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Introduction to Accounting E-book
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Discussion topics
Introduction to accounting
Background
Business Cycle
Use of Financial Statements
Income Statement
Introduction
Accrual basis of accounting
Cash basis of accounting
Revenue recognition principle
Matching principle of costs
Balance Sheet
Introduction
Accounting Equation
Debit and Credit
Assets / Liabilities
Key Questions
Cash flow Statement
Introduction
Calculating cash flow from operations, investing and finance
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Introduction to Accounting
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Starting a Business: some background
Kartik want to start a new business. Kartik sees the need for “Movers and Packers” business in Mumbai. He has researched this idea and has prepared a business plan that documents the viability of his new business
Kartik met his lawyer friend to discuss the form of business he should use. Given his situation, they concluded that a corporation will be best form. Kartik names his company as FastTrack Inc?
What is a corporation?
What are other form of business types?
Kartik is a hard worker and a smart man, but admits he is not comfortable with matters of accounting
Kartik asks his banker to recommend a professional analyst who is skilled in explaining business accounting to someone without an accounting background
Kartik wants to understand financial statements and wants to keep on top of his new business
Kartik asks you the following questions
What is business cycle?
Why do we use financial statements at all?
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What is a Business Cycle?
Simple Business Cycle for FastTrack Inc
Kartik Infuses Capital
Uses the money to purchase
trucks, inventory, pay
labor and admin costs
Provides Service
“Movers and Packers”
Receives Money from Clients,
Earns Profit/Loss
Cash Outflow Cash Inflow
Shareholder of the
firm
Kartik receives money from the clients – Profit or Loss
Kartik has following options
Kartik can reinvest the profit made in the business to expand his business or
Can simply keep the money!
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Why do we use Financial Statements?
FastTrack Movers & Packers Transactions
Based on Kartik’s business plan, you now understand that there will likely be thousands of transactions each year
Kartik seems puzzled by the term transaction, so you gives him five examples of transactions that FastTrack Inc will need to record:
Kartik will start his business by putting some of his own personal money into it. In effect, he is buying shares of FastTrack Inc common stock
FastTrack Inc will need to buy a few transport vehicles - truck
The business will begin earning fees and billing clients for relocating their parcels from one place to another
The business will be collecting the fees that were earned
The business will incur expenses in operating the business, such as a salary for Kartik, labors, expenses associated with packaging material, delivery vehicle, advertising, etc
With thousands of such transactions in a given year, Kartik is being advised to make an entry of these transactions in an accounting software on a daily basis
Why Accounting?
Understanding of company’s profitability, assets and cash position
Generate sales invoices and accounting entries
Prepare statements for customers with no additional work
Can you now explain Kartik, the content and purpose of the three main financial statements – Income Statement, Balance Sheet and Cash Flow statement
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Income Statement
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Income Statement – Jargons introduced!
The order of deduction of cost is as follows:
Cost of products sold
Sales, general and administrative costs
Interest Expenses
Tax Expenses
Lets get back to our FastTrack Inc example
Revenues result from the entity’s operating activities (selling
merchandise, selling services)
Costs and expenses are incurred in generating revenues and operating
the entity
The income statement shows the profit for the period of time under consideration
FastTrack Movers & Packers Inc.
Sales $ xxx
Cost of goods sold $ xxx
Gross Profit $ xxx
Selling,general and admin. expenses $ xxx
Income from operations $ xxx
Interest expense $ xxx
Income before taxes $ xxx
Net Income $ xxx
Earnings per share $ xxx
Income Statement, for year ended 31st December, 2007
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FastTrack Movers & Packers Revenues
Even though Kartik’s clients won't be paying FastTrack Inc until January 15, the accrual basis of accounting requires that the $1,000 be recorded as December revenues, since that is when the delivery work actually took place
What is accrual basis of accounting?
What is cash method of accounting?
What is revenue recognition principle?
After expenses are matched with these revenues, the income statement for December will show just how profitable the company was in delivering parcels in December
Case 1: Revenues
If Kartik delivers 200 parcels in December for $5 per delivery, he has technically earned fees totaling
$1,000 for that month. He sends invoices to his clients for these fees and his terms require that his
clients must pay by January 15
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FastTrack Movers & Packers Revenues
Receipts of $1,000 will not be considered to be January revenues, since the revenues were already reported as revenues in December when they were earned
This $1,000 of receipts will be recorded in January as a reduction in Accounts Receivable (In December Kartik had made an entry to Accounts Receivable and to Sales) – Don’t worry, we will explain you this in a bit!
The actual date of payment of $400 does not matter
What matters is when the work was done and when the corresponding expense was incurred
In our case work was done in December and hence, $400 expense is counted as a December expense even though the money will not be paid out until January 3
What is matching principle?
Case 2: Revenues
When Kartik receives the $1,000 worth of payment checks from his customers on January 15, he will
make an accounting entry to show the money was received.
Case 3: Expenses
If Kartik hires some labor to help him with December deliveries and Kartik agrees to pay him $300 on
January 3 and another $100 for pakaging and other supporting material; Total expenses of $400
expense for December deliveries
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Income Statement - Expenses
What is the monthly interest expense that is shown for Kartik’s monthly income statement?
Case 4: Expenses
FastTrack Movers and Packers borrowed $20,000 from a bank to start his business on 1st December
and the company agrees to pay 5% in interest, or $1,000. The interest is to be paid in a lump sum on
December 1st of each year.
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FastTrack Income Statement as per the transaction discussed for the month of December, 2007
FastTrack Movers & Packers Inc.
Sales $1,000
Cost of goods sold $400
Gross Profit $600
Selling,general and admin. Expenses 1
$30
Income from operations $570
Interest expense $83
Income before taxes $487
Income Tax @ 33% $161
Net Income $326
Note 1: SG&A expense is assumed to be $30 in December,2007
Income Statement, for month ended 31st December, 2007
Consolidating the Income Statement
Accrual basis of accounting
Concept of Matching Principle
Concept of Matching Principle
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Balance Sheet
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Balance Sheet – Jargons reintroduced!
“Snapshot" of a company's financial position at a given moment
Reports the amount of a company's
Assets – Current assets/Long term assets
Liabilities – Current liabilities/Long term liabilities
Stockholders' (or owner's) equity – Common stock / Retained earnings
Assets Liabilities & Stockholder's Equity
Current assets Current Liabilities
Cash $ xxx Short-term debt $ xxx
Accounts Receivables $ xxx Accounts Payable $ xxx
Inventory $ xxx Total current liabilities $ xxx
Total current assets $ xxx
Long term Liabilities
Long term assets Long term debt $ xxx
Plant and Equipment $ xxx
Less:Acc depreciation ($ xxx) Stockholder's Equity
Net PPE $ xxx Common Stock $ xxx
Retained Earnings $ xxx
Total Stockholder's Equity $ xxx
Total Assets $ xxx Liabilities & Stockholder's Equity $ xxx
FastTrack Movers & Packers Inc
Balance Sheet, December 31st 2007
Assets Liability Shareholder’s Equity = +
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Debits and Credits
Double Entry
Double entry is a 500-year-old accounting procedure
Double entry is a simple yet powerful concept and each and every transactions will result in an amount recorded into at least two of the accounts in the accounting system
Debit and Credit
Double entry system requires that the same dollar amount of the transaction must be entered on both the left side of one account, and on the right side of another account
Assets Liability Shareholder’s Equity = +
Left means Debit!
Right means Credit!
Remember these simple tips:
Increase in assets – DEBIT
Decrease in assets – CREDIT
Increase in Liability & Equity – CREDIT
Decrease in Liability & Equity - DEBIT
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Shareholder’s Equity
Common Stock will be increased when the corporation issues shares of stock in exchange for cash (or some other asset)
Retained Earnings will increase when the corporation earns a profit and there will be a decrease when the corporation has a net loss
Core link between a company's balance sheet and income statement
Balance Sheet
Assets Liabilities & Stockholder's Equity
Cash $20,000 Liabilities $0
Stockholder's Equity
Common Stock $20,000
Total Assets $20,000 $20,000
FastTrack Movers & Packers Inc
Balance Sheet, December 1st 2007
Cash from Kartik’s personal investment
Increase in its stockholders' equity account Common Stock
by $20,000
Case 5: Cash and Common Stock
On December 1, 2007 Kartik starts his business FastTrack Movers and Packers. The first transaction that
Kartik will record for his company is his personal investment of $20,000 in exchange for 5,000 shares of
FastTrack Movers & Packers common stock. There are no revenues because no delivery fees were earned
by the company, and there were no expenses.
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Debit and Credit
Balance Sheet
Assets Liabilities & Stockholder's Equity
Cash $20,000 Liabilities $0
Stockholder's Equity
Common Stock $20,000
Total Assets $20,000 $20,000
FastTrack Movers & Packers Inc
Balance Sheet, December 1st 2007
Cash from Kartik’s personal investment
Increase in its stockholders' equity account Common Stock
by $20,000
Case 5: Cash and Common Stock
On December 1, 2007 Kartik starts his business FastTrack Movers and Packers. The first transaction that
Kartik will record for his company is his personal investment of $20,000 in exchange for 5,000 shares of
FastTrack Movers & Packers common stock. There are no revenues because no delivery fees were earned
by the company, and there were no expenses.
Assets Liability Shareholder’s Equity = +
Common Stock increases by $20,000
Cash increases by $20,000
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Kartik also needs to know that the reported amounts on his balance sheet for assets such as equipment, vehicles, and buildings are routinely reduced by depreciation
What is Depreciation
Matching principle?
Depreciation of land?
The accountant might match $2,800 ($14,000
5 years) of depreciation expense with each year's revenues for five years
Balance Sheet
Cash reduces to $6,000 and vehicle account increases to
$14,000
No change in stockholder’s position
Assets Liabilities & Stockholder's Equity
Cash $6,000 Liabilities $0
Vehicle $14,000
Stockholder's Equity
Common Stock $20,000
Total Assets $20,000 $20,000
FastTrack Movers & Packers Inc
Balance Sheet, December 2nd 2007
Case 6: Purchase of Vehicle
On December 2, FastTrack Movers & Packers purchases a truck for $14,000 by writing a check for $14,000.
The two accounts involved are Cash and Vehicles (or Delivery Truck)
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Debit and Credit?
Balance Sheet
Cash reduces to $6,000 and vehicle account increases to
$14,000
No change in stockholder’s position
Assets Liabilities & Stockholder's Equity
Cash $6,000 Liabilities $0
Vehicle $14,000
Stockholder's Equity
Common Stock $20,000
Total Assets $20,000 $20,000
FastTrack Movers & Packers Inc
Balance Sheet, December 2nd 2007
Case 6: Purchase of Vehicle
On December 2, FastTrack Movers & Packers purchases a truck for $14,000 by writing a check for $14,000.
The two accounts involved are Cash and Vehicles (or Delivery Truck)
Assets Liability Shareholder’s Equity = +
Cash decreases by $14,000
Vehicle asset increases by $14,000
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Balance Sheet
Between Dec 1st & Dec 31st, $100 worth of insurance premium is "used up" or "expires"
The expired amount will be reported as Insurance Expense on December's income statement
The remaining portion of unexpired insurance premium is reported as Pre-paid Insurance
What is the remaining portion of Pre-paid insurance as of Dec 31st , 2007?
Cash reduces further to $4,800 and Prepaid insurance account increases to $1,200
No change in stockholder’s position
Assets Liabilities & Stockholder's Equity
Cash $4,800 Liabilities $0
Prepaid Insurance $1,200
Stockholder's Equity
Vehicle $14,000 Common Stock $20,000
Total Assets $20,000 $20,000
FastTrack Movers & Packers Inc
Balance Sheet, December 2nd 2007
Case 7: Prepaid Expenses
On December 2 when Kartik contacts an insurance agent regarding insurance coverage for the Truck just
purchased. The agent informs him that $1,200 will provide insurance protection for the next one year.
Kartik immediately writes a check for $1,200.
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Balance Sheet
Debit and Credit?
Cash reduces further to $4,800 and Prepaid insurance account increases to $1,200
No change in stockholder’s position
Assets Liabilities & Stockholder's Equity
Cash $4,800 Liabilities $0
Prepaid Insurance $1,200
Stockholder's Equity
Vehicle $14,000 Common Stock $20,000
Total Assets $20,000 $20,000
FastTrack Movers & Packers Inc
Balance Sheet, December 2nd 2007
Case 7: Prepaid Expenses
On December 2 when Kartik contacts an insurance agent regarding insurance coverage for the Truck just
purchased. The agent informs him that $1,200 will provide insurance protection for the next one year.
Kartik immediately writes a check for $1,200.
Assets Liability Shareholder’s Equity = +
Cash decreases by $1,200
Prepaid insurance increases by $1,200
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Assets Liabilities & Stockholder's Equity
Cash $24,800 Liabilities $0
Prepaid Insurance $1,200 Long term debt $20,000
Stockholder's Equity
Vehicle $14,000 Common Stock $20,000
Total Assets $40,000 Liabilities & Stockholder's Equity $40,000
FastTrack Movers & Packers Inc
Balance Sheet, December 3rd 2007
Balance Sheet
Cash increases by $20,000 (amount of debt raised from
the bank)
Long term debt raised from the bank
Case 4 Revisited : Raising Debt
FastTrack Movers and Packers borrowed $20,000 from a bank to start his business on 1st December
and the company agrees to pay 5% in interest, or $1,000. The interest is to be paid in a lump sum on
December 1st of each year.
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Debit and Credit
Assets Liabilities & Stockholder's Equity
Cash $24,800 Liabilities $0
Prepaid Insurance $1,200 Long term debt $20,000
Stockholder's Equity
Vehicle $14,000 Common Stock $20,000
Total Assets $40,000 Liabilities & Stockholder's Equity $40,000
FastTrack Movers & Packers Inc
Balance Sheet, December 3rd 2007
Balance Sheet
Cash increases by $20,000 (amount of debt raised from
the bank)
Long term debt raised from the bank
Case 4 Revisited : Raising Debt
FastTrack Movers and Packers borrowed $20,000 from a bank to start his business on 1st December
and the company agrees to pay 5% in interest, or $1,000. The interest is to be paid in a lump sum on
December 1st of each year.
Assets Liability Shareholder’s Equity = +
Long term debt increases by $20,000
Cash increases by $20,000
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On 10th December, wholesale price of boxes has been risen by 20% & at today's price Kartik’s could purchase them for $1.20 each. What is the value of inventory shown on balance sheet?
What is Cost Principle?
Lets say that since the time Kartik bought inventory, the wholesale price of boxes has been cut by 40% and at today's price he could purchase them for $0.60 each. What is the value of inventory shown on the balance sheet in this case?
What is the principle of Conservatism?
Assets Liabilities & Stockholder's Equity
Cash $23,800 Liabilities $0
Prepaid Insurance $1,200 Long term debt $20,000
Inventory $1,000 Stockholder's Equity
Common Stock $20,000
Vehicle $14,000
Total Assets $40,000 Liabilities & Stockholder's Equity $40,000
Balance Sheet, December 3rd 2007
FastTrack Movers & Packers Inc
Balance Sheet
Cash decreases by $1,000 and inventory increases by $1,000
No change
Case 8: Inventory
Kartik keeps an inventory of packing boxes not only to use it for his business but also earn additional
revenues by carrying an inventory of packing boxes to sell. Let's say that FastTrack Movers and Packers
purchased 1,000 boxes wholesale for $1.00 each.
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Assets Liabilities & Stockholder's Equity
Cash $23,800 Liabilities $0
Prepaid Insurance $1,200 Long term debt $20,000
Inventory $1,000 Stockholder's Equity
Common Stock $20,000
Vehicle $14,000
Total Assets $40,000 Liabilities & Stockholder's Equity $40,000
Balance Sheet, December 3rd 2007
FastTrack Movers & Packers Inc
Balance Sheet
Cash decreases by $1,000 and inventory increases by $1,000 No change
Case 8: Inventory
Kartik keeps an inventory of packing boxes not only to use it for his business but also earn additional
revenues by carrying an inventory of packing boxes to sell. Let's say that FastTrack Movers and Packers
purchased 1,000 boxes wholesale for $1.00 each.
Assets Liability Shareholder’s Equity = +
Cash decreases by $1,000
Inventory asset increases by $1,000
Debit and Credit?
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Other liabilities
For the loan Kartik received from Bank (Notes Payable or Loan Payable), the interest on the loan he owes to his bank (Interest Payable)
Amount he owes to the supply store for items purchased on credit (Accounts Payable)
Wages he owes an employee but hasn't yet paid to him (Wages Payable)
Assets Liabilities & Stockholder's Equity
Cash $24,400 Liabilities $0
Prepaid Insurance $1,200 Unearned Revenue $600
Inventory $1,000 Long term debt $20,000
Stockholder's Equity
Vehicle $14,000 Common Stock $20,000
Total Assets $40,600 Liabilities & Stockholder's Equity $40,600
Balance Sheet, December 4th 2007
FastTrack Movers & Packers Inc
Balance Sheet
Cash increases by $600 Liability increases by $600
Case 9: Unearned Revenues
In addition to 200 parcels delivered by FastTrack Movers and Packers in December, they enters into an
agreement with one of its customers stipulating that the customer prepays $600 in return for the delivery
of 30 parcels every month for 6 months. Assume FastTrack Movers & Packers receives $600 payment on
Dec 1,2007 for deliveries to be made between Dec 1,2007 and May 31,2007
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Debit and Credit
Assets Liabilities & Stockholder's Equity
Cash $24,400 Liabilities $0
Prepaid Insurance $1,200 Unearned Revenue $600
Inventory $1,000 Long term debt $20,000
Stockholder's Equity
Vehicle $14,000 Common Stock $20,000
Total Assets $40,600 Liabilities & Stockholder's Equity $40,600
Balance Sheet, December 4th 2007
FastTrack Movers & Packers Inc
Balance Sheet
Cash increases by $600 Liability increases by $600
Case 9: Unearned Revenues
In addition to 200 parcels delivered by FastTrack Movers and Packers in December, they enters into an
agreement with one of its customers stipulating that the customer prepays $600 in return for the delivery
of 30 parcels every month for 6 months. Assume FastTrack Movers & Packers receives $600 payment on
Dec 1,2007 for deliveries to be made between Dec 1,2007 and May 31,2007
Assets Liability Shareholder’s Equity = +
Unearned revenues increases by $600
Cash increases by $600
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Missing links
Accounts Receivables
Accounts Payable
Interest Payable
The arrow indicates that net income affects retained earnings, which is a component of owners’ equity
Assets = Liabilities +
Owners'
Equity Net income = Revenues - Expenses
Balance Sheet Income Statement
Case 1&2: Revenues
If Kartik delivers 200 parcels in December for $5 per delivery, he has technically earned fees totaling
$1,000 for that month. He sends invoices to his clients for these fees and his terms require that his
clients must pay by January 15
Case 3: Expenses
If Kartik hires some labor to help him with December deliveries and Kartik agrees to pay him $300 on
January 3 and another $100 for pakaging and other supporting material; Total expenses of $400
expense for December deliveries
Case 4: Expenses
FastTrack Movers and Packers borrowed $20,000 from a bank to start his business on 1st December
and the company agrees to pay 5% in interest, or $1,000. The interest is to be paid in a lump sum on
December 1st of each year.
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FastTrack Movers & Packers Inc.
Sales $1,100
Cost of goods sold $400
Gross Profit $700
Selling,general and admin. Expenses 1
$30
Depreciation Expense $233
Insurance Expense $100
Income from operations $337
Interest expense $83
Income before taxes $254
Income Tax @ 33% $84
Net Income $170
Note 1: SG&A expense is assumed to be $30 in December,2007
Income Statement, for month ended 31st December, 2007
Consolidating all cases in Income Statement
Case 1 (accrual) + Case 9 (earned revenue for December)
Case 6, monthly depreciation = $2,800/12 = $233
Case 7, insurance premium worth $1,200/12 =$100 is utilized per
month
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Consolidated Balance Sheet
Assets Liabilities & Stockholder's Equity
Current assets Current Liabilities
Cash $24,370 Unearned Revenue $500
Prepaid Insurance $1,100 Accounts Payable $400
Accounts Receivable $1,000 Interest Payable $83
Inventory $1,000 Income Tax Payable $84
Total Current Assets $27,470 Total Current liabilities $1,067
Vehicle $14,000 Long term debt $20,000
Accumulated depreciation $233
Net $13,767 Stockholder's Equity
Common Stock $20,000
Retained Earnings $170
Total Assets $41,237 Liabilities & Stockholder's Equity $41,237
FastTrack Movers & Packers Inc
Balance Sheet, December 31st 2007
Insurance premium worth $1,200/12 =$100 is utilized for
December
Cash receipt on January 15th, however, sales has been completed
and booked as Accounts Receivables
Net Income Flows through the Income Statement
Revenues worth $100 earned in December, hence Unearned revenue
of $600 adjusted for the earned revenues
Unpaid expenses, classified as
liabilities
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Balance Sheet – Key questions?
Balance sheet shows the company’s assets worth?
YES?
NO?
Balance sheet does not provide us with the fair market value of the company?
Long-term assets reported at their cost minus amounts already sent to Income Statement as depreciation expense
The asset Land is not depreciated, so it will appear at its original cost even if the land is now worth one hundred times more than its cost
However, Short-term asset amounts are likely to be close to their market values, since they tend to "turn over" in relatively short periods of time
Is reputation cost captured in Balance Sheet – Brand, Logo etc?
Bill Gates
Nike
BMW
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Cash Flow Statement
Private and Confidential – Not for Circulation
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Cash Flow Statement – Cash is the King!
Purpose of this cash flow statement is to identify sources & uses of cash during the year
Cash Flow is divided into three parts
Cash flow from operations: Include all the transactions and other events related to its earnings process
Cash flow from Investments: Include all the transactions involving acquiring and selling long-term investment, property, plant, and equipment
Cash Flow from Finance: Include all the transactions involved in obtaining and disbursing resources from and to owners and repaying the amounts borrowed
Net Cash
Cash flow from
Operations
Cash flow from
Investing Cash flow from
Finance + +
Cash Inflows:
Generation of funds in normal operations
Cash Outflows:
Expenditure of funds in normal operations
Cash Inflows:
Debt issuance, common stock, preferred stock and other securities
Cash Outflows:
Retirement of debt, common stock and preferred stock
Payment of cash dividend
Cash Inflows:
Sale of plants and equipments
Liquidation of long term investments
Cash Outflows:
Purchase of plants and equipments
Investments in long term investments
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Calculating Cash flows
Cases
Cash Impact
(yes/no)Cash Amount Classification Comments
Case 1 No $0 Operation Revenues earned but not paid
Case 2 No $0 Operation Revenues earned but not paid
Case 3 No $0 Operation Expenses incurred but not paid
Case 4 No $0 Operation Interest expense incurred but not paid
Case 4 Yes $20,000 Finance FastTrack borrows from the bank
Case 5 Yes $20,000 Finance Kartik infuses capital
Case 6 Yes ($14,000) Investing Purchase of truck
Case 7 Yes ($1,200) Operation Prepaid expenses
Case 8 Yes ($1,000) Operation Purchase of Inventory (boxes)
Case 9 Yes $600 Operation Customer Prepays
Others Yes ($30) Operation SG&A expenses incurred and paid
Cash flows $24,370
Cash flow from operations ($1,630)
Cash flow from investing ($14,000)
Cash flow from financing $40,000
Total Change in cash $24,370
End Cash Cash at the
beginning Change in cash during
the period = +
Flows into the Balance Sheet as “Cash”
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