increase in accounts Receivable (290,000)
Increase in Inventories (70,000)
Decrease in Accounts Payable (20,000)
Net cash provided from operating activities P 1,120,000
Cash Flows for Investing Activities
Purchase delivery truck for cash (2,000,000)
Cash from Financing Activities
Loan obtained from bank P 1,800,000
Cash withdrawal by proprietor John Lee 200,000
Net cash from financing activities 1,600,000
Net change in cash – Increase 720,000
Cash Balance, December 31, 2011 450,000
FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT 2

Cash Balance, December 31, 2012 P 1,170,000

Direct Method
John Lee Company
Statement of Cash Flows
For the Year Ended December 31, 2012

Cash Flows from Operating Activities

Cash collections from customers
Total Revenue P 5,400,000
Less: Increase in Accounts Receivable (290,000) P 5,110,000
Payment for Cost of Sales
Cost of Sales 3,000,000
Add: Increase in Inventories 70,000
Decrease in Accounts Payable 20,000 (3,090,000)
Payment of Operating Expenses (900,000)
Net cash from Operating Activities 1,120,000

Cash for Investing Activities

Bought delivery truck for cash (2,000,000)
Cash from Financing Activities
Obtained loan from bank P 1,800,000
Proprietor John Lee withdrew cash (200,000)
Net cash from financing activities 1,600,000
Net change in cash – Increase 720,000
Add: Cash balance, December 31, 2011 450,000
Cash Balance, December 31, 2012 P 1,170,000

TOPIC QUESTIONS AND ACTIVITIES

1. Give the reasons why net income is not necessarily the same as net cash receipts.
2. Why is net cash inflow as important, or sometimes more important, than net income?
3. Observe the operations of your favorite fast food restaurant. What is good about their cash flow?
4. Compare cell phone with a (a) prepaid plan against (b) postpaid plan. Name the advantages of (a)
over (b), and (b) over (a) in terms of cash receipts and service income.
5. Inquire from your family members and relatives how credit card transactions generate cash to the
sellers. Why would sellers resort to selling through credit cards?