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Introduction to Accounting

Introduction to Accounting E-book

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Discussion topics
Introduction to accounting
Background Business Cycle Use of Financial Statements

Introduction to Accounting

Income Statement
Introduction

Accrual basis of accounting


Cash basis of accounting Revenue recognition principle Matching principle of costs

Balance Sheet
Introduction Accounting Equation Debit and Credit

Assets / Liabilities
Key Questions

Cash flow Statement


Introduction Calculating cash flow from operations, investing and finance

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Introduction to Accounting

Introduction to Accounting

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Starting a Business: some background


Kartik want to start a new business. Kartik sees the need for Movers and Packers business in Mumbai. He has researched this idea and has prepared a business plan that documents the viability of his new business Kartik met his lawyer friend to discuss the form of business he should use. Given his situation, they concluded that a corporation will be best form. Kartik names his company as FastTrack Inc?
What is a corporation?

Introduction to Accounting

What are other form of business types?

Kartik is a hard worker and a smart man, but admits he is not comfortable with matters of accounting

Kartik asks his banker to recommend a professional analyst who is skilled in explaining business accounting to someone without an accounting background
Kartik wants to understand financial statements and wants to keep on top of his new business Kartik asks you the following questions

What is business cycle?


Why do we use financial statements at all?

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What is a Business Cycle?


Simple Business Cycle for FastTrack Inc
Shareholder of the firm

Introduction to Accounting

Kartik Infuses Capital

Cash Inflow

Receives Money from Clients, Earns Profit/Loss

Uses the money to purchase trucks, inventory, pay labor and admin costs

Cash Outflow

Provides Service Movers and Packers

Kartik receives money from the clients Profit or Loss Kartik has following options
Kartik can reinvest the profit made in the business to expand his business or Can simply keep the money!

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Why do we use Financial Statements?


FastTrack Movers & Packers Transactions Based on Kartiks business plan, you now understand that there will likely be thousands of transactions each year Kartik seems puzzled by the term transaction, so you gives him five examples of transactions that FastTrack Inc will need to record:
Kartik will start his business by putting some of his own personal money into it. In effect, he is buying shares of FastTrack Inc common stock

Introduction to Accounting

FastTrack Inc will need to buy a few transport vehicles - truck


The business will begin earning fees and billing clients for relocating their parcels from one place to another

The business will be collecting the fees that were earned


The business will incur expenses in operating the business, such as a salary for Kartik, labors, expenses associated with packaging material, delivery vehicle, advertising, etc

With thousands of such transactions in a given year, Kartik is being advised to make an entry of these transactions in an accounting software on a daily basis

Why Accounting?
Understanding of companys profitability, assets and cash position Generate sales invoices and accounting entries

Prepare statements for customers with no additional work

Can you now explain Kartik, the content and purpose of the three main financial statements Income Statement, Balance Sheet and Cash Flow statement
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Introduction to Accounting

Income Statement

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Income Statement Jargons introduced!

The income statement shows the profit for the period of time under consideration

Introduction to Accounting

FastTrack Movers & Packers Inc. Income Statement, for year ended 31st December, 2007 Sales Cost of goods sold Gross Profit Selling,general and admin. expenses Income from operations Interest expense Income before taxes Net Income Earnings per share $ xxx $ xxx $ xxx $ xxx $ xxx $ xxx $ xxx $ xxx $ xxx

Revenues result from the entitys operating activities (selling merchandise, selling services)

Costs and expenses are incurred in generating revenues and operating the entity

The order of deduction of cost is as follows:

Cost of products sold


Sales, general and administrative costs Interest Expenses

Tax Expenses

Lets get back to our FastTrack Inc example


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FastTrack Movers & Packers Revenues


Case 1: Revenues

Introduction to Accounting

If Kartik delivers 200 parcels in December for $5 per delivery, he has technically earned fees totaling $1,000 for that month. He sends invoices to his clients for these fees and his terms require that his clients must pay by January 15
Even though Kartiks clients won't be paying FastTrack Inc until January 15, the accrual basis of accounting requires that the $1,000 be recorded as December revenues, since that is when the delivery work actually took place
What is accrual basis of accounting?

What is cash method of accounting?


What is revenue recognition principle?

After expenses are matched with these revenues, the income statement for December will show just how profitable the company was in delivering parcels in December

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FastTrack Movers & Packers Revenues


Case 2: Revenues

When Kartik receives the $1,000 worth of payment checks from his customers on January 15, he will make an accounting entry to show the money was received.

Introduction to Accounting

Receipts of $1,000 will not be considered to be January revenues, since the revenues were already reported as revenues in December when they were earned This $1,000 of receipts will be recorded in January as a reduction in Accounts Receivable (In December Kartik had made an entry to Accounts Receivable and to Sales) Dont worry, we will explain you this in a bit!

Case 3: Expenses

If Kartik hires some labor to help him with December deliveries and Kartik agrees to pay him $300 on January 3 and another $100 for pakaging and other supporting material; Total expenses of $400 expense for December deliveries
The actual date of payment of $400 does not matter What matters is when the work was done and when the corresponding expense was incurred

In our case work was done in December and hence, $400 expense is counted as a December expense even though the money will not be paid out until January 3
What is matching principle?

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Income Statement - Expenses


Case 4: Expenses

Introduction to Accounting

FastTrack Movers and Packers borrowed $20,000 from a bank to start his business on 1st December and the company agrees to pay 5% in interest, or $1,000. The interest is to be paid in a lump sum on December 1st of each year.
What is the monthly interest expense that is shown for Kartiks monthly income statement?

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Consolidating the Income Statement


FastTrack Income Statement as per the transaction discussed for the month of December, 2007
FastTrack Movers & Packers Inc. Income Statement, for month ended 31st December, 2007
Accrual basis of accounting

Introduction to Accounting

Sales Cost of goods sold Gross Profit Selling,general and admin. Expenses Income from operations Interest expense Income before taxes Income Tax @ 33% Net Income
Note 1: SG&A expense is assumed to be $30 in December,2007
1

$1,000 $400 $600 $30 $570 $83 $487 $161 $326

Concept of Matching Principle

Concept of Matching Principle

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Introduction to Accounting

Balance Sheet

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Balance Sheet Jargons reintroduced!


Snapshot" of a company's financial position at a given moment

Reports the amount of a company's


Assets Current assets/Long term assets Liabilities Current liabilities/Long term liabilities Stockholders' (or owner's) equity Common stock / Retained earnings
FastTrack Movers & Packers Inc Balance Sheet, December 31st 2007 Assets Current assets Cash Accounts Receivables Inventory Total current assets Long term assets Plant and Equipment Less:Acc depreciation Net PPE $ xxx ($ xxx) $ xxx $ xxx $ xxx $ xxx $ xxx Long term Liabilities Long term debt Stockholder's Equity Common Stock Retained Earnings Total Stockholder's Equity Total Assets $ xxx Liabilities & Stockholder's Equity $ xxx Liabilities & Stockholder's Equity Current Liabilities Short-term debt Accounts Payable Total current liabilities $ xxx $ xxx $ xxx

Introduction to Accounting

$ xxx $ xxx $ xxx $ xxx

Assets

Liability

Shareholders Equity

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Debits and Credits


Double Entry
Double entry is a 500-year-old accounting procedure
Double entry is a simple yet powerful concept and each and every transactions will result in an amount recorded into at least two of the accounts in the accounting system

Introduction to Accounting

Debit and Credit


Double entry system requires that the same dollar amount of the transaction must be entered on both the left side of one account, and on the right side of another account
Assets = Liability + Shareholders Equity

Left means Debit!


Right means Credit!

Remember these simple tips:


Increase in assets DEBIT Decrease in assets CREDIT Increase in Liability & Equity CREDIT Decrease in Liability & Equity - DEBIT

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Balance Sheet
Case 5: Cash and Common Stock

Introduction to Accounting

On December 1, 2007 Kartik starts his business FastTrack Movers and Packers. The first transaction that Kartik will record for his company is his personal investment of $20,000 in exchange for 5,000 shares of FastTrack Movers & Packers common stock. There are no revenues because no delivery fees were earned by the company, and there were no expenses.
FastTrack Movers & Packers Inc Balance Sheet, December 1st 2007 Assets Cash $20,000 Liabilities & Stockholder's Equity Liabilities Stockholder's Equity Common Stock Total Assets $20,000 $0

$20,000 $20,000

Cash from Kartiks personal investment

Increase in its stockholders' equity account Common Stock by $20,000

Shareholders Equity
Common Stock will be increased when the corporation issues shares of stock in exchange for cash (or some other asset) Retained Earnings will increase when the corporation earns a profit and there will be a decrease when the corporation has a net loss

Core link between a company's balance sheet and income statement

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Balance Sheet
Case 5: Cash and Common Stock

Introduction to Accounting

On December 1, 2007 Kartik starts his business FastTrack Movers and Packers. The first transaction that Kartik will record for his company is his personal investment of $20,000 in exchange for 5,000 shares of FastTrack Movers & Packers common stock. There are no revenues because no delivery fees were earned by the company, and there were no expenses.
FastTrack Movers & Packers Inc Balance Sheet, December 1st 2007 Assets Cash $20,000 Liabilities & Stockholder's Equity Liabilities Stockholder's Equity Common Stock Total Assets $20,000 $0

$20,000 $20,000

Cash from Kartiks personal investment

Increase in its stockholders' equity account Common Stock by $20,000

Debit and Credit


Assets = Liability + Shareholders Equity Common Stock increases by $20,000

Cash increases by $20,000

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Balance Sheet
Case 6: Purchase of Vehicle

On December 2, FastTrack Movers & Packers purchases a truck for $14,000 by writing a check for $14,000. The two accounts involved are Cash and Vehicles (or Delivery Truck)

Introduction to Accounting

FastTrack Movers & Packers Inc Balance Sheet, December 2nd 2007 Assets Cash Vehicle $6,000 $14,000 Liabilities & Stockholder's Equity Liabilities Stockholder's Equity Common Stock Total Assets $20,000 $0

$20,000 $20,000

Cash reduces to $6,000 and vehicle account increases to $14,000

No change in stockholders position

Kartik also needs to know that the reported amounts on his balance sheet for assets such as equipment, vehicles, and buildings are routinely reduced by depreciation What is Depreciation
Matching principle? Depreciation of land?

The accountant might match $2,800 ($14,000 5 years) of depreciation expense with each year's revenues for five years
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Balance Sheet
Case 6: Purchase of Vehicle

On December 2, FastTrack Movers & Packers purchases a truck for $14,000 by writing a check for $14,000. The two accounts involved are Cash and Vehicles (or Delivery Truck)

Introduction to Accounting

FastTrack Movers & Packers Inc Balance Sheet, December 2nd 2007 Assets Cash Vehicle $6,000 $14,000 Liabilities & Stockholder's Equity Liabilities Stockholder's Equity Common Stock Total Assets $20,000 $0

$20,000 $20,000

Cash reduces to $6,000 and vehicle account increases to $14,000

No change in stockholders position

Debit and Credit?


Assets

Liability

Shareholders Equity

Vehicle asset increases by $14,000

Cash decreases by $14,000 All Rights Reserved. Corporate Bridge

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Balance Sheet
Case 7: Prepaid Expenses

Introduction to Accounting

On December 2 when Kartik contacts an insurance agent regarding insurance coverage for the Truck just purchased. The agent informs him that $1,200 will provide insurance protection for the next one year. Kartik immediately writes a check for $1,200.
FastTrack Movers & Packers Inc Balance Sheet, December 2nd 2007 Assets Cash Prepaid Insurance Vehicle Total Assets $4,800 $1,200 $14,000 $20,000 Stockholder's Equity Common Stock $20,000 $20,000 Liabilities & Stockholder's Equity Liabilities $0

Cash reduces further to $4,800 and Prepaid insurance account increases to $1,200

No change in stockholders position

Between Dec 1st & Dec 31st, $100 worth of insurance premium is "used up" or "expires"

The expired amount will be reported as Insurance Expense on December's income statement
The remaining portion of unexpired insurance premium is reported as Pre-paid Insurance
What is the remaining portion of Pre-paid insurance as of Dec 31st , 2007?

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Balance Sheet
Case 7: Prepaid Expenses

Introduction to Accounting

On December 2 when Kartik contacts an insurance agent regarding insurance coverage for the Truck just purchased. The agent informs him that $1,200 will provide insurance protection for the next one year. Kartik immediately writes a check for $1,200.
FastTrack Movers & Packers Inc Balance Sheet, December 2nd 2007 Assets Cash Prepaid Insurance Vehicle Total Assets $4,800 $1,200 $14,000 $20,000 Stockholder's Equity Common Stock $20,000 $20,000 Liabilities & Stockholder's Equity Liabilities $0

Cash reduces further to $4,800 and Prepaid insurance account increases to $1,200

No change in stockholders position

Debit and Credit?


Assets
=

Liability

Shareholders Equity

Prepaid insurance increases by $1,200

Cash decreases by $1,200 All Rights Reserved. Corporate Bridge

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Balance Sheet
Case 4 Revisited : Raising Debt

Introduction to Accounting

FastTrack Movers and Packers borrowed $20,000 from a bank to start his business on 1st December and the company agrees to pay 5% in interest, or $1,000. The interest is to be paid in a lump sum on December 1st of each year.
FastTrack Movers & Packers Inc Balance Sheet, December 3rd 2007 Assets Cash Prepaid Insurance $24,800 $1,200 Liabilities & Stockholder's Equity Liabilities Long term debt Stockholder's Equity Common Stock Liabilities & Stockholder's Equity $0 $20,000

Vehicle Total Assets

$14,000 $40,000

$20,000 $40,000

Cash increases by $20,000 (amount of debt raised from the bank)

Long term debt raised from the bank

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Balance Sheet
Case 4 Revisited : Raising Debt

Introduction to Accounting

FastTrack Movers and Packers borrowed $20,000 from a bank to start his business on 1st December and the company agrees to pay 5% in interest, or $1,000. The interest is to be paid in a lump sum on December 1st of each year.
FastTrack Movers & Packers Inc Balance Sheet, December 3rd 2007 Assets Cash Prepaid Insurance $24,800 $1,200 Liabilities & Stockholder's Equity Liabilities Long term debt Stockholder's Equity Common Stock Liabilities & Stockholder's Equity $0 $20,000

Vehicle Total Assets

$14,000 $40,000

$20,000 $40,000

Cash increases by $20,000 (amount of debt raised from the bank)

Long term debt raised from the bank

Debit and Credit


Assets = Liability + Shareholders Equity Long term debt increases by $20,000

Cash increases by $20,000

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Balance Sheet
Case 8: Inventory

Introduction to Accounting

Kartik keeps an inventory of packing boxes not only to use it for his business but also earn additional revenues by carrying an inventory of packing boxes to sell. Let's say that FastTrack Movers and Packers purchased 1,000 boxes wholesale for $1.00 each.
FastTrack Movers & Packers Inc Balance Sheet, December 3rd 2007 Assets Cash Prepaid Insurance Inventory $23,800 $1,200 $1,000 Liabilities & Stockholder's Equity Liabilities Long term debt Stockholder's Equity Common Stock $0 $20,000

$20,000

Vehicle Total Assets

$14,000 $40,000 Liabilities & Stockholder's Equity $40,000

Cash decreases by $1,000 and inventory increases by $1,000

No change

On 10th December, wholesale price of boxes has been risen by 20% & at today's price Kartiks could purchase them for $1.20 each. What is the value of inventory shown on balance sheet?
What is Cost Principle?

Lets say that since the time Kartik bought inventory, the wholesale price of boxes has been cut by 40% and at today's price he could purchase them for $0.60 each. What is the value of inventory shown on the balance sheet in this case?
What is the principle of Conservatism?

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Balance Sheet
Case 8: Inventory

Introduction to Accounting

Kartik keeps an inventory of packing boxes not only to use it for his business but also earn additional revenues by carrying an inventory of packing boxes to sell. Let's say that FastTrack Movers and Packers purchased 1,000 boxes wholesale for $1.00 each.
FastTrack Movers & Packers Inc Balance Sheet, December 3rd 2007 Assets Cash Prepaid Insurance Inventory $23,800 $1,200 $1,000 Liabilities & Stockholder's Equity Liabilities Long term debt Stockholder's Equity Common Stock $0 $20,000

$20,000

Vehicle Total Assets

$14,000 $40,000 Liabilities & Stockholder's Equity $40,000

Cash decreases by $1,000 and inventory increases by $1,000

No change

Debit and Credit?


Assets = Liability + Shareholders Equity

Inventory asset increases by $1,000

Cash decreases by $1,000 All Rights Reserved. Corporate Bridge


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Balance Sheet
Case 9: Unearned Revenues

Introduction to Accounting

In addition to 200 parcels delivered by FastTrack Movers and Packers in December, they enters into an agreement with one of its customers stipulating that the customer prepays $600 in return for the delivery of 30 parcels every month for 6 months. Assume FastTrack Movers & Packers receives $600 payment on Dec 1,2007 for deliveries to be made between Dec 1,2007 and May 31,2007
FastTrack Movers & Packers Inc Balance Sheet, December 4th 2007 Assets Cash Prepaid Insurance Inventory $24,400 $1,200 $1,000 Liabilities & Stockholder's Equity Liabilities Unearned Revenue Long term debt Stockholder's Equity Common Stock Liabilities & Stockholder's Equity $0 $600 $20,000

Vehicle Total Assets

$14,000 $40,600

$20,000 $40,600

Cash increases by $600

Liability increases by $600

Other liabilities

For the loan Kartik received from Bank (Notes Payable or Loan Payable), the interest on the loan he owes to his bank (Interest Payable)
Amount he owes to the supply store for items purchased on credit (Accounts Payable)

Wages he owes an employee but hasn't yet paid to him (Wages Payable)

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Balance Sheet
Case 9: Unearned Revenues

Introduction to Accounting

In addition to 200 parcels delivered by FastTrack Movers and Packers in December, they enters into an agreement with one of its customers stipulating that the customer prepays $600 in return for the delivery of 30 parcels every month for 6 months. Assume FastTrack Movers & Packers receives $600 payment on Dec 1,2007 for deliveries to be made between Dec 1,2007 and May 31,2007
FastTrack Movers & Packers Inc Balance Sheet, December 4th 2007 Assets Cash Prepaid Insurance Inventory $24,400 $1,200 $1,000 Liabilities & Stockholder's Equity Liabilities Unearned Revenue Long term debt Stockholder's Equity Common Stock Liabilities & Stockholder's Equity $0 $600 $20,000

Vehicle Total Assets

$14,000 $40,600

$20,000 $40,600

Cash increases by $600

Liability increases by $600

Debit and Credit


Assets = Liability + Shareholders Equity Unearned revenues increases by $600

Cash increases by $600

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Missing links
Accounts Receivables
Case 1&2: Revenues

Introduction to Accounting

If Kartik delivers 200 parcels in December for $5 per delivery, he has technically earned fees totaling $1,000 for that month. He sends invoices to his clients for these fees and his terms require that his clients must pay by January 15
Accounts Payable
Case 3: Expenses

If Kartik hires some labor to help him with December deliveries and Kartik agrees to pay him $300 on January 3 and another $100 for pakaging and other supporting material; Total expenses of $400 expense for December deliveries
Interest Payable
Case 4: Expenses

FastTrack Movers and Packers borrowed $20,000 from a bank to start his business on 1st December and the company agrees to pay 5% in interest, or $1,000. The interest is to be paid in a lump sum on December 1st of each year.
Balance Sheet Assets = Liabilities + Owners' Equity Net income = Income Statement Revenues Expenses

The arrow indicates that net income affects retained earnings, which is a component of owners equity
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Consolidating all cases in Income Statement


FastTrack Movers & Packers Inc. Income Statement, for month ended 31st December, 2007

Introduction to Accounting

Sales Cost of goods sold Gross Profit Selling,general and admin. Expenses Depreciation Expense Insurance Expense Income from operations Interest expense Income before taxes Income Tax @ 33% Net Income
Note 1: SG&A expense is assumed to be $30 in December,2007
1

$1,100 $400 $700 $30 $233 $100 $337 $83 $254 $84 $170

Case 1 (accrual) + Case 9 (earned revenue for December)

Case 6, monthly depreciation = $2,800/12 = $233

Case 7, insurance premium worth $1,200/12 =$100 is utilized per month

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Consolidated Balance Sheet


FastTrack Movers & Packers Inc Balance Sheet, December 31st 2007

Introduction to Accounting

Assets Current assets Cash Prepaid Insurance Accounts Receivable Inventory Total Current Assets Vehicle Accumulated depreciation Net

$24,370 $1,100 $1,000 $1,000 $27,470 $14,000 $233 $13,767

Liabilities & Stockholder's Equity Current Liabilities Unearned Revenue Accounts Payable Interest Payable Income Tax Payable Total Current liabilities Long term debt Stockholder's Equity Common Stock Retained Earnings

$500 $400 $83 $84 $1,067 $20,000


Unpaid expenses, classified as liabilities

$20,000 $170 $41,237


Net Income Flows through the Income Statement

Total Assets
Insurance premium worth $1,200/12 =$100 is utilized for December

$41,237

Liabilities & Stockholder's Equity

Cash receipt on January 15th, however, sales has been completed and booked as Accounts Receivables

Revenues worth $100 earned in December, hence Unearned revenue of $600 adjusted for the earned revenues

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Balance Sheet Key questions?


Balance sheet shows the companys assets worth?
YES? NO?

Introduction to Accounting

Balance sheet does not provide us with the fair market value of the company?
Long-term assets reported at their cost minus amounts already sent to Income Statement as depreciation expense The asset Land is not depreciated, so it will appear at its original cost even if the land is now worth one hundred times more than its cost However, Short-term asset amounts are likely to be close to their market values, since they tend to "turn over" in relatively short periods of time

Is reputation cost captured in Balance Sheet Brand, Logo etc?


Bill Gates Nike BMW

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Introduction to Accounting

Cash Flow Statement

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Private and Confidential Not for Circulation

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Cash Flow Statement Cash is the King!


Purpose of this cash flow statement is to identify sources & uses of cash during the year Cash Flow is divided into three parts
Cash flow from operations: Include all the transactions and other events related to its earnings process

Introduction to Accounting

Cash flow from Investments: Include all the transactions involving acquiring and selling long-term investment, property, plant, and equipment
Cash Flow from Finance: Include all the transactions involved in obtaining and disbursing resources from and to owners and repaying the amounts borrowed

Net Cash

Cash flow from Operations


Cash Inflows: Generation of funds in normal operations Cash Outflows: Expenditure of funds in normal operations

Cash flow from Investing


Cash Inflows: Sale of plants and equipments Liquidation of long term investments Cash Outflows: Purchase of plants and equipments Investments in long term investments

Cash flow from Finance


Cash Inflows: Debt issuance, common stock, preferred stock and other securities Cash Outflows: Retirement of debt, common stock and preferred stock Payment of cash dividend

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Calculating Cash flows


Cases Cash Impact (yes/no) No No No No Yes Yes Yes Yes Yes Yes Yes Cash Amount $0 $0 $0 $0 $20,000 $20,000 ($14,000) ($1,200) ($1,000) $600 ($30) $24,370 ($1,630) ($14,000) $40,000 $24,370 Classification Operation Operation Operation Operation Finance Finance Investing Operation Operation Operation Operation Comments Revenues earned but not paid Revenues earned but not paid Expenses incurred but not paid Interest expense incurred but not paid FastTrack borrows from the bank Kartik infuses capital Purchase of truck Prepaid expenses Purchase of Inventory (boxes) Customer Prepays SG&A expenses incurred and paid

Introduction to Accounting

Case 1 Case 2 Case 3 Case 4 Case 4 Case 5 Case 6 Case 7 Case 8 Case 9 Others Cash flows

Cash flow from operations Cash flow from investing Cash flow from financing Total Change in cash

End Cash

Cash at the beginning

Change in cash during the period

Flows into the Balance Sheet as Cash

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Introduction to Accounting

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