Statement of Cash Flows - IFRS Edition

1. Class Introduction: Why cash is the king to run any business? Is it that important? What about generating profits? What about income statements? Can we have a profit with negative cash flows at the same time? How cash is reported in financial statements. In this class, you will learn how to prepare the statement of cashi flaws and why it is important to study the cashI flaws together with the profit amounts. I am Matz, a finance professional and instructor. I started my career in 2006 and then became a qualified management accountants in 2012. Currently, I am working as a finance manager. I prepare all financial statements on monthly, quarterly and yearly basis. So I have the experience and knowledge to help you throughout the course. This class requires a basic background in accounting. You just need to know at least the principles to make this course easy for you. It is for accountants, financial professionals, and business owners who need a deep understanding in reporting cash flaws, by the end of this class. You will be able to prepare the statement of cash flaws using the indirect method, report cash receipts, and cash payments during a period. Provide a cash basis information about operating, investing and financing activities. You will be able to evaluate a company's ability to generate future cash flaws. We will start with the purpose of the cash flows statement, covering all three categories of cashe flaws from operating, investing and financing activities. After that, we will study the components of cash and cash equivalents. We will see the general format of our statement. What sources of information are needed? How to reconcile profit amount from accrual basis to cash basis, how to report specific items such as interest, dividends, and taxes. After we build a good understanding, we will practice two exercises. Together, we will learn the details Step by Step. I will always be available in Q and A section to answer any question you have. Thanks for joining me. See you in the first listen. 2. Importance of Cash: Before we start with the statement of cash flows, we need to understand first, why cash is that important, Why cash is the king in any business. What about net income? Investors usually look at net income as a main indicator to evaluate the company's performance and project future results. But the main question here, how long this profit would be expected to continue. Let us take this example. The following graph shows the net income of one company over eight years period. We notice in our example how the company showed income growth in the first five years from $100,000 until it become $220,000. After that, net income started to reduce from year six to year eight, until it reaches at the end a net loss of $40,000. But why? This is mainly due to negative cash if flows generated from year five until year eight, is that possible to have a profit and negative cache flows, at the same time, the answer is, yes. Revenue is recognized based on accrual accounting. As a result. We can report our profit in the income statement, even though we did not collect the cash from our customers. But if this case continues for a long period, The company will start to generate negative cashe flaws from its operations in the long run. It will not be able to settle its liabilities, and it may be filed for bankruptcy. In our example, we learned how the income statement shows net income, but it does not indicate the amount of cash generated by operating activities. That's why the investors who analyze the statement of cash flaws are more likely to find an early warning signal of the company operating problems. Again, cash is the king. 3. Purpose of Cash Flows Statement: Now we understand the importance of cash. Next, we will discuss two main purposes of cash flow statement, which provide the following information. Our first purpose to report cash receipts and cash payments during a period. Notice here, there are two parts in this point. First, the presentation of cash receipts and payments. Second, we mentioned here during a period. Why this is important. We have four financial statements in accounting. They present different financial information in different ways. Let us start with income statement, statement of changes in equity, or statement of returned earnings in corporations. And finally, statement of cash a flaws. All these three statements represent financial information during a period. What about balance sheet? It is different. It reports the financial position at a specific date, rather than a period. Our point here that statement of cashe flows provide a detailed summary of where cash came from during a period and how it was used during the same period. The second purpose of our statement to provide cash basis information about operating, investing and financing activities. These classifications will help the user to measure a company ability to generate future cash flows. For example, operating activities are considered the most important why? Because it shows the cash provided by company operations, this source of cash is usually the best measure of a company's ability to generate enough cash to continue in the future as a going concern. We will go through all these classifications in detail in a future lessons. 4. Usefulness of Statement of Cash Flows : After we understand two main purposes for the statement of cache flaws. Now we will discuss the benefits to prepare this statement. We will talk about four main benefits as follow. First, evaluate the ability to generate future cache flows. This is a primary objective of our statement to provide information that allow us to estimate the amounts, timing, and uncertainty of a future cache flows. But how by understanding the relationship between different items, such as a conversion between sales and net cash flow from operating activities. We can make another conversion between net increase or decrease in cash and net cash flow from operating activities. Such information will provide better forecast for future cash flows than is possible using accrual basis data alone, our second benefit to evaluate the ability to pay dividends and settle obligations. Cash is essential. Without enough cash. A company cannot pay employees, settle debts, pay dividends, or buy equipment. In general, creditors, stockholders, and customers should be interested in this estement, because it indicates the flows of cash in a business. Third, it shows the reasons for the difference between net income and net cash flow from operating activities. Net income is reported on accrual basis, which require many estimates. As a result, users need to know the reasons of such difference to assess the reliability of net income figure. We will learn these differences once we prepare our statement using the indirect method. Our last benefit to report cash and non cash transactions from investing and financing activities. Beside operating activities. Companies engage with different transactions of investing and financing activities. Investing activities include the porchese and sale of assets, which are not related to a company's product and services. On the other hand, financing activities include borrowings and repayment of loans, investment by owners, and distributions to owners. By reporting these activities, a financial statement reader can better understand why assets and liabilities increased or decreased during a period. For example, the reader can find answers to the following questions. How much did the company spend on property plan and equipment last year? How much money did the company borrow during the year? Did the amount of dividends paid increased last year? These questions can be easily answered using the statement of cash flows. 5. Operating Cash Flows: To prepare the statement of cash flaws, we need to classify the cash receipts and cash payments into three categories, operating, investing and financing activities. Let's start with operating activities. In general, these activities generate cash any flaws and out of flaws related to revenue and expense transactions that affect net income. In other words, operating activities are revenue producing activities, which include delivering or producing goods for sale and providing services, to have better idea. Let us see the following examples under cash flaws. We have receipts from the sale of goods and services. Then we have interest received from loans. And finally, dividends received from equity securities, Let us move now to cash out of loss. First, we have payments to suppliers for goods and services. Second example is payment to employees for their wages and salaries. Then we have payments of interest and payments of taxes. These are the most used examples of operating cache flows. There are special considerations for interest, dividends and taxes, which we will cover later in this course. But it is important to understand that in our course, we will follow this classification to these cache flows and their operating activities. Another point here to indicate that this section is considered the default category. What does it mean? Any cash flows that do not meet the criteria of investing or financing activities will be classified under operating cash flows. One example is a cash payment to acquire property plan and equipment that are held for rental to customers and routinely sold in the ordinary course of business. This cash out of flows can typically be viewed as investing activity, but it will be classified as operating cash out of flow. Since it is related to the main revenue generating activity of the entity. For example, car rental companies that acquire vehicles with the intention of holding them as rental cars for a limited period, and then selling them after rental. The acquisition cost will be recorded as inventory in the balance sheet, and the cash out of flows will be classified and their operating activities. In case of sales a proceed from these cars, the same classification will be applied and their operating activities. That's why we can have another definition of operating cash flows as revenue producing activities that are not investing or financing activities. Our last point here, Why operating activities are that important. Because it provide a key indicator that the entity has generated sufficient cash flows from its operations. These funds can be used to pay its obligations, dividends, and also make investments from its operating capability without depending on external sources of financing. Also, historical information about operating cache flaws are used in the process of forecasting future cash flows. That's why this section of the statement of cache flaws is the best measure of the company's ability to continue as going concern. 6. Investing Cash Flows: Our second classification to prepare the statement of cash flaws is investing activities. These activities include the acquisition and disposal of long term assets and other investments that are not included in cash equivalent or held for trading purposes. We will have a separate lesson for cash equivalent. But for now, let us see the following examples of investing cash flaws under cash I flaws. We have sale of property plan and equipment. Then we have sale of equity instruments, such as investment and shares of other entities. After that, we have sale of debt instruments, like sale of investment and bonds, which are issued by other entities. Finally, we have the principal collections from loans given to other entities, other than loans made by financial institutions, like banks. In such case, it will be considered an operating activity rather than investing activity. Since it is part of revenue producing activities of these financial institutions, let us move now to cash out of flows. These examples are totally the opposite. For example, first, we have the porches of property plan and equipment, then the porches of equity instruments like shares. After that, we have the porches of debt instruments like bonds. Finally, we have loans made to other entities, again, other than made by financial institutions. Be careful here. Because we are talking about the receipts and payments of principal values of all these examples. Not the return on these investments. For example, gain or loss from sale of assets will be classified under operating activities because it affects net income of the entity. Another example is the return on shares, which called dividends. These dividends received are classified and operating activities since they also affect net income. One more example, is interest received from bonds and loans to other entities, it will be classified under operating activities as well. To recap the subject, the cash flows generated from principle values will be classified under investing activities. While the cash flows generated from the return on these investments will be classified under operating activities. This is true. Since the return on investments, affect income statement of the entity. 7. Financing Cash Flows: Our last classification and the statement of cash flaws is financing activities. These activities involve liabilities and equity items. They include obtaining resources through borrowings and repayment of the amounts borrowed Both short term and long term borrowings are included under financing activities. Information on financing cash flows indicate the amounts of external financing obtained to meet operating and investing needs? To have better idea. Let us see the following examples under cash flaws. We have proceeds from issuing shares or other equity instruments. Then we have proceeds from issuing debt, which include short term or long term borrowings. After that, we have proceeds from the sale of treasury stocks. What do you mean by treasury stocks? When the company buys its own shares in the open market and hold these shares for later use, these shares are called treasury stocks. Since the company cannot own itself, these treasury shares are reported as a contra equity account in the balance sheet. Let us move now to cash out of flows. First, we have payments of dividends. Be careful here, because dividends received are considered operating activities. Since it affects income statement, while dividends paid affect equity items, they are reported under financing activities. Then we have repayment of debt principal values. Finally, we have reports of entities on shares, which we call them earlier treasury stocks. These are three classifications to prepare the statement of cash flows. To summarize this subject, let us see the following. We can see operating activities include income statement items while investing activities generally and include long term asset items. Finally, financing activities generally and include short term or long term borrowings and equity items. This is our general guideline to classify each catch of flaw in our statement. 8. Interest and Dıvıdends: The entity is required to disclose cash flows from interest and dividends received and paid separately in the statement of cash flows, IFRS is considered a principle based system, rather than a rules based The standard gives us a guideline for both interest and dividends, which allow us to report them under different classifications. The chosen classification should be applied in a constant manner from one period to another. Let us have a look at the following. Interest paid may be classified under either operating or financing activities. While interest received may be included in either operating or investing cash flows. What about dividends? Dividends paid can be classified under either operating or financing cash flows. While dividends received may be included in either operating or investing activities. All these treatments are equally acceptable. But our question now, why we have all these options? Let's start with operating activities. They are revenue producing activities, which include delivering or producing goods for sale and providing services. The FRC treatment to report any cash flow that affect income statement as an element of operating activities. On this basis, we will consider interest paid with interest and dividends received as operating cash flows. Dividends paid would be reported under financing cash flows, since they affect equity items and considered a cost of obtaining financial resources. As we said earlier, we will follow this approach, since it is the common practice in reporting the statement of cash flows. Another treatment argued that operating activities are considered a key indicator of a company ability to generate sufficient cash from its operations to repay loans, pay dividends, and make a new investments without depending on external sources of financing. On this basis, interest paid would be a financing cash flow. While interest and dividends received would be classified as investing cash flows. As we explained, most entities would also treat dividends paid as financing cash flaws because they are considered a cost of obtaining financial resources. These are the main justifications of such treatments in our statement. 9. Cash and Cash Equivalents : Cash and cash equivalents is the first item presented in the balance sheet. They are reported under current assets and considered the most liquid asset in the entity. But before we move forward, we have to understand the component of cash and cash equivalents. If we notice, there are two parts. There is cash and there is cash equivalence. Cash comprises cash on hand and demand deposits in the bank. What is the meaning of demand deposits? They are unrestricted amounts that can be withdrawn on demand without prior notice or a penalty being charged. For example, forfeiture and loss of interest. Usually, demand deposits can be drawn within 24 hours or one business day. Be careful here, because the amounts not classified as demand deposits may qualify as cash equivalents and end up being treated in the same way. That's why we need to indicate whether an amount meet the definition of cash equivalent or not. Cash equivalents are short term, highly liquid investments that are readily convertible to known amount of cash and which are subject to an insignificant risk of changes in value. The common examples are treasury bills, commercial papers, and short term government bonds. Cash equivalents are held for the purpose of meeting short term cash commitments, rather than for investment or other purposes. If we look back at our definition, we notice there are three parts, highly liquid, which means it must have an active market, then readily convertible into non amount of cash. Normally, only an investment with a short maturity of three months or less from the date of acquisition is qualified as cash equivalent. The standard here refers to known amount of cash, which means the amount should be known at the date when an investment is acquired, not at the date of disposal. Finally, cash equivalents are subject to insignificant risk of changes in value. That's why, the longer the term of investment, the greater the risk of changes in market conditions, which can have an effect on its value. For this reason, the standard excludes most equity investments from cash equivalents and restrict the inclusion to those investments with a maturity period of three months or less from the date of acquisition. Now we understand the component of cash and cash equivalents. Let us move next and see the following examples. Our first example for a time deposit with an original maturity period of nine months. This deposit cannot be withdrawn for any reason until the time duration on the deposit has expired at the date of preparing our financial statements. There is one month remaining to its maturity. The question is, can we consider this deposit as cash equivalent? The answer is no. But why? Because the maturity period must be three months or less from the date of acquisition, not from the date of preparing the financial statements. Our second example is investment in a long term government bond with a maturity period of five years at the date of acquisition, the remaining maturity period was three months. The question is, can we consider this investment as cash equivalent? The answer is, yes. Because at the date of acquisition, there were three months remaining to its maturity, and there is insignificant risk to change in its value. Let us see now our next example. A banking group held a mandatory reserve deposit with a local central bank. This amount is not available to finance the entity's day to day operations. Our question now, can we consider this deposit as a component of cash and cash equivalent? The answer is no. Because this amount is restricted and not readily convertible into cash. The purpose of this deposit is meeting regulatory requirements by central banks. Not for the purpose of meeting short term cash commitments. Our last example is bank overdraft. Over drafts occur when the bank account lacks the fund to cover the withdrawal transaction. The bank allows this transaction based on the facility agreement signed with the entity up to certain limit. As a result, the bank balance become negative, and it will be considered a bank loan. Bank borrowings are normally considered financing activities. In some countries, bank overdraft blaze an integral part of the entity's cash management. As a result, overdrafts can be included as a component of cash and cash equivalents, if the following conditions are met, the bank overdraft is repayable on demand, and the bank balance often fluctuate from positive to negative. These are the main examples to understand the component of cash and cash equivalents. 10. The General Format: There are three activities constitute the format of the statement of cash of flaws. Operating activities always reported first. It is followed by investing activities, and then financing activities. In general, major classes of gross receipts and gross payments should be reported separately. What do we mean here by gross amounts? These individual flows and out of flows are not knitted against each other. For example, a cash out of flow resulted from the purchase of property plan and equipment is reported separately from the cash flow, resulted from the sale of these assets. Another example, a cash flow resulted from the issuance of debt is reported separately from the cash out of flow, resulted from the settlement of the same debt, Notice that the gross values are reported in our statement. They are not combined as one line item. Instead, they are reported separately. Let us see now the general format of the statement of cash flows. We will start with the cash flows from operating activities, which include the followings, cash receipts from customers, cash paid to suppliers, cash paid to employees, interest received, interest paid, dividends received, and finally, income tax paid. The sum of these values is reported as net cash flows from operating activities. After that, we report cash flows from investing activities, which include the followings. Porchase of property plan and equipment proceeds from the sale of assets. Porchae of debt and equity instruments proceeds from the sale of debt and equity instruments. Loans made to other entities, and finally, collections from the loans given to other entities. The sum of these values is reported as net cash flows from investing activities. After operating and investing activities. We report financing activities, which include the followings, proceeds from issuing shares or other equity instruments. Proceeds from issuing debt, that includes short and long term borrowings. Repayment of debt principal values, proceeds from the sale of treasury stocks, and finally, porches of treasury stocks. As a result, the sum of these values is reported as net cash flows from financing activities. Notice that the gross values are reported in our statement. The positive values are presented separately from the negative values. These amounts are not knitted against each other. What is next? After financing activities. We report the net increase or decrease in cash and cash equivalents, which represent the net cash of flaws during the period. This amount reconciles the beginning and ending balances of cash and cash equivalents as reported in the balance sheet. That means the ending balance in the statement of cash of flaws must match the reported balance of cash and cash equivalents in the balance sheet. This is the general format of the statement of cash of flaws. 11. Sources of Information: We have learned the general format of the statement of cache flaws. But which information is needed to prepare our statement? Can we use the adjusted trial balance only? The simple answer is no. There are two main reasons. First, the statement of cache flaws requires detailed information about the changes and accounts balances between two points of time. Second reason. Because our statement reports, cash receipts, and cash payments, as a result, the entity must adjust the effect of accrual accounting to determine the cash flows. Our question now, what do we need to prepare the statement of cash flows? The information to prepare this es statement usually comes from three sources. First, a comparative es statement of financial position, which we call it the balance sheet. But why we need a two years estement? Because it provides the amount of the changes in assets, liabilities, and equity accounts from the beginning to the end of a period. Our second source is current income statement. Why the current statement, it helps to determine the amount of net cash provided by operating activities during the period. As we learned earlier, any cash flow that affect income statement will be classified under operating activities. As a result, a current income statement is a must to prepare the statement of cash flows. Our final source is other selected data that provide detailed information needed, such as the declared dividends in the returned earnings. Were they paid by cash or just declared without any payment during the period. Another example is the sale of equipment. A detailed information is required, such as the acquisition cost, net book value, and the sale price for cash credit or by issuing det instruments. Such information cannot be taken from the face of our financial statements. Instead, it should be provided separately. We will go through all these sources once we start preparing our statement in a future lessons. 12. Direct vs Indirect Methods : There are two methods to prepare the statement of cash flows. Direct method and indirect method. Both are allowed, and both have the same result for operating, investing and financing cash flows. The only difference exists in the items of operating section. But how the direct method reports cash receipts and cash payments from operating activities. While the indirect method reconciles net income from accrual bases to cash bases. That's why we can call it reconciliation method. Both direct and indirect methods will result the same amount of net cash flows from operating activities. Let us see the following example. We start with operating activities. Under direct method, we report cash receipts from customers and cash payments to suppliers. The result will be net cash flows from operating activities for the amount of $50,000. On the other hand, if we use the indirect method, we should reconcile accrual basis net income to net cash flows from operating activities. We will have the same result of $50,000. We will learn how to do the reconciliation of net income in future lessons. For now, we just have to understand the differences between these two methods. They have the same result, but they differ in the items to calculate operating cash flows. The next step to report net cash flows from investing activities. In our example, it is negative by $10,000 for both methods. Then we report net cashe flows from financing activities, which is $30,000. Again, it is the same in both methods. If we add beginning balance of cash and cash equivalents of $15,000, the ending balance will be $85,000. Whether we use direct or indirect method, this amount must match the balance of cash and cash equivalents in the balance sheet. Our question now, which method should be used? Even though most entities select the indirect method, because it's easier to prepare the international standard encourages entities to use the direct method. But why? Simply because the direct method provides information that helps to estimate future cash flows. Cash receipts and cash payments from operations are clearly indicated in the direct method, which are not available under indirect method. If the direct method is used, it is required to provide a separate reconciliation of accrual basis net income to net cash flows from operating activities. Therefore, whether we choose to use the direct or indirect method, companies must reconcile net income to cash basis. 13. Indirect Method Items: We learned how operating section and the statement of cache flaws can be presented with two methods, direct and indirect. Indirect method reconciles net income from accrual bases to cash bases. The indirect format begins with the amount of net income. Revenue and expense items that not affecting cash are added back or deducted to arrive at net cash flows from operating activities. In this regard, let us see the following. Usually, we start with net income before tax. Then we add or deduct three categories. First, N cash items, such as depreciation, amortization, and provision expenses. We add them back to net income to reach the cash basis profit. But why? When we initially booked these expenses, net income was reduced to remove its effect. We have to add this amount back to net income. Our second category is changes in working capital. Working capital includes current assets and current liabilities. We exclude here two items, cash and cash equivalents, and short term loans. Cash changes are excluded from the adjustments because we are removing the effect of non cash transactions to reach the cash basis income. Short term borrowings are execluded as well, because they are classified under cash flows from financing activities, not operating activities. Let us start with current assets. Normally, we add the decrease in these accounts and we deduct the increased amount. For example, accounts receivable. When this account is decreased from one period to another, that means we have collected our receivables. As a result, our cash balance has increased. On the other hand, When the receivables account is increased, it means we did not collect our money and revenues are billed on accredit basis. As a result, net income should be reduced to reach the amount of cash basis profit. Let us move now to current liabilities. We notice that we add the increase in these accounts and we deduct the decreased amount For example, accounts payable. When this account is increased from one period to another, that means we did not pay our suppliers. Our purchases were made on accredit basis rather than a cash basis. On the other hand, when the Babels account is decreased, it means we have paid our suppliers. As a result, our cash balance has decreased. Our third category is items of income or expense that are associated with investing or financing activities. For example, we should deduct the gain from sale of assets, and we add back the losses amount. But why gains increase net income, to remove its effect, we should deduct to reach the cash basis profit The opposite concept can be applied to losses amounts. They decrease net income, and to remove its effect, we should add them back. Our main question here. Why do we have to include these items in the operating section? The symbol answer is to avoid duplication. The total value of sales proceeds is included in the investing section, which represents the actual cash received in the bank. Gain or loss amounts should be removed from the operating section to avoid such duplication. To recap our subject, let us see the following calculations. We start with net income before tax. Then we add depreciation and amortization expenses. After that, we add the decrease in current assets and deduct the increase in these accounts. On the other hand, we add the increase in current liabilities and deduct the decrease in these accounts. Finally, we add the losses on sales of assets and deduct the gains on sales of these assets. These are the main adjustments to reconcile net income from accrual basis to cash basis. We will learn in the next lesson, additional disclosure requirements to be included in our statement. 14. Income Tax Paid: There are additional disclosures that are required to be included in the statement of cashe flaws. Whether we use direct or indirect method. As per the standard, cash flaws arising from taxes on income should be disclosed separately in the operating activities. Unless they can be specifically identified as part of investing or financing activities. Taxes paid are usually classified as cash flaws from operating activities because it is often impractical to match tax cash flaws with the specific elements of tax expense. Also, those tax cash flows may arise in a different period from the underlying transaction. However, when it is practical to make this determination, The tax cash flow is identified as an investing or financing activity. Let us see how this disclosure may affect our statement using the indirect method as explained. We usually start with net income before tax. Then we make the following adjustments, non cash items, changes in working capital, and finally, items that are associated with investing and financing activities. The sum amount of all these items will result in cash generated from operations. Our question now, how to report income tax paid in our statement. In this example, it is straightforward. We just add income tax paid at the bottom. But why? Because we started our reconciliation with net income before tax. This is the most used format to prepare the indirect method. Actually, we have another option. We can start with net income after tax. In this case, our starting point already includes income tax expense. This time, we cannot simply add tax payment in the bottom. First, we should remove the expense effect from net income by adding income tax expense to our adjustments. Then we can deduct tax payment at the end. These two options are allowed as part of the standard, but starting with net income before tax will make the preparation of our statement a little easier. In the next lesson, we will see a similar approach, but with interest and dividends. 15. Disclosure of Interest and Dividends: We have learned that a disclosure of income tax paid should be reported separately in the statement of cashi flaws. We have here one additional disclosure of interest and dividends. Whether we use direct or indirect method. As per the standard, Cashe flows from interest and dividends received and paid shall each be disclosed separately. Each shall be classified in a constant manner from period to period as operating, investing or financing activities. Interest paid and interest and dividends received are usually classified as operating cash flaws. Because they affect the income statement, and they are resulted from revenue producing activities of the entity. Dividends paid may be classified as financing cash flows, because they are considered the cost of obtaining financial resources. Let us see how this disclosure may affect our statement using the indirect method, As explained in our previous liston, we usually start with net income before tax. Then we make three adjustments for non cash items, changes in working capital and items that are associated with investing and financing activities. The sum amount of all these items will result in cash generated from operations. We will start with the disclosure of interest paid. Since our starting point, which is profit before tax, that includes interest expense. We have to remove its effect by adding back interest expense to our adjustments. Then we can deduct interest payment at the end. Our next item is interest received. Since net income includes interest revenue. We have to remove its effect by deducting interest revenue from our adjustments. Then we can add interest received at the end. Our last item is dividend received. Since net income includes investment revenue. We have to remove its effect by deducting this revenue from our adjustments. Then we can add dividends received at the end. These are the main disclosure requirements that affect the preparation of our statement using indirect method. 16. Example One Introduction: After we learned how to prepare the statement of cache flaws, we are now ready to take the first example. We will have a look at our example in this listen and start our solution in the next one. The following data was extracted from a service company data provides services to earn revenues and generate a profit. Let us see the income statement. Sales revenue was $900,000 while operating expenses excluding depreciation were 684,000. The depreciation expense was $60,000. The deduction of operating expenses from sales revenue will result in gross profit of 156,000 After that, we have loss on sale of asset for 26,000. Then we have interest expense for 10,000. Total losses and other expenses are 36,000. If we deduct this amount from gross profit, we will have a profit before taxation of 120,000. After deducting income tax of 36,000, we will reach the profit amount at the end of $84,000. Let us move now to additional information from the statement of financial position, which includes comparative data as of December 1. First, we have accounts receivable with a balance of $42,000 for the current year, compared to $64,000 in the last year. Then we have accounts payable with a balance of 51,000 for the current year, compared to 36,000 in the last year. After that, we have income tax payable with a balance of 4,000 for the current year. Compared to e and 500 in the last year. Finally, we have interest payable with a balance of 2000 for the current year compared to $500 in the last year. At the end. We are required to prepare the operating section of the statement of casher flaws using the indirect method by considering the followings. All revenues and operating expenses are billed on credit, and accounts payable are linked with operating expenses. This is our question. Let us get started with the solution. 17. Example One Working Capital Changes: We will start our solution by studying working capital changes. We will see how each amount will be used in our adjustments to net income value. As we explained earlier, it is important to consider such amounts to convert net income from accrual bases to cash bases using the indirect method. Let us see the first item, which is accounts receivable. It was 42,000 for the current year compared to 64,000 in the last year. We notice that the value has decreased by 22,000. This amount will be added to net income. But why? Because when accounts receivable is decreased, it represents a collection from customers, which will increase the cash amount as a result. Next, we have accounts payable. It was 51,000 for the current year, compared to 36,000 in the last year. We notice that the value has increased by 15,000. This amount will be added to net income. Why? Because when accounts payable is increased, it is considered that we did not pay our suppliers. As a result, cash amount will increase. After that, we have income tax payable. It was 4,000 for the current year compared to 500 in the last year. We noticed that the value has decreased by 4,500. Be careful here. This amount is not relevant in our adjustments. As per the standard, we have to report income tax payment separately as a result. We should add income tax expense and deduct income tax payment. In case we start with the profit before taxation, a deduction of income tax payment will be enough. No need to add income tax expense in our adjustments. Finally, we have interest payable. It was 2000 for the current year compared to 500 in the last year. We notice that the value has increased by 10500. This amount is also not relevant in our adjustments. As bar the standard, we have to report interest payment separately. As a result, we should add interest expense and deduct interest payment. We will learn about calculating interest and income tax payment in the next lessons. 18. Example One Calculate Interest Paid: Before starting our solution, we have to calculate two numbers, interest paid and income tax paid. These two numbers should be reported separately in our statement. If we go back to our question, we will find out that interest payable balance was $2,000 in the current year compared to $500 in the last year. Our question now, how to calculate interest paid during the year. To do that, we have to open a T account for interest payable. Notice that the term dibit means left, and the term credit means right. Dibits and credits do not mean increase or decrease, but they indicate where the transaction is booked on the left side or on the right side. For example, the act of entering an amount on the left side is called dibing the account while recording an entry on the right side is called crediting the account. Since interest payable is a liability account. It increases on the credit side and decreases on the dibit side. For this reason, beginning and ending balances are shown on the credit side of the account by $500 and $2,000 respectively. If we go back to our income statement, we notice that interest expense was $10,000 during the year. This expense increases interest payable on the credit side. To calculate the payment of interest. We have to take the difference amount which equals $8,500, which is reported on the thibit side of the account. We can also use a formula to calculate interest payment as follows beginning balance of 500 plus expense amount of 10,000 minus ending balance of 2000. The result will be the same for $8,500. This amount has to be reported separately in the statement of cash flows. 19. Example One Calculate Tax Payment: After calculating interest payment, we have to calculate one more figure, which is income tax payment. If we go back to our question, we will find out that income tax payable balance was 8,500 in the current year compared to 4,000 in the last year. Our question now, how to calculate income tax payment during the year. To do that, we will open a T account for income tax payable. Since income tax payable is a liability account, it increases on the credit side and decreases on the debit side. For this reason, beginning and ending balances are shown on the credit side of the account by 8,000 504,000 respectively. If we go back to our income statement, we notice that income tax expense was 36,000 during the year. This expense increases income tax payable on the credit side. To calculate the payment of taxes. We have to take the difference amount which equals $40,500, which is reported on the debit side of the account. We can also use a formula to calculate the payment of income tax as follows, beginning balance of 8,500 plus expense amount of 36,000 minus ending balance of 4,000. The result will be the same for $40,500. This amount has to be reported separately in the statement of cash flows. 20. Example One Final Solution : Now we are ready to prepare the operating section of the statement of cash flaws. As we said earlier, we have two options. Starting with the profit before taxation and starting with the profit after taxation. We will do both in our solution. Let us start with the first solution with the profit amount before taxation, which was 120,000. After that, we add the following adjustments to convert net income from an accrual basis to a cash basis. First, we add the depreciation amount of $60,000, which represents an cash item. Then we add the loss from the sale of equipment of 26,000, which represents an item that is associated with investing activities. After that, we add the changes in working capital for accounts receivable of 22,000 and accounts payable of 15,000. The next tip is to report interest payment, but how to do that? Since our starting point, which is profit before taxation, that includes interest expense. We have to remove its effect by adding back interest expense to our adjustments for $10,000. Then we can deduct the interest payment of 8,500. The final step is to report income tax payment, since our starting point, which is profit before taxation. That does not include income tax expense. As a result, we can deduct the payment of income tax directly of 40,500. Let us move now to the second solution, which starts with profit after taxation of $84,000. Since our starting point includes income tax expense, we have to remove its effect by adding back income tax expense to our adjustments of 36,000. Then we can deduct the payment of income tax of 40,500. Notice that both solutions are allowed, but it is preferred to use profit before taxation, since it is easier and commonly used. 21. Example One Receivables Analysis: If we go back to our solution, we will find out that we have added the decrease in accounts receivable to net income by 22,000. We will understand in this listen why we did that. If we open a T account. We will notice that the beginning balance of accounts receivable was 64,000 while the ending balance was 42,000. Since accounts receivable is an asset account, both balances are shown on the Dibit side. As by our example, the income statement reported credit sales of 900,000. This amount is shown on the Dib side of the account. To calculate the collctions from customers, we have to take the difference amount which equals 922,000, which is reported on the credit side of the account. We can also use a formula to calculate the collections as follows, beginning balance of 64,000 plus credit sales of 900,000 minus ending balance of 42,000. The result will be the same for 922,000. The question now, why to calculate the receipts from customers? Since the statement of cash flows combats profit amount from ACL bases to cash bases. We have to compare the cash receipts from customers with the credit sales. Credit sales are reported in the income statement for 900,000. If we make the comparation, we find that cash receipts were 922,000, which is higher than credit sales by 22,000 to convert the profit amount from accrual basis to cash basis. We need to increase net income by $22,000, which represents the real cash transactions in our statement. 22. Example One Payables Analysis: L et us do the same analysis, but for accounts payable. We will do it to understand why we have added the decrease in accounts payable to net income by 15,000. If we open a T account, we will notice that the beginning balance was 36,000, while the ending balance was 51,000. Since accounts payable is a liability account, both balances are shown on the credit site. As part of our example, the income statement reported operating expenses of 684,000, which was billed on credit. This amount represents credit porchases, and it is shown on the credit side of the account to calculate the payment to suppliers. We have to take the difference amount which equals 669,000 which is reported on the Dibit side of the account. We can also use a formula to calculate the payments as follows beginning balance of 36,000 plus credit porchases of 684,000 minus ending balance of 51,000. The result will be the same for 669,000. The question now, why to calculate the payments to suppliers? Since the statement of cash flows compares profit amount from accrual bases to cash bases. We have to compare the cash payments to suppliers with the credit porchases. If we make the comparision, we find that cash payments were 669,000, which is lower than credit purchases by 15,000 to convert the profit amount from accrual basis to cash basis. We have to increase net income by $15,000, which represents the real cash transactions in our statement. 23. Example Two Introduction: We will see now a more complicated example to prepare the statement of cache flows using the indirect method. We will do all three sections of our statement, which are operating, investing, and financing cash flows. Our question starts with income statement. First, we have sales revenue of 590,000. Then the cost of goods sold of 300,000. If we deduct this amount from our sales revenue, we will get gross profit of 290,000. After that, we deduct both operating expenses of 216,000 and depreciation expense of 24,000. Total operating expenses are 240,000. If we deduct this amount from the gross profit, the result will be operating profit of $50,000. The next step is other expenses and other income. We add investment income of 16,000, then we deduct the loss on sale of equipment of 6,000. After that, we deduct interest expense of 7,000. The total amount of these items is $3,000. If we add it to operating profit, the result will be a profit before taxation of $53,000. After deducting taxes on income of 15,000, the final profit amount will be 38,000. Let us see now the comparative statement of financial position for the current year and for the last year. The first part is current assets, which include cash and cash equivalents, accounts receivable and inventory. The total amount of current assets for the current year is 153,000, compared to 126,000 for the last year. The next part is non current assets, which include long term investment, property plan and equipment, and accumulated depreciation. The total amount of non current assets for the current year is 204,000 compared to 162,000 for the last year. Total assets for the current year are 357,000 compared to 288,000 for the last year. After that, we have current liabilities, which include accounts payable, income tax payable, and short term loans. The total amount of current liabilities for the current year is 60,000 compared to 56,000 for the last year. Then we have non current liabilities, which include long term bonds. Total liabilities for the current year are 150,000, compared to 120,000 for the last year. The final part of our balance sheet is shareholders equity, which includes share capital, returned earnings, and the treasury stocks. The total amount of equity for the current year is 207,000, compared to 168,000 for the last year. The total amount for both liabilities and shareholders equity for the current year is 357,000 compared to 288,000 for the last year. Let us see now some additional information to help us to prepare our statement. All sales and purchases of inventory where on credit. Additional equipment with an original cost of 78,000 was purchased during the year, 10,000 paid by cash and 68,000 by issuing long term bonds. Equipment with an original cost of 30,000 and accumulated depreciation of 12,000 was sold for $12,000 by cash. Out of the investment income of 16,000, the company received cash dividends from investment of $10,000 during the year. The company issued 5,000 shares of capital and received 25,000 by cash, long term bonds with a face value of 42,000, were paid at the date of maturity by cash, Treasury stocks of $10,000, were ports by the company during the year. Increase in bank loans represents new loans received by cash. The company declared and paid dividends of 14,000 to its shareholders by cash. The interest expense of 7,000 was incurred and fully paid during the year. All other operating expenses incurred were paid during the year. Finally, let us see the instructions. Prepare the fulls statement of cash flows using the indirect method. For the operating section, start with the profit amount before taxation. This is our question. Let us get started. 24. Example Two Working Capital Changes: Before starting with the operating section. We need to calculate the working capital changes. We will see how each amount will be used in our adjustments to net income value. As we said earlier, it is important to study such amounts to convert net income from accrual bases to cash bases using the indirect method. Let us see the first item, which is accounts receivable. It was 74,000 for the current year compared to 55,000 in the last year. We notice that the value has increased by 19,000. This amount will be deducted from net income. Because when accounts receivable is increased, it means our credit sales are higher than actual receipts from customers. As a result, the cash amount should decrease. Next, we have inventory account. It was 70,000 for the current year compared to 59,000 in the last year. We notice that the value has increased by 11,000. This amount will be deducted from net income. Because when inventory account is increased, it means my Porches value of inventory is higher than my sales value of inventory. As a result, the cash amount should decrease. After that, we have accounts payable. It was 35,000 for the current year. Compared to 40,000 in the last year. We notice that the value has decreased by 5,000. This amount will be deducted from net income. Because when accounts payable is decreased, it means we paid our suppliers by cash as a result, the cash amount will decrease. After that, we have income tax payable. It was 12,000 for the current year compared to 7,000 in the last year. We notice that the value has increased by 5,000. Be careful here. This amount is not relevant in our adjustments. As per the standard, we have to report income tax payments separately. Since we start our solution with the profit amount before taxation, a deduction of income tax payment will be enough. No need to add income tax expense in our adjustments. Finally, we have short term loans. It was 13,000 for the current year compared to 9,000 in the last year. We notice that the value has increased by 4,000. This amount is also not relevant in our adjustments. As per the standard, we have to report all bank loans under financing cash flows rather than operating cash flows. 25. Example Two Receivables Analysis: If we go back to working capital changes, we will find that we have deducted the increase in accounts receivable from net income by 19,000. We will understand in this listen why we did that. If we open a T account, we will notice that the beginning balance of accounts receivable was 55,000 while the ending balance was 74,000. Since accounts receivable is an asset account, both balances are shown on the Dibit side. As for our example, the income statement reported credit sales of 590,000. This amount is shown on the Dibit side of the account. To calculate the collections from customers. We have to take the difference amount, which equals 571,000, which is reported on the credit side of the account. We can also use a formula to calculate the collections as follow, beginning balance of 55,000 plus credit sales of 590,000 minus ending balance of 74,000. The result will be the same for 571,000. Let us see now, why to calculate the receipts from customers? Since the statement of cash flows, coms profit amount from accrual bases to cash bases. We need to compare the cash receipts from customers with the credit sales. Credit sales are reported in the income statement for 590,000. If we make the comparsion, we find that cash receipts we 571,000, which is lower than credit sales by 19,000 to convert the profit amount from accrual bases to cash bases. We have to decrease net income by 19,000, which represents the real cash transaction in our statement. 26. Example Two Inventory Analysis: Let us move now to the inventory analysis. We will find that we have deducted the increase in inventory account from net income by 11,000. We will understand in this listen why we did this deduction. If we open a T account, we will notice that the beginning balance of inventory was 59,000 while the ending balance was 70,000. Since inventory is an asset account, both balances are shown on the debit side. As part of our example, the income statement reported the cost of goods sold of 300,000. This amount is shown in the credit side of the account to represent the reduction in the quantity due to the sale of inventory. On the other hand, to calculate the porcheses of inventory, we need to take the difference amount which equals 311,000, which is reported on the deibit side of the account. We can also use a formula to calculate the portases as follow. Ending balance of 70,000 plus cost of good sold of 300,000 minus beginning balance of 59,000. The result will be the same for 311,000. Let us see now, why to calculate the porchases of inventory? Since the statement of cash of flaws cons profit amount from accrual bases to cash bases. We need to compare the portases from suppliers with cost of good sold. Cost of good sold is reported in the income statement by 300,000. If we make the comparsion, we find that portss of inventory were 311,000, which is higher than cost of good sold by 11,000 to convert the profit amount from accrual bases to cash bases, we have to decrease net income by 11,000, which represents the real cash transaction in our statement. 27. Example Two Payable Analysis: Let us see now the payable analysis. We will find out that we have deducted the decrease in accounts payable from net income by 5,000. We will understand in this listen why we did that. If we open a T account, we will notice that the beginning balance of accounts payable was 40,000, why the ending balance was 35,000. Since accounts payable is a liability account, both balances are shown on the credit side. As per our inventory analysis, the purchases of inventory were 311,000. Since all purchases were made on a credit, this amount is shown on the credit side of the supplier account to calculate the payments to suppliers. We need to take the difference amount, which equals 316,000, which is reported on the Eibit side of the account. We can also use a formula to calculate the payments as follow, beginning balance of 40,000 plus credit porchases of 311,000 minus ending balance of 35,000. The result will be the same for 316,000. Let us see now, why to calculate the payments to suppliers? Since the statement of cash flows comas profit amount from accrual bases to cash bases. We need to compare the cash payments to suppliers with credit porchases. If we make the comparision, we find that cash payments were 316,000, which is higher than credit portases by 5,000, to convert the profit amount from accrual bases to cash bases. We need to decrease net income by 5,000, which represents the real cash transactions in our statement. 28. Example Two Calculate Tax Payment: As per the international standard, we have to report income tax payments separately in the statement of cash flows. If we go back to our question, we will find out that income tax payable was 12,000 in the current year compared to 7,000 in the last year. Our question now, how to calculate income tax payment during the year. To do that, we have to open a T account for income tax payable. Since income tax payable is a liability account, it increases on the credit side and decreases on the debit side. For this reason, beginning and ending balances are shown on the credit side of the account by 700020000 respectively. If we go back to our income statement, we notice that income tax expense was 15,000 during the year. This expense increases income tax payable on the credit side to calculate payment of taxes. We have to take the difference amount which equals $10,000, which is reported on the tibit side of the account. We can also use a formula to calculate the payment of income tax as follows. Beginning balance of 7,000 plus expense amount of 15,000 minus ending balance of 12,000. The result will be the same for $10,000. This amount has to be reported separately in the statement of catchy flaws. 29. Example Two Operating Cash Flows: Now we are ready to prepare the statement of cache flaws. We will start with the operating section. Here we have two options to report operating cache flaws, starting with profit before taxation and starting with profit after taxation. As per our question, we need to start with the profit amount before taxation. The profit value in this case will be 53,000. After that, we add the following adjustments to convert net income from an accrual basis to a cash basis. First, we add the depreciation amount of 24,000, which represents an n cash item. Then we add the loss from the sale of equipment of 6,000, which represents an item that is associated with investing activities. After that, we deduct the changes of working capital for three accounts. The increase in accounts receivable of 19,000, the increase in inventory account of 11,000 and the decrease in accounts payable of 5,000. The nexist tib is to report dividends received. The question is, how to do that. Since our starting point, which is profit before taxation, that includes investment income. We need to remove its effect by deducting the investment income of 16,000 from our adjustments. Then we can add dividends received of $10,000 in the bottom. After that, we need to report interest payment. As part our question, the interest expense of 7,000 was incurred and fully paid during the year. Since our starting point, which is profit before taxation, that includes interest expense. We need to remove its effect by adding back interest expense to our adjustment of $7,000. Then we can deduct the interest payment of 7,000. Notice that the value of cash generated from operations will be 39,000. The final stib is to report income tax payment. Since our starting point, which is profit before taxation. That does not include income tax expense as a result. We can deduct the payment of income tax directly for 10,000. The sum amount of all these values will result in net cash flows from operating activities of 32,000. This is the first part of the statement of cash flows. 30. Example Two Investing Cash Flows: The second part to prepare the statement of cash of flaws is investing activities. We have here two items only, the porchase of equipment and the proceeds from the sale of another equipment. Let us start with the porchase of equipment. If we go back to our question. We notice that the Porchese transaction was done by cash of 10,000 and also through issuing long term bonds of 68,000. In this case, we should consider the cash amount only, but why? Because issuing debt instruments to acquire assets does not affect cash at all. Instead, we were reported in the notes of our statement as a non cash investing and financing activities. As a result, we will show here the cash out of flow of 10,000, which represents the payment of cash to acquire this equipment. The next item is the proceeds from the sale of equipment. If we go back to our question, we notice that the equipment with original cost of 30,000 and accumulated depreciation of 12,000 was sold for 12,000 by cash. The net book value in this case is 18,000, which is the result of deducting accumulated depreciation of 12,000 from the original cost of 30,000. The loss amount from the sale is 6,000, which was already reported under operating cash flows. We will show here only the cash receipt from this transaction of 12,000. At the end, the sum amount of these two items is positive 2000, which represents the net cash flows from investing activities. Next, we will see how to report financing cash flows. 31. Example Two Financing Cash Flows: The next part to prepare the statement of cashi flaws is financing activities. We have here multiple items as follows, first. We have the proceeds from issuing shares of capital. If we go back to our question, we notice that the company issued 5,000 shares of capital and received $25,000 by cash. This amount is reported as a cash in of flow and their financing activities. After that, we have repayment of long term bonds with a face value of 42,000. This amount is reported as a cash out of flow and their financing activities. Be careful here because we are talking about the issuance and repayment of debt instruments that are issued by the company itself. In case the company porches debt instruments issued by other entities, it will be considered as investing cash flows, not financing cash flows. Our next item is the re porchase of the company owned shares, which we call treasury stocks. This amount is reported as a cash out of flow and their financing activities of 10,000. Then we have bank loans received. As for our question. The increased amount of loans from beginning and ending balances represent a new loans received from the bank, which equals 4,000. This amount is reported as a cash inflow. The last item under financing activities is dividends paid. The company declared and paid dividends of 14,000 to the shareholders by cash. This amount will be reported as a cash outflow. Next is the sum amount of all these items, which equals a negative value of 37,000. Let us now continue our statement by calculating the net increase or decrease in cash and cash equivalents. This amount is calculated by adding net cash flows from operating activities of 32,000 investing activities of 2000, and finally, financing activities of negative 7,000. The result will be a negative cash flow of 3,000. If we add this amount to the beginning balance of cash and cash equivalents of 12,000, the final result will be 9,000. This amount represents the ending balance of cash and cash equivalents, which is reported in the balance sheet. This is our solution to prepare the statement of cash flows, but we miss one important disclosure which we will cover in the next listen. 32. Example Two Non Cash Investing and Financing Activities: Nn cash transactions only appear in the statement of cash flaws as adjustments to profit endless amount when using the indirect method and their operating activities. On the other hand, investing and financing transactions that do not involve cash or cash equivalents are excluded from the statement of cash flaws. Disclosure is required elsewhere in the financial statements to provide all relevant information about these transactions. Examples of such non cash transactions include the acquisition of assets, either by assuming directly related liabilities or by means of a finance lease. Another example is a conversion of debt to equity and the issuance of stocks to acquire assets. If we go back to our example, we will see that we have one major non cash transaction that includes acquiring equipment by issuing long term bonds of 68,000. This disclosure will be reported in the notes of our financial statements to provide all relevant information about this purchase of equipment. During the year, the company paid $10,000 by cash and 68,000 by issuing long term bonds. Total original cost is the sum amount of 78,000. This is the end of our solution to prepare the statement of cash flaws. 33. Example Two Challenge: We have prepared the operating section starting with the profit amount before taxation. We will do it again. But this time by starting with the profit amount after taxation, we will have the same result of net cash flows from operating activities on both options. Please post the video. Try to solve it yourself, and once you are ready to see the solution, press the play again. At the beginning. We will start with the profit amount after taxation of 38,000, then followed by the same adjustments, except for one item, which is income tax expense. Since our starting point includes the expense of income tax. We need to remove its effect by adding back the expense amount of 15,000. Total cash generated from operations is the same amount of 39,000. Let us continue our solution. We will find out that we have the same amounts, especially for income tax paid of 10,000. As per the standard, we need to report it separately in the statement of cashe flaws. The final result is the sum amount of all these items, which is the net cash flows from operating activities of 32,000. This amount matches our previous solution that started with a profit before taxation. 34. Class Recap: Congratulations for completing the class, and thanks for joining me. Your time is valuable, and I wish I added such value for you. We have learned the key points in preparing the statement of cash flaws. We started with the importance of cash, followed by the three categories of cash flaws from operating, investing, and financing activities. After that, we studied the component of cash and cash equivalents, the general format of our statement, and all three sources of information. We saw the differences between direct and indirect methods. We learned the indirect method items and reconciled profit amount from accrual basis to cash basis. We reported specific items such as interest, dividends, and taxes. At the end, don't forget to post your project in the project gallery. Follow me on skill share to get notified for all my new classes, and please leave a review. Thanks for taking the class.