BUS103: Introduction to Financial Accounting

This appendix shows how a work sheet could be used to assist in preparing a statement of cash flows. We use the comparative balance sheets, income statement, and additional data for the Welby Company, shown on Exhibit 53, as the basis for this example.

Look at the working paper in Exhibit 56 for Welby Company, which we use to analyze the transactions and prepare the statement of cash flows. While discussing the steps in preparing the working paper, we describe the items and trace their effects in the entries.

• Enter the beginning account balances of all balance sheet accounts in the first column and the ending account balances in the fourth column. Notice that the debit items precede the credit items.
• Total the debits and credits in the first and fourth columns to make sure that debits equal credits in each column.
• Write "Cash Flows from Operating Activities" immediately below the total of the credit items. Skip sufficient lines for recording adjustments to convert accrual net income to cash flows from operating activities. Then write "Cash Flows from Investing Activities" and allow enough space for those items. Finally, write "Cash Flows from Financing Activities" and allow enough space for those items.
• Enter entries for analyzing transactions in the second and third columns. The entries serve two functions: (a) they explain the change in each account; and (b) they classify the changes into operating, investing, and financing activities. We discuss these entries individually in the next section.
• Total the debits and credits in the second and third columns; they should be equal. You will have one pair of totals for the balance sheet items and another pair for the bottom portion of the working paper. We use the bottom portion of the working paper to prepare the statement of cash flows.

To complete the working paper in Exhibit 56, we must analyze the change in each noncash balance sheet account. The focus of this working paper is on cash, and every change in cash means a change in a noncash balance sheet account. After we have made the proper entries to analyze all changes in noncash balance sheet accounts, the working paper shows all activities affecting cash flows. The following explanations are keyed to the entry numbers on the working paper:

Entry 0 In comparing the beginning and ending cash balances, we determine the change in the Cash account during the year is an USD 11,000 increase. An entry on the working paper debits Cash for USD 11,000 and credits Increase in Cash for Year near the bottom of the schedule. This 0 entry does not explain the change in cash but is the "target" of the analysis. The entry sets out the change in cash that the statement seeks to explain. No further attention need be paid to cash in completing the working paper.

We now direct our attention toward changes in other balance sheet accounts. These accounts can be dealt with in any order; first, we record the net income for the period and analyze the current assets (other than cash) and the current liabilities. Second, we analyze the changes in the noncurrent accounts.

Entry 1 The income statement shows a net income for 2010 of USD 10,000. Entry 1 records the USD 10,000 as the starting point in measuring cash flows from operating activities and credits Retained Earnings as a partial explanation of the change in that account.

The next task is to analyze changes in current accounts other than Cash. The current accounts of Welby Company are closely related to operations, and their changes are included in converting net income to cash flows from operating activities.

Entry 2 We deduct the USD 10,000 increase in accounts receivable from net income when converting it to cash flows from operating activities. If accounts receivable increased, sales to customers exceeded cash received from customers. To convert net income to a cash basis, we must deduct the USD 10,000.

The working paper technique makes the recording of these effects almost mechanical. By debiting Accounts Receivable for USD 10,000, we increase it from USD 20,000 to USD 30,000. If Accounts Receivable is debited, we must credit an item that can be entitled "Increase in Accounts Receivable". We deduct the increase from net income in converting it to cash flows from operating activities.

Entry 3 is virtually a duplicate of entry 2, except it involves merchandise inventory rather than receivables and is a decrease rather than an increase.

Entry 4 records the effect of a decrease in accounts payable on net income in converting it to cash flows from operating activities.

Entry 5 records the effect of an increase in accrued liabilities payable in converting net income to cash flows from operating activities.

Next, we analyze the changes in the noncurrent balance sheet accounts.

Entry 6 We add the USD 5,000 depreciation back to net income and credit the respective accumulated depreciation account. You can find the depreciation expense (1) on the income statement, or (2) by solving for the credit needed to balance the accumulated depreciation account on the balance sheet.

 
Exhibit 56: Working paper for statement of cash flows

Entry 7 We debit the Equipment account and credit "Purchase of Equipment" in the investing activities section for the USD 20,000 cash spent to acquire new plant assets (equipment).

Entry 8 We show the USD 30,000 cash received from sale of common stock as a financing activity. The entry also explains the change in the Common Stock account. If stock had been sold for more than its stated value of USD 50 per share, we would record the excess in a separate Paid-In Capital in Excess of Stated Value account. However, we would report the total amount of cash received from the issuance of common stock as a single figure on the statement of cash flows. Only this total amount received is significant to creditors and other users of the financial statements trying to judge the solvency of the company.

Entry 9 We debit Retained Earnings and credit Payment of Cash Dividends for the USD 4,000 dividends declared and paid. The entry also completes the following explanation of the change in Retained Earnings. Notice that on the statement of cash flows, the dividends must be paid to be included as a cash outflow from financing activities.

Using the data in the lower section of the working paper, we would prepare the statement of cash flows under the indirect method shown in Exhibit 54 (Part B).