UNIT 3

Study objectives
Statement of Cash Flows
Taxation of bussiness
Source of bussiness finance
Cost systems, flow of cost
Similarities and differenes between job
order and process cost systems

1
 Statement of Cash Flows
After studying this topic, you should be able to:
• Indicate the usefulness of the statement of cash
flows.
• Distinguish among operating, investing, and
financing activities.
• Prepare a statement of cash flows using one of
two approaches:
– (a) the indirect method, or
– (b) the direct method.
• Use the statement of cash flows to evaluate a
company. 2
 The Primary Purpose of the
Statement of Cash Flows Is...
• To provide information about:
– cash receipts,
– cash payments, and
– the net change in cash resulting from:
•operating,
•investing, and
•financing activities of a
company during a period.
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Questions the Statement of Cash
Flow Answers

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 Operating Activities...

Include:
– The cash effects of transactions that create
revenues and expenses and
– Enter into determination of net income.

In volve Income S tatement

Items
5
 Investing Activities...

Include:
– Purchasing and disposing of investments
and productive long-term (fixed) assets
using cash and
– Lending money and collecting the loans.

Inv olv e In vest ments and

Noncurrr ent As set I tems
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 Financing Activities...

Include:
– Obtaining cash from issuing debt and repaying
the amounts borrowed and
– Obtaining cash from stockholders and paying
dividends.

Involv e Noncurr ent Liability

and Stockhold ers’ E quit y
Items 7
 Types of Cash Flows -
Operating Activities
• Cash inflows:
– From sale of goods or services
– From return on loans (interest received) and on
equity securities (dividends received)
• Cash outflows:
– To suppliers for inventory
– To employees for services
– To government for taxes
– To lenders for interest
– To others for expenses

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 Types of Cash Flows -
Investing Activities
• Cash inflows:
– From sale of property, plant, and equipment
– From sale of debt or equity securities of other entities
– From collection of principal on loans to other entities
• Cash outflows:
– To purchase property, plant, and equipment
– To purchase debt or equity securities of other entities
– To make loans to other entities

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 Types of Cash Flows -
Financing Activities
• Cash inflows:
– From sale of equity securities (company's own
stock)
– From issuance of debt (bonds and notes)
• Cash outflows:
– To stockholders as dividends – disbursment of
dividends

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Operating Activities -exceptions
• Some cash flows relating to investing or
financing activities are classified as
operating activities. For example...
– Receipts of investment revenue (interest
and dividends) and - inflows
– Payments of interest to lenders are
classified as operating activities because
these items are reported in the income
statement.-outflows
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 Significant
Noncash Activities...
• That do NOT affect cash are NOT reported
in the body of the statement of cash flows.
• Are reported:
– In a separate schedule at the bottom of the
statement of cash flows or
– In a separate note or supplementary
schedule to the financial statements.

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 Significant
Noncash Activities...
1. Issuance of common stock to purchase
assets.
2. Conversion of bonds into common stock.
3. Exchanges of plant assets.

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 Let’s Review
Which is an example of a cash flow from an
operating activity?

a. Payment of cash to lenders for interest.

b. Receipt of cash from the sale of capital stock.
c. Payment of cash dividends to the company’s
stockholders.
d. None of the above.
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 Let’s Review
Which is an example of a cash flow from an
operating activity?

a. Payment of cash to lenders for interest.

b. Receipt of cash from the sale of capital stock.
c. Payment of cash dividends to the company’s
stockholders.
d. None of the above.
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 Format of the
Statement of Cash Flows
Three parts:
– operating
– investing
– financing

Plus significant noncash investing and

financing activities in separate schedule
or at bottom of the statement of cash
flows. 16
 Format of the Statement of Cash
Flows
Three activities:
– operating
– investing Body of
Statement
– financing
PLUS
– noncash investing and financing activities

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 Why Report the Causes of Changes
in Cash?
Because investors, creditors, and
other interested parties want to know
what is happening to a company’s
most liquid asset:

CAS H 18
 Statement of Cash Flows Helps
Users Evaluate
1. The entity's ability to generate future cash flows.
2. The entity's ability to pay dividends and meet
obligations.
3. The reasons for the difference between net income
and net cash provided (used) by operating activities.
4. The investing and financing transactions during the
period.

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Statement of Cash Flows Helps Answer
the Following Questions
• How did cash increase when there was a net
loss for the period?
• How were the proceeds of the bond issue used?
• How was the expansion in the plant and
equipment financed?
• Why were dividends not increased?
• How much money was borrowed during the
year?
• Is cash flow greater or less than net income?
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 Sources of Information for the
Statement of Cash Flows
• Comparative balance sheet - Indicates the amount of changes in assets,
liabilities, and stockholders' equities from the beginning to the end of the
period.

• Current income statement - Information in this statement helps the reader

determine the amount of cash provided or used by operations during the
period.

• Additional information

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 Tec hn olo gy Se rvic es Comp any
Com pa rativ e B al an ce Sh ee t
Dec em ber 31, 2 00 5

Assets Dec. 31, Jan.1, Increase/Decrease

2005 2005
Cash $34,000 $0 $34,000 increase
Accounts rec. 30,000 0 30,000 increase
Equipment 10,000 0 10,000
Total $74,000 $0 increase

Liabilities
and
stockholders’
equity $4,000 $0 $4,000 increase
Common payable
Accounts stock 50,000 0 50,000 increase
Retained 20,000 0 20,000 increase
earnings
Total $74,000 $0
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 Income Statement and Additional
Information
Technology Services Company
Income Statement
For the Year Ended December 31, 2005
Revenues $85,000
Operating expenses 40,000
Income before income taxes 45,000
Income tax expense 10,000
Net income $35,000
Additional Information:
(a) Examination of selected data indicates
that a dividend of $15,000 was declared and paid
during the year.
(b) The equipment was purchased at the
end of 2005. No depreciation was taken in 2005.
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3 Major Steps in Preparing the
Statement of Cash Flows

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 Indirect and Direct Methods
• Convert net income from an accrual
basis to a cash basis.
• This conversion may be done
by two methods:
– Indirect (99%)
– direct

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 Indirect and Direct Methods
• Both methods arrive at the same total
amount for “Net cash provided by
operating activities”.
• The methods differ in disclosing the
items that make up the total amount.
• The choice of methods affects only the
operating activities section; the
investing and financing activities
sections are the same.
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 Indirect Method
• The indirect method is used extensively in
practice.
• Most companies favor the indirect
method for the following reasons:
– it is easier to prepare.
– it focuses on the differences between net
income and net cash flow from operating
activities.
– it tends to reveal less company information
to competitors. 27
Statement Of Cash Flows - Indirect
Method exercise
• The transactions of Technology Services
Company for the year ended 2005 are used to
illustrate the preparation of a statement of cash
flows .
• Technology Services Company started in
January 1, 2005, when it issued 50,000 shares of
$1 par value common stock for $50,000 cash.
• The company rented its office space and
furniture and performed consulting services
throughout the first year.
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 Determine Net Cash Provided/Used By
Operating Activities
• Adjust net income for items that did not
affect cash.
• Net income must be converted because
earned revenues may include credit sales
that have not been collected in cash and
expenses incurred that may not have been
paid in cash.

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Determine Net Cash Provided/Used By
Operating Activities

Determinations that affect net

income are:
Receivables, payables, prepayments,
and inventories must be analyzed for
their effects on cash.

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Determine Net Cash Provided/Used By
Operating Activities
• Technology Services Company had revenues
of $85,000 in its first year of operations.
• However, TSC collected only $55,000 in cash.
Accrual basis revenue was $85,000, cash
basis revenue would be $55,000.
• The increase in accounts receivable of
$30,000 must be deducted from net income.
• If accounts receivable decrease, the decrease
must be added to net income.
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 Technology Services Company
Statement of Cash Flows--Indirect Method (Partial)
For the Year Ended December 31, 2005

Cash flows from operating activities

Net income $35,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Increase in accounts receivable $(30,000)

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 Determine Net Cash Provided/Used By
Operating Activities
• Accounts payable - When accounts payable increase
during a year, operating expenses on an accrual basis
are higher than they are on a cash basis.
• For TSC, operating expenses reported in the income
statement were $40,000.
• Since Accounts Payable increased $4,000, $36,000
($40,000 – $4,000) of the expenses were paid in cash.
• To convert net income to net cash provided by
operating activities, an increase in accounts payable
must be added to net income, a decrease subtracted.

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 Technology Services Company
Statement of Cash Flows--Indirect Method (Partial)
For the Year Ended December 31, 2005

Cash flows from operating activities

Net income $35,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Increase in accounts receivable $(30,000)
Increase in accounts payable 4,000
(26,000)
Net cash provided by operating activities $ 9,000

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 Determine Net Cash Provided/Used By
Investing and Financing Activities
• No data are given for the increases in Equipment
of $10,000 and Common Stock of $50,000. Assume
any differences involve cash.
• The increase in equipment is from a purchase of
equipment for $10,000 cash. This purchase is
reported as a cash outflow in the investing
activities section.
• The increase of common stock results from the
issuance of common stock for $50,000 cash. It is
reported as an inflow of cash in the financing
activities section of the statement of cash flows.
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 Technology Services Company
Comparative Balance Sheet
December 31, 2005

Assets Dec. 31, Jan.1, Increase/Decrease

2005 2005
Cash $34,000 $0 $34,000 increase
Accounts rec. 30,000 0 30,000 increase
10,000 0 10,000
Equipment
Total $74,000 $0 increase

Liabilities
and
stockholders’
equity $4,000 $0 $4,000 increase
Common payable
Accounts stock 50,000 0 50,000 increase
Retained earnings 20,000 0 20,000 increase

l
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 Determine Net Cash Provided/Used By
Investing and Financing Activities
• Reasons for the increase of $20,000 in the
Retained Earnings.
– Net income increased retained earnings by
$35,000. REPORTED IN THE OPERATING
ACTIVITIES SECTION.
– The additional information indicates that a
cash dividend of $15,000 was declared and
paid. REPORTED IN THE FINANCING
ACTIVITIES SECTION.

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 Technology Services Company
Statement of Cash Flows--Indirect Method (Partial)
For the Year Ended December 31, 2005
Cash flows from operating activities
Net income $35,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Increase in accounts receivable $(30,000)
Increase in accounts payable 4,000
(26,000)
Net cash provided by operating activities $
9,000
Cash flows from investing activities
Purchase of equipment (10,000
Cash flows from financing activities
Issuance of common stock $50,000
Payment of cash dividends (15,000)
Net cash provided by financing activities 38
Major Classes of Cash Receipts and Payments --
Direct Method

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Formula to Compute Cash Receipts from
Customers-Direct Method

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Formula to Compute Cash Payment to Suppliers-
Direct Method

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Formula to Compute Cash Payments for
Operating Expenses-Direct Method

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 Technology Services Company
Statement of Cash Flows--Direct Method (Partial)
For the Year Ended December 31, 2005

Cash flows from operating activities

Cash receipts from customers $ 765,000
Cash payments
To supplier $550,000
For operating expenses 158,000
For income taxes 48,000 756,00
Net cash provided by operating activities $ 9,000

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 Free Cash Flow
• In the Statement of Cash Flows, cash from
operations is intended to indicate the cash-
generating capability of the company.
• Statement of Cash flows fails to take into
account that a company must invest in new
fixed assets to maintain its current level of
operations and it must maintain dividends
at current levels to satisfy investors.

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 Free Cash Flow

Cash Provided By Operations

– Capital Expenditures
– Dividends Paid

Free Cas h Flow

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 Using Cash Flows
to Evaluate a Company
The 2001 statement of cash flows of Microsoft Corporation
provides information for the computations of these measures.
MICROSOFT CORPORATION
STATEMENT OF CASH FLOWS (PARTIAL)
2001
Cash flows from operations $13,422
Additions to property, plant,
and equipment $ (1,103)
Other assets and investments ( 66,346)
Short-term investments 58,315
Cash used by investing activities
(9,134)
Cash paid for dividends on preferred stock 46
 MICROSOFT CORPORATION
STATEMENT OF CASH FLOWS (Partial)
2001
Cash flows from operations 13,422
Less: Expenditures on property, plant,
and equipment 1,103
Dividends 0
Free Cash Flow 12,319

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II. Financial Statement Analysis
• Describe and apply horizontal analysis.
• Describe and apply vertical analysis.
• Identify and compute ratios used in
analyzing a company’s liquidity,
solvency, and profitability.
• Understand the concept of quality of
earnings.

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 Comparative Analysis
1. Any item reported in a financial statement
indicates that the item exists at a given time
and in a certain quantity.(For example, when
Kellogg Company reports $140 million on its
balance sheet as cash, we know that Kellogg
did have cash and that the quantity was $140
million.

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 Comparative Analysis
2.Whether the amount represents an increase/decrease over prior years, or
whether it is adequate in relation to the company's needs, cannot be
determined from the amount alone.
3. The amount must be compared with other financial data to provide more
information.
4. There are three types of comparisons to provide decision usefulness of
financial information:
• Intracompany basis - Comparisons within a company are often useful to
detect changes in financial relationships and significant trends.
• Intercompany basis- Comparisons with other companies provide insight
into a company's competitive position
• Industry averages - Comparisons with industry averages provide
information about a company's relative position within the industry.

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 Financial Statement Analysis
Three basic tools are used in financial statement
analysis :
• Horizontal analysis- Is a technique for evaluating a series of financial
statement data over a period of time. Its purpose is to determine whether
The increase or
an increase or decrease has taken place.
decrease can be expressed as either an
amount or a percentage.
• Vertical analysis-
• Ratio analysis
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Horizontal Analysis- example
The percentage change in sales for each of the 5 years,
assuming 1997 as the base period is:
Kellogg Company
Net Sales (in millions) Base Period 1997
2001 2000 1999 1998 1997
$8,853.3 $6,954.7 $6,984.2 $6762.1 $6,830.1
129.62% 101.82 % 102.26% 99% 100.0%

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 Horizontal Analysis
of a Balance Sheet - exercise
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)
Increase (Decrease)
during 2001
2001 2000 Amount Percent
Assets
Current Assets $ 1,902.0 $1,617.1 $ 284.9 17.6
Plant assets 2,952.8 2,526.9 425.9 16.9
Other assets 5,513.8 742.0 4,771.8 643.1
Total assets $10,368.6 $4,886.0 $5,482.6 112.2

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 Vertical Analysis
• Is a technique for evaluating financial
statement data that expresses each item in a
financial statement as a percent of a base
amount.
• Total assets is always the base amount in
vertical analysis of a balance sheet.
• Net sales is always the base amount in
vertical analysis of an income statement.

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 Vertical analysis - example
KELLOGG COMPANY, INC.
Condensed Balance Sheets
December 31
(In millions)

2001 2000 z
Assets Amount Percent Amount Percent
Current Assets $ 1,902.0 18.3 $1,617.1 33.1
Property Assets 2,952.8 28.5 2,526.9 51.7
Other assets 5,513.8 53.2 742.0 15.2
Total assets $10,368.6 100.0% $4,886.0 100.0%

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 Ratio Analysis
• Three types:
Liquidity ratios
Solvency ratios
Profitability ratios
• Can provide clues to underlying conditions that may
not be apparent from an inspection of the individual
components.
• Single ratio by itself is not very meaningful.

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 Liquidity Ratios
• Definition: Measure the short-term ability
of the enterprise to pay its maturing
obligations and to meet unexpected needs
for cash.
• Aimed to: Short-term creditors such as
bankers and suppliers

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 Liquidity Ratios
• Working capital- Indicates immediate short-term debt-paying ability.
(Current Assets - Current Liabilities)
• Current ratio- Indicates short-term debt-paying ability (Current Assets / Current
libilities)
• Current cash debt coverage ratio- Indicates short-term debt-paying ability (cash
basis)
(Cash provided by operations /Average current liabilities)
• Inventory turnover ratio- Indicates liquidity of inventory (Costs of goods
sold/average inventory)
• Days in inventory-Indicates liquidity of inventory and inventory management
(365days/inventory ratio turnover)

• Receivables turnover ratio- Indicates liquidity of receivables (Net Credit Sales/

Average Gross Receivables
• Average collection period-Indicates liquidity of receivables and collection
success.(365 days/Receivables Turnover Ratio)

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 Solvency Ratios
• Solvency is the ability of a firm to survive over the
long term.
– One measure of solvency is the debt to total assets ratio.
• A measure of solvency that uses cash figures is the
cash debt coverage ratio (cash by operating
activities/average total liabilities)
• This ratio measures a company's ability to repay its
liabilities from cash generated from operations

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 Profitability
• Profitability refers to a company's
ability to generate a reasonable return.
• Accrual-based ratios that measure
profitability are the gross profit rate,
profit rate margin, and return on
assets.
• A cash-based measure of performance
is the cash return on sales ratio.
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 Let’s Review

Which is an example of a cash flow from a

financing activity?
Receipt of cash from sale of land.
Issuance of debt for cash.
Purchase of equipment for cash.
None of the above.

61
 Taxation of bussiness

• Tax
❘ Pu bli c r evenues with wh ic h
the st ate functions are
fin anced
❘ Authority: Publi c R evenue
Of fic e
❘ In come T ax = 1 5%
❘ Valu e A dded Tax = 1 8%

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 Value Added Tax (VAT)

• Paid by the final user/ consumer

• The companies
– Pay only VAT to the new added net value
– Provide a service – transfer of the tax
from final consumer to the government
– Get tax refund

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 COST ACCOUNTING SYSTEMS
 Cost accounting involves
 The measuring
 The recording, and
 The reporting of product costs
 There are two basic types of cost accounting systems:
 Job order cost system and
 Product cost system

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 Job order cost system – basic features
 Costs are assigned to each job or batch

 A job may be for a specific order or inventory

 A key feature:
Each job or batch has its own distinguishing characteristics

 The objective: to compute the cost per job

 Measures costs for each job completed - not for set time periods
 Used when a large volume of similar products are manufactured (Ceral,
Cars, Compact discks etc)
 Cost are accumulated for a specific time period (a week or a month)
 Costs are assigned/allocated to departments or processes for a set period of
time.

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Job order cost system illustration

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 JOB ORDER COST FLOWS
 The cost flow parallels with the physical flow of the
materials as they are converted into finished goods.
 Manufacturing costs are assigned to Work in Process.

 Cost of completed jobs is transferred to Finished Goods

Inventory.
 When units are sold, the cost is transferred to Cost of
Goods Sold.

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JOB ORDER COST FLOWS
System

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 SIMILARITIES AND DIFFERENCES
between job order cost systems and process cost systems

In job order cost systems:

 Costs are assigned to each job.
 The products have unique characteristics.
In process cost systems :
 Costs are tracked through a series of connected
manufacturing processes or departments.
 The products are uniform or relatively homogeneous and
produced in a large volume.

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NATURE OF PROCESS COST SYSTEMS
SIMILARITIES AND DIFFERENES

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 NATURE OF PROCESS COST SYSTEMS
SIMILARITIES AND DIFFERENES

Job order and process cost systems are similar in 3 ways:

 Same manufacturing cost elements
Direct Materials, Direct Labor, and Manufacturing Overhead.

 Similar accumulation of costs

Debit raw materials costs to Raw Material Inventory
Debit factory labor costs to Factory Labor
Debit manufacturing overhead costs Manufacturing Overhead.

 Same accounts for flow of costs

Work in Process, Finished Goods Inventory, and Cost of Goods Sold;
however,
the methods of assigning the costs differ significantly.

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 NATURE OF PROCESS COST SYSTEMS
SIMILARITIES AND DIFFERENES

• Job order and process cost

systems differ in 4 ways:

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 Summary of Study Objectives
 Explain the characteristics and purposes of cost accounting.
Involves measuring, recording, and reporting product costs.
The two basic types of cost accounting systems:
Job Order Costing and Process Costing

 Describe the flow of costs in a job order cost accounting system.

Manufacturing costs are first accumulated in three accounts:
 Raw Materials Inventory
 Factory Labor
 Manufacturing Overhead
The accumulated costs are then assigned to Work in Process.
As jobs are completed, the Work in Process costs are then assigned to Finished Goods.
Once goods are sold, the Finished Goods costs are then assigned to Cost of Goods Sold.

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