Accounting Fundamentals Course Transcript

This is the transcript from our popular accounting fundamentals course at the Corporate Finance Institute

Accounting Fundamentals

Part 1 (video course)

Intro  
–    Hi, and welcome to Accounting fundamentals- Module 1: – constructing a balance sheet and income statement
–    In this session we will:
–    Explain the format of the balance sheet and income statement, record transactions, and prepare a simple income statement and balance sheet
–    Let’s get started.    


 

Financial statements 
–    Let’s first start with an explanation of what financial statements are.
–    The financial statements are a record of the financial activities of a business.
–    There are three key financial statements.
–    The balance sheet, also known as the statement of financial position, shows what a business owns (assets), what it owes (liabilities) and what it is worth (equity) at a particular point in time.
–    The income statement, also referred to as profit and loss statement (or P&L), shows what a business has earned as revenues, what it has paid out in expenses, and the resultant profit or loss for a given period. 
–    The statement of cash flows shows how a business has generated or used cash for operating, investing or financing activities
–    Now, let’s explore each of the financial statements in more detail.
    We need visuals.  I have put three diagrams at the bottom of the slide.  These should appear as they are talked about.  

 

Balance sheet
–    In order to understand what makes up the balance sheet we need to define a number of terms.
–    Assets are things that a business owns.  This includes cash in the bank and furniture in the office – all of the things that have been purchased to use or sell in the operation of the business.
–    Assets are classified as “current” or “non-current”.  A non-current asset is something you expect to still own in more than one year’s time.  For example, a building is something you would expect to own for more than a year, and therefore is typically classified as a non-current asset.  Cash in the bank, on the other hand, is readily available and is typically classified as a current asset.
–    Liabilities are what the business owes.  The most common liability is the amounts a business owes its suppliers.  A liability is created every time a company purchases something and agrees to pay for it at a later date.
–    Liabilities are also classified as current and non-current.  A loan from a bank that does not have to be repaid in the next year is classified as a non-current liability.
–    In contrast, the amount a company owes to suppliers is typically classified as a current liability as supplier credit terms normally range from 30 to 90 days.
–    Equity is what the business is worth.  At the start of a business, equity is equal to the amount the business owner invests in exchange for shares.  If the business generates profits and these profits are retained in the business, equity increases.  Profits that are retained in the business are commonly referred to as retained earnings.
–        Reveal the various components when they are discussed.

 

Building a balance sheet
–    Let’s start building a simple balance sheet.  Before continuing, it is important to flag that a balance sheet must always balance.
–    To ensure this is the case all transactions are recorded in the balance sheet in two places.
–    As we work through a simple example keep in mind that we have two options.  
–    We either record the transaction on both the asset and liabilities sides of the balance sheet or we record the transaction twice on the same side of the balance sheet as both a positive and negative number.
–        Have a scale with “assets” on one side and “liabilities & equity” on the other.  You may want it to move up and down like a see-saw before balancing.

 

Transactions
–    Let’s imagine that a company engages in the following transactions.
–    Issued shares for 100
–    Took out a four year bank loan of 50
–    Bought equipment and machinery  for 80
–    Bought inventory for 60
–    Sold all the inventory for 90
–    Paid salaries of 20
–    Paid interest of 3.
–    How would each of the transactions be recorded in the balance sheet?

 

Shares
–    Let’s start by looking at what happens when the company issues shares for 100 in cash.  First, the company’s cash balance increases from zero to 100.  This is recorded as a current asset.  
–    Now we either have to record a transaction on the liabilities side of the balance sheet or record a negative number on the asset side of the balance sheet.
–    In this instance, we record 100 next to common shares under equity.  
–    The balance sheet balances.  Assets equal total liabilities and equity.
    Use the red circle to flag what is being discussed.

 

Loan
–    Now let’s consider what happens to the balance when the company takes out a four year bank loan of 50.
–    The company “owes” 50 to the bank.  This is recorded as a non-current liability because the loan is not due to be repaid for four years.
–    The proceeds from the loan initially sit in cash – increasing the company’s cash balance to 150.  
–    The balance sheet still balances.  Now let’s move on to the next transaction.
    Use the red circle to flag what is being discussed.

 

Equipment   
–    What happens to the balance sheet when the company buys a piece of equipment for 80?
–    First, the company’s cash is reduced by 80.
–    However, the company now has a non-current asset called “equipment” with a value of 80. 
–    On a real balance sheet, we typically see the term “PP&E” or “property, plant & equipment” rather than just “equipment”.
–    The balance sheet continues to balance.  Assets equal total liabilities and equity.
     Use red circles again.  When the text mentions PP&E use red font (that reads PP&E) and a red arrow and have the arrow pointing at property.

 

Inventory 
–    What happens to the balance sheet when the company buys inventory for 60?
–    First, the company’s cash is reduced by additional 60.
–    However, the company now has a second current asset called “inventory” with a value of 60. 
–    Sometimes companies refer to their inventory as “stock”.
–    The balance sheet continues to balance.  Assets equal total liabilities and equity.
    Use red circles again.  When the text mentions “stock” use red font (that reads “sometimes called stock”) and a red arrow and have the arrow pointing at inventory.

 

Inventory 2
–    What happens to the balance sheet when the company sells the inventory for 90?
–    First, the company’s cash increase by 90.
–    Next, the company’s inventory drops to zero.
–    The company has made a profit of 30.  It generated revenues of 90 by selling inventory that cost it 60. 
–    Revenues are sometimes referred to as “sales” or as “turnover”.
–    The cost of inventory is typically referred to as “cost of sales” or “cost of goods sold”.
–     Profits belong to shareholders.  As a result, we will record this profit as retained earnings under shareholders’ equity.
–        Use red circles again.  When the text mentions “sales” and “turnover” use red font (that reads “sales or turnover”) and a red arrow and have the arrow pointing at revenues.  When the text mentions “cost of goods sold” use red font (that reads “COGS”) and a red arrow and have the arrow pointing at cost of sales.

 

Salaries
–    What happens to the balance sheet when the company pays salaries of 20?
–    First, the company’s cash decreases by 20.
–    Salaries are an expense like cost of sales which reduces the company’s profit from 30 to 10.
–    The balance sheet continues to balance.  Assets equal total liabilities and equity.

    Use red circles again.  
 

Interest   
–    Finally, what happens to the balance sheet when the company pays interest on its bank loan?
–    First, the company’s cash decreases by 3.
–    Interest is an expense like cost of sales and salaries.  As a result, the company’s profit is reduced from 10 to 7.
–    As before, the balance sheet continues to balance.  –        


 

Pop quiz    
See PowerPoint slides.    

 

Cash
–    In our previous example, the company bought and sold its inventory for cash.  In practice, companies regularly buy and sell goods and services using credit terms rather than cash. 
–    Accounts receivable is the terms used for amounts owed by customers to the company
–    Accounts payable is the term used for amounts owed by the company to suppliers.
–    How would our previous balance sheet example look different if the company bought inventory for 60 on credit rather than using cash?
–    What about if the company sold all its inventory for 90 on credit rather than for cash?    

 

Inventory
–    If the company sells its inventory on credit for 90, it records revenues of 90 when it makes the sale.  However, instead of increasing cash by 90 the company records that a customer owes them 90.  
–    In other words, accounts receivable is increased to 90.  
–    Accounts receivable is typically found under current assets because we expect to receive payment from the customer in less than one year.
–    If the company buys its inventory on credit for 60, it initially records inventory of 60 which it later reduces to zero when it sells this inventory.  However, instead of reducing cash by 60 the company records that it owes a supplier 60.  
–    In other words, accounts payable is increased to 60.  
–    Accounts payable is typically found under current liabilities because we expect to pay the suppliers in less than one year.
–    As always, the balance sheet continues to balance.-        

 

Constructing a balance sheet exercise    
–    Now it’s your turn to construct a simply balance sheet
–    Click on the link entitled “Vadero Inc exercise”.
–    Once you are finished, click on the “Vadero Inc solution”. 
–    Good luck!    

 

Pop quiz    
See PowerPoint slides.    

 

Income Statement
–    The income statement is sometimes referred to as “the statement of operation”, “the profit and loss account”, or simply the “P&L”.
–    When you think about the number of transactions an operating company would have during the year you can see that it doesn’t make sense to display them all in the balance sheet.  
–    These transactions are summarized in a different statement, the income statement.  
    
Income Statement 2
–    Let’s look at the income statement in more detail.
–    The income statement starts with revenues.  Recall that sometimes revenues are referred to as “sales” or “turnover”.
–    Direct operating expenses such as the cost of inventory come next.  These direct expenses are often referred to as “cost of sales” or “cost of goods sold”.  
–    Revenues less cost of sales give us our first profit figure – gross profit.  
–    Next come indirect operating expenses such as administration expenses.  These indirect operating expenses are sometimes grouped into one line item called “selling, general & administration expenses” or “SG&A”.
–    Revenues less direct and indirect operating expenses give us operating income.  The terms “profit” or “earnings” are sometimes used instead of “income”.  Operating income is also commonly referred to as EBIT or “earnings before interest and tax”.
–     Once we deduct interest expenses and tax we are left with the profit attributable to shareholders – referred to as “net income”, “net profit” or “net earnings”.
    
Balance Sheet
–    Let’s create an income statement using our previous balance sheet example.  
–    On the left you see an extract from our balance sheet.  
–    We are going to focus on the items that make up retained earnings.
–    We start by taking revenues and cost of sales and netting them off to calculate gross profit.  In this instance gross profit is 30.
–    We then take off all other operating expenses to get operating profit.  In this example, the only other operating expense we have is salaries.  Recall that we often refer to other indirect operating expenses as “SG&A expenses”
–    Deducting salaries from gross profit gives us an operating profit of 10.
–    Next we take off interest and taxes to get net profit.  In our example, we have assumed that taxes are zero.
    Ideally, I would like the numbers to fly over from the left to the right as they are discussed so that the income statement is built as it is talked about.

 

Revenue
–    The income statement includes only the revenues and expenses that relate to the accounting year.
–    Let’s look at an example.  During the final month of this accounting year, the company buys insurance for 12 months at a cost of 12,000.  How much insurance expense would be recorded in the income statement for this accounting year?
    
Insurance
–    We have 12 months of insurance for 12,000 or 1,000 per month.  If we record this expense as we paid for it we would have an expense of 12,000 in one month and nothing for the following 11 months.  This doesn’t really make sense, as we have the insurance coverage for a year, not one month.  We need to reduce the expense to 1,000.  
–    What do we do with the remaining 11,000?
–    This amount is called a prepaid expense, and is included as an asset on the balance sheet.
–    If we consider an asset as something we own, not something we owe, it makes sense that we own 11 months of insurance coverage, as we have paid for it, and will use it next year.  Do you think this would be a current or non current asset?  
–     As we will be using the rest of the insurance in the coming year, it is a current asset.
    
Example
–    Here’s another example.  
–    Imagine that a company used 2,000 worth of office supplies in the current year but that these office supplies were not paid for until the following year?
–    How much of this expense should be included in the income statement for the current year?
    
Expense 
–    The company should include the full expense of 2,000 as this is the value of the office supplies used in the current year.
–    Since the company hadn’t paid for the office supplies in the current year, how do we record the second half of the transaction?
–    We record it as a current liability.  The amount is called an “accrued expense” and is recorded as a current liability because we will have to pay it in the next year.
    
Pop quiz    
See PowerPoint slides.    

 

Accruals / prepayment exercise    
–    Now it’s your turn.
–    Click on the link entitled “Luton Inc exercise”.
–    Once you are finished, click on the “Luton Inc solution”. 
–    Good luck!    

 

Depreciation
–    The final concept for this module is depreciation.  
–    Recall that in our original balance sheet example, we purchased equipment with a value of 80.  We recorded this as PP&E under non-current assets.
–    Let’s now assume that the useful life of this equipment is 4 years, that we can allocated that usefulness evenly over the years of use, and that after 4 years the equipment has a scrap value of 30.
–    How would we account for the reduction in value of the equipment as we use it in our operations?
–    The answer is that we record an expense called “depreciation”.
    
Depreciation 2
–    Let’s look at depreciation in more detail.  
–    In the income statement we record a “depreciation” expense.  In this instance the deprecation expense is calculated by taking the purchase price (80), deducting the scrap value (30) and dividing the difference by 4 years.  This gives us a depreciation expense of 12.5 a year.
–    On the balance sheet, the value of the equipment would start at 80 but would reduce by 12.5 a year for the next 4 years.  At the end of 4 years, the equipment would be valued on the balance sheet at 30.
    
Depreciation exercise    
–    Now it’s your turn.
–    Click on the link entitled “Jenga Inc exercise”.
–    Once you are finished, click on the “Jenga Inc solution”. 
–    Good luck!    

 

Conclusion    
–    That concludes this session on accounting fundamentals – constructing a balance sheet and income statement.
–    In this session we explored the format of the balance sheet and income statement demystifying financial terms such as accounts receivable, accounts payable, prepayments, and accruals.
–    We also learnt how to record financial transactions on the balance sheet and income statement and prepare a simple set of financial statements.
–    We hope you’ve enjoyed this module and look forward to seeing you for accounting fundamentals – constructing the cash flow statement

 

 

Part 2 (video course)

Cash Flow   
Welcome to Accounting fundamentals module two – constructing a cash flow statement.

In this module we will outline the format of the cash flow statement, explain the difference between the cash flow statement and the income statement, and build a cash flow statement from scratch.
    
Financial statements
You’ll recall that there are three key financial statements.  

The balance sheet shows what a business owns (assets), what it owes (liabilities) and what it is worth (equity) at a particular point in time.

The income statement shows what a business has earned as revenues, what it has paid out in expenses, and the resultant profit or loss for a given period. 

The statement of cash flows shows how a business has generated or used cash for operating, investing or financing activities

In this module, we are going to explore the cash flow statement.
    Please circle the cash flow statement when it is discussed.  

 

Cash flow statement
In theory, it is not necessary to have a cash flows statement as all cash items could be recorded in the balance sheet.
However, in practice just the closing cash balance is recorded on the balance sheet and all the details are shown in the cash flow statement. 
Understanding where cash has come from, and how it has been used is very useful for both management and users of financial statements.
    
Operating activities
The cash flow statement organizes cash inflows and outflows based on whether they relate to operating activities, investing activities or financing activities.    
Examples of cash flows that relate to operating activities include receipts from customers as well as payments to suppliers.

Examples of cash flows relating to investing activities include the sale and purchase of property, plant and equipment as well as buying and selling investments.

Examples of cash flows relating to financing activities include the issuance of shares, paying dividends, issuing bonds and repaying loans.
    
Prepayments
Let’s explore why profit and cash are not the same thing.  In module 1, we learnt about prepayments and accrued expenses.  The “accrual concept” requires a business to recognize revenues and costs in the income statement as it earns or incurs them, not as it receives or pays cash.  

The cash flow statement, on the other hand, looks only at when cash is paid or received.  Let’s look at how this works in practice.
      
Costs
Imagine a five day transit pass that costs $40 and is paid for on Monday with cash.  How mush is the daily cost of travel on Thursday – first, on a cash flow basis and then secondly, on a matching or accruals basis?  Once you have calculated your answers, consider which basis better reflects the cost of an individual journey?
    
Travel
On a cash flow basis the cost of travel on Thursday is zero as the cash expense happened on Monday.  However, on a matching basis the cost of travel on Thursday would be $8 (the total expense of $40 divided by 5 days).  

What basis better reflects the cost of an individual journey?  Both approaches provide valuable information to the user of financial statements.
    
Depreciate or not  
Test yourself with the following example.  Let’s imagine ABC Inc. buys a truck for 45,000 in cash, will use it in the business for 5 years and  then expects to sell it for 15,000 at the end of 5 years.

What do we show in the cash flow statement, the income statement, and the balance sheet in year 1?  Assume the company uses straight line depreciation and charges a full year of depreciation in the year of purchase.
      
Example
In year 1, ABC Inc. would record a cash outflow of $45,000 under the heading “investing activities” on the cash flow statement. 

The income statement would show a depreciation expense of $6,000.  This is calculated by taking the purchase price of $45,000 and deducting the expected scrap value of $15,000.  The difference is $30,000.  We then divide $30,000 by 5 years to get our annual depreciation charge.

The balance sheet would show an increase in property, plant and equipment of $39,000 at the end of year 1 given that the company charges a full year of depreciation in the year of purchase.  The value of the truck would start at $45,000 in the balance sheet but would be reduced by $6,000 a year. 

Now that we’ve explain the purpose of the cash flow statement and how it differs from the other two statements, let’s start building a cash flow statement from scratch.
    
Operating cash flow
We’ll start with the first section of the cash flow statement which deals with operating cash flows.  

The most obvious way of showing operating cash flows would be operating cash inflows less operating cash outflows.  Unfortunately, however, this method is rarely used in practice.  
    
Indirect method
Instead most organizations calculate their operating cash flows using the “indirect” method.

The indirect method begins with net income.  If all the items in the income statement were cash items, the net income number would be the only item in the operating cash flows section.  

However, adjustments are needed if some of the company’s sales are made on credit, if some of the company’s purchases are made on credit, if some of the company’s inventory is not sold, or if there are other non-cash items such as depreciation on the face of the income statement.
     
Cash flow layout
Here is a typical indirect operating cash flow layout.  You will see that it starts with net income, then adds back depreciation (as depreciation is a non-cash expense), and then calculates the impact of changes in inventory, receivables, and payables on operating cash flows.

We are going to build up the operating cash flow section of a cash flow statement using real numbers and using both the direct and indirect methods.  
Let’s get started.
     
Transactions
Below is a list of transactions and balances for Johannes GmbH.  If you’d like to test yourself as we go, please download the Excel attachment entitled “Johannes Periods 1 to 3 Template”.  You should try to complete period 1 before moving on in this module.  Alternatively, you may want to try and complete the attached spreadsheet once we walk through the solution on the next slide.

Johannes has cash purchases of 250, cash sales of 370, cash expenses of 40 and depreciation of 55. Johannes had no inventory at the year end. 

    
Example
Let’s work through each item individually.  First Johannes has cash purchases of 250.  We therefore record a negative number on the income statement next to “purchases” and on the direct method cash flow statement next to “cash on purchases”.  

Next Johannes has cash sales of 370.  We record positive 370 as “revenues” on the income statement and as “cash from sales” on the direct method cash flow statement.  

Cash expenses of 40 are recorded under “expenses” and “cash expenses” on the income statement and direct method cash flow statement respectively.  

Finally depreciation of 55 is recorded on the income statement but is not recorded on the direct method cash flow statement as depreciation is a non-cash expense.  

Netting revenues with expenses on the income statement gives us net income of 25.  Netting cash inflows and outflows on the direct method cash flow statement gives us an increase in cash of 80.  

Now let’s prepare the indirect method cash flow statement.  We start with net income of 25.  We then add back all non-cash expenses.  In this instance, we only have one non-cash expense – depreciation.  Adding back depreciation gives us an increase in cash of 80.  

Both the direct and indirect methods should always result in the same change in cash.
    The numbers should be revealed when they are talked about.

 

Advanced Example
Now let’s look at a slightly more complicated period 2.  Below is a list of new transactions and balances for Johannes GmbH.  Again, if you’d like to test yourself as we go, please use the Excel attachment entitled “Johannes Periods 1 to 3 Template” and complete period 2 before moving on in this module.  Alternatively, you may want to try and complete period 2 once we walk through the solution on the next slide.

In this period, Johannes has cash purchases of 280, cash sales of 300, sales on credit of 170, cash expenses of 50, receipts from receivables of 140 and depreciation of 55. Johannes had no inventory at the year end. 

    
More Detail
Let’s work through each item individually.  First Johannes has cash purchases of 280.  We therefore record a negative number on the income statement next to “purchases” and on the direct method cash flow statement next to “cash on purchases”.  

Next Johannes has cash sales of 300.  We record positive 300 as “revenues” on the income statement and as “cash from sales” on the direct method cash flow statement.  

Johannes has also made sales on credit of 170.  We add 170 to revenues on the income statement giving us total revenues of 470.  

Cash expenses of 50 are recorded under “expenses” and “cash expenses” on the income statement and direct method cash flow statement respectively.  

There were receipts from customers or accounts receivable of 140.  We add 140 to cash from sales on the direct method cash flow statement.

Finally depreciation of 55 is recorded on the income statement but is not recorded on the direct method cash flow statement as depreciation is a non-cash expense.  

Netting revenues with expenses on the income statement gives us net income of 85.  Netting cash inflows and outflows on the direct method cash flow statement gives us an increase in cash of 110.  

Now let’s prepare the indirect method cash flow statement.  We start with net income of 85.  We then add back all non-cash revenues and expenses.  In this instance, we only have two items – change in accounts receivable and depreciation.  The change in accounts receivable can be calculated by comparing accounts receivables at the start and end of the period.  Accounts receivables at the start of the period were zero.  Accounts receivable at the end of the period were 30 (which is the difference between revenues of 470 and cash from sales of 440).  We deduct the difference of 30 from net income.  As in period 1, we also need to add back depreciation of 55 which gives us an increase in cash of 110.  

Both the direct and indirect methods again result in the same change in cash.
    The numbers should be revealed when they are talked about.

 

Example
Now let’s look at an even more complicated period 3.  Below is a list of new transactions and balances for Johannes GmbH.  Again, if you’d like to test yourself as we go, please use the Excel attachment entitled “Johannes Periods 1 to 3 Template” and complete period 3 before moving on in this module.  Alternatively, you may want to try and complete period 3 once we walk through the solution on the next slide.

In this period, Johannes has cash purchases of 150, cash sales of 320, sales on credit of 310, purchases on credit of 180, receipts from receivables of 260, payments to payables of 140, cash expenses of 70, and depreciation of 55. Johannes had no inventory at the year end. 
    
Online example 
Let’s work through each item individually.  First Johannes has cash purchases of 150.  We therefore record a negative number on the income statement next to “purchases” and on the direct method cash flow statement next to “cash on purchases”.  

Next Johannes has cash sales of 320.  We record positive 320 as “revenues” on the income statement and as “cash from sales” on the direct method cash flow statement.  

Johannes has also made sales on credit of 310.  We add 310 to “revenues” on the income statement giving us total revenues of 630. There were purchases on credit of 180.  We add 180 to “purchases” on the income statement giving us total purchases of 330.

At the same time, there were receipts from customers of 260.  We add 260 to the 320 “cash from sales” on the direct method cash flow statement giving us cash from sales of 580.

There were payments to payables of 140.  We add 140 to “cash on purchases” giving us total “cash on purchases” of 290.  

Cash expenses of 70 are recorded under “expenses” and “cash expenses” on the income statement and direct method cash flow statement respectively.  

Finally depreciation of 55 is recorded on the income statement but is not recorded on the direct method cash flow statement as depreciation is a non-cash expense.  

Netting revenues with expenses on the income statement gives us net income of 175.  Netting cash inflows and outflows on the direct method cash flow statement gives us an increase in cash of 220.  

Now let’s prepare the indirect method cash flow statement.  We start with net income of 175.  We then add back all non-cash revenues and expenses.  In this instance, we have three items – changes in receivables, changes in payables and depreciation.  Accounts receivables at the start of the period were zero.  Accounts receivable at the end of the period were 50 (which is the difference between revenues of 630 and cash from sales of 580).  We deduct the difference of 50 from net income.  

Accounts payable at the start of the period were zero.  Accounts payable at the end of the period were 40 (which is the difference between purchases of 330 and cash on purchases of 290).  We add the difference of 40 to net income.  

As in previous periods, we also need to add back depreciation of 55 which gives us an increase in cash of 220.  

Both the direct and indirect methods again result in the same change in cash.    The numbers should be revealed when they are talked about.
 

Pop Quiz    
See slides    

 

Exercise    
Now it’s your turn.  Click on the link entitled “Johannes Period 4 exercise”. Once you are finished, click on the “Johannes Period 4 solution”. 
Good luck!
    
Coplete statement
We have so far only derived the operating cash flow section of the cash flow statement.  Now let’s move on and build a complete cash flow statement using the income statement and balance sheet.

As we will see, it is possible to derive the cash flow statement using this year’s balance sheet, last year’s balance sheet and this year’s income statement.

Usually analysts forecast future income statements and balance sheets and derive cash flows using the method described over the next few slides.
    
Negative  
In order to complete an entire cash flow statement, the first step is to compare this year’s and last year’s balance sheets.  

For every item in the balance sheet, we must calculate the difference between this year’s figure and last year’s figure.

If assets have increased this will have resulted in a cash outflow and therefore we will record the difference as a negative amount.

If liabilities have increased this will have resulted in a cash inflow and therefore we will record the difference as a positive amount.

We then add up the total of all the differences and it should equal the increase or decrease in cash. 

Let’s see how this works in practice.
        
Example
Here is an extract from ABC Inc’s balance sheet. 

Accounts receivable have increased from 80 to 150.  The difference of 70 will be recorded as a negative amount.

Inventory has increase from 60 to 80.  The difference of 20 also will be recorded as a negative amount.

Finally, accounts payable have increased from 30 to 50.  The difference of 20 will be recorded as a positive amount.
    Use red circles to highlight what is being discussed.

 

Financing activities
Once we have completed our analysis of this year and last year’s balance sheets, the next step is to put each of the differences into the cash flow statement classifying them 
as either operating cash flows, investing cash flows or financing cash flows.

How should we classify ABC Inc’s cash flows related to accounts receivable, accounts payable, and inventories? 
    
AR
ABC Inc’s cash flows related to accounts receivable, accounts payable, and inventories would all be classified under operating activities.  If we assume ABC Inc’s net income is 8 and its depreciation expense is 90, operating cash flows would be 28.
    
PP&E
When dealing with the difference between this year and last year’s property, plant and equipment, we need to recognize that there are two reasons why a difference in PP&E might arise – depreciation and/or net capital expenditure (also known as CAPEX).

Therefore the difference in the PPE number must be disaggregated into these two components.  Depreciation is included in the operating cash flow section while net capital expenditure is included in the investing section. 

Let’s again see how this works in practice.
    
PPE
We can calculate net capital expenditure as long as we have the following three items – the opening net book value of PP&E from the balance sheet, the closing net book value of PP&E from the balance sheet and the depreciation expense from the income statement.

If ABC Inc’s depreciation expense is 90 and PP&E in the balance sheet is 810 in year 1 and 730 in year 2, what is ABC Inc’s net capital expenditure?
    
Capex  
We know that opening PP&E plus net capital expenditure less depreciation will give us closing PP&E.  If we know that opening PP&E is 810, depreciation is 90 and closing PP&E is 730, we can solve for net capital expenditure.

In this example, net capital expenditure must be 10 and would be recorded as a cash outflow classified under “investing activities”.
    
Retained Earnings
When dealing with the difference between this year and last year’s retained earnings, there are again usually two reasons why a difference arises –  net income and/or dividends.

Therefore the difference in retained earnings must be disaggregated into these two components.  Net income is included in the operating cash flow section while dividends are included in the investing section. 
    
Quiz    
Pop Quiz
    
Exercise    
Now it’s your turn.  There are two exercises for you to try – “Jenga cash flow exercise” and “Candor cash flow exercise”.  Once you’ve had a go, click on the appropriate solution – “Jenga cash flow solution” or “Candor cash flow solution”.  Good luck!
    
Conclusion    
That concludes this session on accounting fundamentals – constructing a cash flow statement.  This course is critical for anyone considering a job in accounting.

In this session we explored the format of the cash flow statement and explained the difference between the cash flow statement and the income statement.  We then went on to build a cash flow statement from scratch.

We hope you enjoyed this module and look forward to seeing you again.