equity

It could be argued that the statement of cash flow is the most important of all the financial statements. It is also the least understood. Understanding the purpose of the statement of cash flow is the key. Once you understand the purpose of the statement, wrapping your brain around how to complete it is much easier.

Most people have a difficult time understanding the concept of accrual accounting. I believe this is because most people live in a cash basis world. As individuals, we do not consider income when it is earned. We recognize our income when it is paid. We recognize expenses when they are paid. It is important to remember that most businesses do not operate that way. Most businesses recognize income when the work is done, whether or not the job has been paid for. These businesses recognize expenses when the cost is incurred, regardless of payment status. In business, we are frequently recording income and expenses when no money has changed hands.

This causes a problem for many people looking at the financial statements. Individuals think in terms of cash so when an individual sees a company with a profit of $500,000, he or she may think that there is an additional $500,000 worth of cash sitting in the bank at the end of the year. Cash might have only increased slightly. It could have even decreased! When that money is not there, the person may believe there is a problem with the income statement.

The purpose of the statement of cash flow is to explain the difference net income and the change in cash over the same period. If there was a $500,000 profit, the statement of cash flow explains why the increase in cash is not also $500,000. The statement begins with net income. Each line on the statement explains where cash is coming from, called a source of cash, or where cash is going, called a use of cash. The statement ends with the amount that cash has increased or decreased over the course of the period and the ending balance in cash.

Every source or use of cash can fit into one of three categories: operating activities, investing activities or financing activities.

Operating Activities

These are activities related to operations or the income statement. In other words, these are items related to income and expenses. There are two main types of operating activities: noncash and those related to current assets and current liabilities.

Noncash operating activities relate to items that appear on the income statement, yet cash was not affected by that item. The most common noncash item is depreciation. Think about the entry recorded for depreciation.

CF1

The entry creates an expense, which appears on the income statement but no cash changes hands. On the income statement, the expense lowers net income but there is no corresponding decrease in cash. This leads to one of the differences between net income and change in cash.

Since the depreciation was subtracted on the income statement, we need to add it back to net income on the statement of cash flow. Adding it back removes it from net income, helping us get closer to the change in cash.

Other noncash items include amortization, gains and losses. While some cash may change hands when an asset is sold, the amount of cash received relates to the removal of the asset. The gain or loss on the transaction is considered to be a noncash part of the transaction. It is essentially there to balance the transaction.

CF2

Notice that $5,000 in cash was received, not $2,000. We eliminate the $2,000 gain in the operating section. Later, we will see what happens to the $5,000.

Any noncash item that is added on the income statement, a gain for example, is subtracted on the statement of cash flows to remove it. Noncash items that are subtracted on the income statement are added back on the statement of cash flows.

Changes in current assets and current liabilities are the second type of operating item. Think of some common current assets and current liabilities: accounts receivable and accounts payable. Both of these items are linked to the income statement.

Current Assets and Changes in Cash

Accounts receivable is created when a company does work and creates revenue. The work has not yet been paid for. However, the income appears on the income statement. This could create a difference between net income and the change in cash. When trying to determine if there is an effect on the change in cash, we need to look at how much accounts receivable has changed. Let’s look at three different scenarios.

Example #1

2012 ending balance in Accounts Receivable was $230,000
2013 ending balance in Accounts Receivable was $230,000
Sales were $3,000,000

If Accounts Receivable was $230,000 at the end of 2012 and is still $230,000 at the end of 2013, that means that $3,000,000 worth of sales were collected in 2013.

CF3

The amount of sales and the amount of cash collected are equal. Therefore, no timing difference exists. There difference between net income and cash is not affected by accounts receivable.

 

Example #2

2012 ending balance in Accounts Receivable was $330,000
2013 ending balance in Accounts Receivable was $230,000
Sales were $3,000,000

In this example, Accounts Receivable decreased by $100,000. Let’s see how this decrease affects the amount of cash collected.

CF4

The company reported $3,000,000 in sales on the income statement but actually collected $3,100,000 in cash related to sales. The decrease in accounts receivable results in an increase in cash. That makes sense because when accounts receivable balances are paid (and the balance decreases), the company receives cash.

The $100,000 difference creates a positive change in cash. You could also say that the $100,000 decrease in accounts receivable is a $100,000 source of cash.

Example #3

2012 ending balance in Accounts Receivable was $230,000
2013 ending balance in Accounts Receivable was $330,000
Sales were $3,000,000

Now we have a $100,000 increase in accounts receivable. What effect do you think this has on cash? If accounts receivable is increasing, the company doesn’t have the cash. Let’s look at the calculation.

CF5

Only $2,900,000 was collected over the course of the year but sales of $3,000,000 appear on the income statement. The $100,000 creates a negative change in cash. My change in cash in this case is less than net income because the company did not collect those funds.

You might be concerned at this point because this seems like a lot of work to do for every line of the cash flow statement. This is just to illustrate what happens. If accounts receivable increases, the change in cash decreases by the same amount. If accounts receivable decreases, the change in cash increases by the same amount.

When completing the statement of cash flow, calculate the change in the account balance. Ask yourself who has the money resulting from that change. Go back to example #2. Accounts receivable decreased by $100,000. Who has the $100,000? The company does because customers paid the additional $100,000. This results in an increase in cash. In example #3, the customers had the $100,000 because they had not paid their bills. This results in a decrease in cash for the company. This method works for all current assets and current liabilities.

All assets behave like accounts receivable. If the balance in prepaid expenses increases, more cash is trapped in that account, resulting in a decrease in cash. If the balance in inventory decreases, the company used up some of the previous inventory rather than spending cash to purchase more. Cash increases because of this.

Current Liabilities and Changes in Cash

Current liabilities, like accounts payable, react the opposite way that assets do. Again, we are examining the differences in current liabilities to determine how these changes affect the change in cash. Let’s run through a few examples just to get the hang of it.

Example #4

2012 ending balance in Accounts Payable was $150,000
2013 ending balance in Accounts Payable was $105,000
Expenses were $2,500,000

Accounts payable decreased by $45,000. Why did accounts payable decrease? Because the company paid all the current expenses and paid off some of last year’s balance. The company paid down debt. This has a negative impact on the change in cash. Let’s look at the full calculation to confirm.

CF6

The company paid $45,000 more in cash than it recorded in expense. This causes a decrease in cash. It can also be said that the decrease in accounts payable is a use of cash.

Example #5

2012 ending balance in Accounts Payable was $150,000
2013 ending balance in Accounts Payable was $175,000
Expenses were $2,500,000

Now, accounts payable is increasing. The company charged more to accounts payable over the course of the year than the company paid off. The $25,000 difference is a source of cash. The company was able to write off expenses that it has not yet paid for.

CF7

The company’s income statement shows expenses of $2,500,000 but the company only spent $2,475,000. It kept the $25,000. Because of the $25,000 increase in accounts payable, the change in cash increased by $25,000.

All current liabilities behave like accounts payable. When accounts payable decreases, cash decreases because cash was used to pay down the liability. When accounts payable increases, cash increases as well because the company used debt rather than cash to finance its activities.

Steps to Complete the Operating Section

  1. First calculate the change in the account balance.
  2. Ask yourself who has the cash from that change. If the company has the cash, it is an increase in cash.  If someone else has the cash, customers or vendors for example, it is a decrease in cash.
  3. Don’t forget to look for noncash items as you work your way down the balance sheet: depreciation, amortization, gains and losses.

 

Investing Activities

In this section, we are concerned with investments that the company has made. What do companies invest in? Long-term assets that will help with company increase revenue. This includes buildings, machinery, intangible assets, investments in other companies and other long-term investments.

In the investing section, we are not allowed to explain a difference in an account balance by listing “change in fixed assets.” The investing section requires us to explain each change. Let’s look at an example.

Example #1

2012 ending balance in Vehicles was $250,000
2013 ending balance in Vehicles was $235,000
In 2013 the company sold a vehicle which was originally purchased for $35,000 for $5,000. The vehicle had $33,000 of accumulated depreciation recorded at the time of sale.

When dealing with assets, we may not have all the transactions listed, but we will always have all the information we need to do the calculation. Let’s start with the beginning balance and run through the information we have so far.

CF8

This does not make sense because the account balance was $235,000. Clearly, something else happened which was not listed in the information. What would cause the balance in the vehicles account to increase? The company must have purchased another vehicle. How much was the new vehicle? It must have been $20,000.

CF9

Now that we have identified all the activity in the vehicles account and were able to reconcile the change in the balance. We now must figure out what we need to record. We must forget for a moment the vehicles and turn our attention to the cash that changed hands.

The company sold a vehicle. How much cash was received? $5,000. It does not matter that the vehicle originally cost $35,000. Now we are only concerned with cash. The company also purchased a vehicle. How much cash was paid? $20,000. On the statement of cash flow, we would record these two items.

CF10

Notice, we listed each item separately. We need to explain to the reader what happened.

You might have noticed that there was a gain on the sale of the vehicle. The vehicle had a book value of $2,000 ($35,000 cost – $33,000 accumulated depreciation). If $5,000 was received, there was a $3,000 gain. Remember when we discussed noncash items in the operating section. This gain would be listed in the operating section and subtracted from net income.

You should follow this procedure for all noncurrent assets on the balance sheet.

  1. Reconcile the beginning and ending balance in the account using the information you have in the problem.
  2. If the balance matches your reconciliation, you are finished. Record the items listed.
  3. If the balance does not match your reconciliation, there must have been additional activity that was not listed. This activity must be an asset purchase. Calculate how much the asset purchase was.
  4. In the statement of cash flow, list all transactions separately, as shown above.

 

Financing Activities

In our analysis of the balance sheet, we have covered current assets, current liabilities and long-term assets. The only items remaining are long-term liabilities and equity. Both of these items go into the financing section.

The financing section is similar to the investing section. We must explain what happened, not just list the changes in each account balance.

Example #1

2012 ending balance in Notes Payable was $95,000
2013 ending balance in Notes Payable $75,000
The company borrowed $35,000 in additional loans

Looking at this example, it is clear that there is information missing. The company borrowed additional money but the Notes Payable balance decreased. That just doesn’t make sense with the information we are given. There are two ways to work this calculation. we can reconcile the balance, similar to the method used in the investing section.

CF11

What is causing the balance to be $55,000 less than anticipated? Think about the reason that the balance in Notes Payable would decrease. Debts decrease when they are repaid. The company must have repaid $55,000 on the debt.

Here is how we would list this on the statement of cash flow in the financing section:

CF12

You should follow this procedure for all noncurrent liabilities on the balance sheet.

 

  1. Reconcile the beginning and ending balance in the account using the information you have in the problem.
  2. If the balance matches your reconciliation, you are finished. Record the items listed.
  3. If the balance does not match your reconciliation, there must have been additional activity that was not listed. Calculate the amount you are off and the reason for the change.
  4. In the statement of cash flow, list all transactions separately, as shown above.

 

Completing the Statement of Cash Flows

Whenever I am working on a cash flow statement, I use the balance sheet as a guide.

First, calculate how much each account has changed from the previous year.

 

Starting at the top of the balance sheet, I work my way through each account. The first account should be cash. We can skip that one since the purpose of the statement of cash flow is to match the change in cash. The next account is most likely accounts receivable. Determine which section accounts receivable would go into: operating, investing or financing (if you said operating, you are correct). Then ask yourself if the change in the balance is a source of cash or a use of cash. Add it to your statement.

Use this same procedure, explaining all the differences and adding them to the correct section of the cash flow statement. When you have explained all the differences, total each section and then add all three sections together to calculate your change in cash. The change in cash you calculate should equal the difference between your beginning and ending cash balance.

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The trial balance is a list of all the accounts a company uses with the balances in debit and credit columns. There are three types of trial balances: the unadjusted trial balance, the adjusted trial balance and the post- closing trial balance. All three have exactly the same format.

The unadjusted trial balance is prepared before adjusting journal entries are completed. This trial balance reflects all the activity recorded from day-to-day transactions and is used to analyze accounts when preparing adjusting entries. For example, if you know that the remaining balance in prepaid insurance should be $600, you can look at the unadjusted trial balance to see how much is currently in the account.

The adjusted trial balance is completed after the adjusting entries are completed. This trial balance has the final balances in all the accounts and is used to prepare the financial statements.

The post-closing trial balance shows the balances after the closing entries have been completed. This is your starting trial balance for the next year. We will discuss the post-closing trial balance in the post regarding closing entries.

Accounts in the trial balance are listed in a specific order to aid in the preparation of the financial statements. Accounts should be listed in the following order:

  • Assets
  • Liabilities
  • Equity
  • Revenue
  • Expenses

Assets and liabilities should be listed in order from most liquid to least liquid. Liquidity refers to how quickly an asset could be converted to cash and how quickly a liability will be paid off with cash. The most liquid asset is cash, because it has already been converted to cash (who knew?). Typically, the next most liquid asset is accounts receivable because most companies collect their receivables within 30 days.

You can also think of assets and liabilities in terms of current and long-term. A current asset is one that will most likely be used up in less than 12 months. A current liability is one that will be paid off in less than 12 months. Long-term assets and liabilities are those that will be on the trial balance for more than 12 months.

Using the Adjusted Trial Balance

TB

Here is a sample adjusted trial balance. Notice the accounts are listed in the order described above. You might be wondering why it is such a big deal to organize the trial balance in this manner. The purpose of the trial balance is to make your life easier when preparing financial statements. Look what happens when we divide the trial balance by statement.

FS1
This is the same trial balance but I have color coded it. The orange section is for the accounts that will be used on the balance sheet, the blue is the statement of retained earnings and the green is the income statement. Because we took the time to organize the accounts, the preparation of the financial statements will be so much easier.

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Journal entries are probably the most important part of any financial accounting class. They are the language of accounting.

JE 1

This is a journal entry. It describes a transaction. The entry above tells us that on January 17, the company purchased land worth $100,000 and a building worth $225,000. The company put down $125,000 cash and took out a note with the bank for $200,000. Once you understand how journal entries are constructed, you will be able to read and write them yourself.

Debits and Credits

Debits and credits are the heart of the journal entry because they tell us if we are acquiring something or giving something up. Depending on the type of account, it will increase or decrease when it is debited or credited.

Remember the accounting equation? Assets = Liabilities + Equity. Just as we need to keep the accounting equation in balance, we must keep our debits and credit in balance. Each journal entry must contain equal debits and credits. Notice the entry above: $325,000 in debits and $325,000 in credits. In order for that to occur, each journal entry must have at least two accounts. You can never have a one line journal entry because it would not balance.

In accounting, we frequently refer to the normal balance in the account. The normal balance is a positive balance or what would need to be done to increase the balance.

JE 2

Because the accounting equation tells us that assets must equal liabilities and equity, it makes sense that the normal balance for assets is a debit and the normal balance for liabilities and equity is a credit. Remember that normal balance means positive or increasing balance. What do you do to decrease the balance of an asset? If a debit increases the balance, than a credit to the account would decrease the balance. As we saw in the example entry above when we wanted to decrease cash, we credited the account.

What about revenue and expenses? Why is revenue’s normal balance a credit while expense’s is a debit? First, let’s discuss the relation these two accounts have to equity. Retained Earnings is a major component of equity. What causes retained earnings to increase? Profit. What causes profit to increase? Revenue. If revenue increases equity, then it should act the same way that equity does. Therefore, revenue has a credit balance. Since expenses decrease profit and equity, it makes sense that the normal balance is a debit.

If you still are not sure, put revenue or expenses in a journal entry with cash. Most people who study accounting quickly learn how cash behaves in most situations. If you know how cash will behave, you can figure out the other account. When a company does work and gets paid, cash increases so we debit cash. The other account, revenue, would be the credit. When a company pays for its rent, cash decreases so we credit Cash. To balance the entry, we debit Rent Expense.

Steps for Completing Journal Entries

  1. Read the transaction to get a feel for what is happening. Do you understand what happened? Try to put it into your own words.
  2. Identify the accounts you will put in your journal entry. Identify the type of account for each account used.
  3. For each account, determine if the balance is increasing or decreasing. Then determine if that increase or decrease is a debit or credit.
  4. Determine the amount that each account is changing.

 

Example:

On January 4, Lisa decides to start a bookkeeping business and invests $10,000 cash and $5,000 worth of computer equipment in exchange for stock in the company.

  1. The company received cash and computer equipment in exchange for stock.
  2. Cash (asset), Computer Equipment (asset) and Common Stock (equity).
  3. Cash – increasing, debit. Computer Equipment – increasing, debit. Common Stock – Increasing, credit.
  4. Cash – $10,000. Computer Equipment – $5,000. Common Stock – $15,000

Je 3

 

This may seem like a lot of steps but when you are first learning how to do journal entries, it really helps to go through each of the steps as you write the entry. You don’t need to write out the answers to each of the steps as I did above, but you should do it mentally as you figure out the entry. I have had many students who will put the abbreviation for the account type next to the account name.

JE 4

If you are going to do that, I recommend using Eq for equity and Ex for expense.

When learning to do journal entries, take your time and go through the steps. Make sure to learn the accounts and what type each account is. You may want to make flash cards with the name of the account on one side and the type of account on the other. You should also learn when to use a particular account, for example, when to use Unearned Revenue instead of Revenue or Prepaid Insurance rather than Insurance Expense.

This may seem difficult at first, but if you learn the terminology and practice, you will get better at it. For most students, a lightbulb goes off in their minds somewhere in the first six weeks of the course; everything clicks and they no longer need to use the steps above. Until you have your lightbulb moment, make sure to use the steps outlined above.

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Accounting is all about balance. Each time we engage in a transaction, there are at least two things that are happening. Usually, we give up something to receive something we need. For example, when you purchase supplies for school, you give up cash in order to get the supplies. When you take out a loan, you get cash today (or tuition or a car) by giving up the right to cash you will receive in the future so you can make your loan payments. Accounting principles work for individuals as well as businesses.

Note: As you progress through the course, think about transactions in your daily life and try to relate them to what you are doing in the course. Analyzing transactions in your own life will make the course easier to relate to and increase your understanding of the topic.

Because of this give and take, accounting is based on a double entry system. Whenever a transaction is recorded, at least two accounts must be effected. This allows us to remain in balance.

The accounting equation is the basis for all of accounting. The accounting equation states:

Assets = Liabilities + Equity

When recording transactions, the accounting equation must stay balanced.

Assets

An asset is something the business owns or has a right to, which can be used to generate future income. Examples of assets include cash, supplies, inventory, vehicles, machinery, equipment, and buildings. This is by no means an exhaustive list and you will spend most of any introductory financial accounting course studying assets.

Liabilities

A liability is an obligation that a business has to another person or entity. Typically, we think of liabilities as loans but there are many different types of liabilities a business can incur. For example, when the electric bill comes and the business has 30 days to pay it, that becomes a liability because the business used the electricity and is obligated to pay for it. If a business agrees to do work for a client and the client pays a deposit (puts money down) for work to be completed at a later date, the business has an obligation to complete the work or refund the money.

Equity

Equity is one of the most difficult concepts for most students to understand in accounting. Equity is the business’ worth to the owners. Let’s rearrange the accounting equation:

Assets – Liabilities = Equity

Now the equation tells us that what we own less what we owe others is equity. This is the value of the business to the owners, also called a business’s net worth. Equity has two main components: contributed capital and retained earnings.

Contributed capital is the value that the owners have contributed to the business. If you started a business tomorrow and put $1,000 cash plus a computer worth $500, the contributed capital in the business would be $1,500 because that is the amount the owner (you) have contributed.

Retained earnings is the amount of profit (earnings) the business has kept (retained) over the years. How is profit generated? When a business sells a product or service, the business generates revenue. When a business incurs costs associated with providing the product or service, the business generates an expense.

Revenue – Expenses = Profit

Once profits are generated the business can either keep those profits within the company to grow the business or protect against future downturns. The business can also choose to pay those profits out to the owners in the form of dividends or distributions. The profits that the business keeps are added to retained earnings.

Using the accounting equation to stay in balance

Let’s go back to the example we used above for contributed capital. You start a business by contributing $1,000 cash and a computer worth $500. Think about the exchange that is happening here. What is the business receiving? $1,000 cash and a computer. What are these? They are assets. The business is receiving $1,500 worth of assets. What is the business giving in exchange for these assets? It is giving you (the owner) $1,500 worth of capital (ownership) in the business. This value is considered contributed capital.

Accounting Equation 1

Our accounting equation is in balance. The business currently has $1,500 worth of assets and $1,500 worth of equity. There are currently no liabilities.

Let’s look at another transaction. The business takes out a loan for $10,000 to provide cash to purchase equipment and start operations. What is the business receiving? $10,000 cash. What is the business exchanging for that cash? The business is giving the bank a promise to pay in the future with assets generated from operations. This is a liability. A loan from the bank is more specifically called a note payable. Let’s add this to our existing balances.

Accounting Equation 2

The business now has $11,500 in assets, $10,000 in liabilities and $1,500 in equity. The equation still balances.

Let’s look at one more transaction. The business purchases a piece of equipment for $4,000 cash. Analyze the transaction to see what the business is receiving and exchanging. The business is receiving a piece of equipment worth $4,000 in exchange for $4,000 cash. Notice that both of these items are assets, therefore, we have one asset increasing and other decreasing.

Accounting Equation 3

*In accounting, a number in parenthesis indicates a negative number or a number that should be subtracted from the numbers around it. You will see this notation frequently.

Notice that the balances in our equation did not change. What did change was the makeup of the assets held by the business. In this part of the course, it is important to understand that the equation must be in balance at all times. As we progress through the course, we will look in greater detail at the individual accounts that make up total assets, liabilities and equity.

You will also notice that we have not yet dealt with revenue or expenses. Let’s look at the effect those transactions will have on the equation. The business does $1,000 worth of work for a client and gets paid when the work is complete. Again, analyze the transaction and determine how the accounting equation will be affected. The business got paid. What does that mean? The business received cash. It does not matter if the business was paid by check, credit card or cash; the payment will end up in the business bank account and the cash can be spent to generate future revenue. Why did the business receive cash? Because it provided a service for a client. Providing goods or services for a customer is called revenue. You will see many different titles for revenue accounts. Because this revenue was generated because a service was provided, you might call it service revenue or fees earned. As you progress through the course, learn the terminology used in your course but also make sure to realize that other terminology can be used.

Let’s add this transaction to the equation. Clearly an asset (cash) is increasing. How does the revenue effect the equation? We stated previously that profit increases equity. Profit is revenue less expenses, which means revenue increases profit and expenses decrease profit. Another way to look at the problem is to ask yourself if the revenue is increasing or decreasing the value of the business. Revenue coming in is good for the business and helps to increase its value. Therefore, revenue increases equity.

Accounting Equation 4

Still in balance! One more transaction to complete the lesson. We have looked at all the accounts except expenses. An expense is a cost of generating revenue. If the business rents an office, the cost of that office is an expense. How would we record the following transaction?

The business pays $400 cash for the current month’s office rent.

Analyze the transaction to determine the exchange. The business receives use of the office in exchange for $400 cash.

 

In this case, both sides of the equation decrease. An expense decreases equity because we are using up resources in the business which decreases the value of the business.

Accounting Equation 5

You’ll notice that we used three categories here because the accounting equation only has three: assets, liabilities and equity. I tell my students to think as if there are five categories, the three above, plus revenue and expenses. Revenue makes equity go up and expenses make equity go down. As we start to discuss journal entries, it is important to think of revenue and expenses as separate categories.

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