Accounting
Financial statements, accrual accounting, adjusting entries, and cash flow analysis (BADM 210)
LO1: Who Uses Accounting Information?
External and internal decision-makers; costs and benefits of disclosure
What is Accounting?
Accounting is the process of recording, summarizing, and analyzing financial transactions to help people make economic decisions.
Financial Accounting
Designed primarily for decision-makers outside the company (investors, creditors, regulators). Reports on past performance.
Managerial Accounting
Designed primarily for decision-makers within the company (managers). Supports internal planning and control.
Decision Makers and Their Questions
| User | Decision | Information Needed |
|---|---|---|
| Shareholders / Investors | Buy, sell, or hold stock? | Profitability, growth potential, dividends, ROE |
| Creditors (banks, bondholders) | Lend? At what rate? How much collateral? | Solvency, cash flows, debt levels, ability to repay |
| Suppliers | Extend credit terms? Long-term supply relationship? | Financial stability, ability to pay obligations |
| Management | Evaluate performance; plan strategy; earn bonuses | Operating results, cost data, efficiency metrics |
| Board of Directors | Oversee management; assess strategy; represent shareholders | Full financial statements; management performance |
| Regulators / Government | Tax compliance; market oversight | Revenues, expenses, assets, disclosures |
Costs and Benefits of Disclosure
Benefits
- Lower borrowing costs (lower interest rates)
- Better supplier terms (long-term relationships)
- Increased investor confidence and access to capital
Costs
- Hiring accountants to prepare statements
- Competitors gain access to strategic information
- Political costs — increased regulation and taxes
LO2: Business Activities & the Accounting Equation
Planning, investing, financing, and operating activities
Four Business Activities
Planning
Setting goals and strategies. Primary goal: create value for owners.
Investing
Acquiring and disposing of assets (resources) used to produce products/services. Short-term assets (inventory) and long-term assets (equipment, buildings).
Financing
Funding investments. Two external sources: debt financing (creditors) and equity financing (owners). Financial management = planning the proper mix.
Operating
Producing, promoting, and selling products/services. Generates revenues and incurs expenses. Net Income = Revenues − Expenses.
The Accounting Equation
Assets = Liabilities + Equity
Creditor Financing + Owner Financing = Economic Resources
| Term | Definition | Nike FY2020 Example |
|---|---|---|
| Assets | Economic resources owned or controlled by the company that provide future benefits | $31,342M |
| Liabilities | Non-owner claims on assets; obligations to creditors (debt financing) | $23,287M |
| Equity | Owner claims on assets; residual interest after liabilities are satisfied | $8,055M |
Operating equation: Net Income = Revenues − Expenses (Nike FY2020: $2,539M = $37,403M − $34,864M)
LO3: The Four Financial Statements
Balance sheet, income statement, stockholders' equity, and cash flows
Balance Sheet
A.K.A. Statement of Financial Position
Point in timeAssets = Liabilities + Equity. Lists all investments (assets) and how they were financed (liabilities + equity). A snapshot of financial position on a specific date.
Assets = Liabilities + EquityIncome Statement
A.K.A. P&L / Statement of Operations / Statement of Earnings
Period of timeReports operating results. Revenues come from business activities; expenses are the cost of generating those revenues.
Revenues − Expenses = Net IncomeStatement of Stockholders' Equity
A.K.A. Equity Reconciliation
Period of timeShows changes in equity: contributed capital (stock issued) and earned capital (retained earnings). Retained earnings = cumulative net income − cumulative dividends.
Beg. RE + Net Income − Dividends = End. REStatement of Cash Flows
A.K.A. Cash Flow Statement
Period of timeReports actual cash in and out across operating, investing, and financing activities. Cash from operations often differs from net income due to accrual accounting timing.
Operating + Investing + Financing Cash FlowsFinancial Statement Articulation
The four statements are linked — called articulation. Net income flows into retained earnings; retained earnings flows to equity on the balance sheet; ending cash on the cash flow statement equals cash on the balance sheet.
Statement linkage chain:
Reporting periods can be annual (fiscal year), quarterly, or monthly. Nike's fiscal year ends May 31.
LO4: Regulation & Accounting Standards
GAAP, SEC, FASB, SOX, and IFRS
| Body / Standard | Full Name | Role |
|---|---|---|
| GAAP | Generally Accepted Accounting Principles | Standards and accepted practices guiding U.S. financial statement preparation. Allows some discretion but ensures comparability. |
| SEC | Securities & Exchange Commission (created by Securities Act of 1934) | Regulates issuance and trading of U.S. securities. Companies with >$10M assets and >500 owners must file annual reports. |
| FASB | Financial Accounting Standards Board | Currently establishes U.S. accounting standards (GAAP). Developed the Conceptual Framework for unaddressed issues. |
| SOX | Sarbanes-Oxley Act (2002) | Congressional response to accounting scandals (Enron). Increases confidence in financial reporting. Established PCAOB. |
| PCAOB | Public Company Accounting Oversight Board | Created by SOX. Approves auditing standards and monitors quality of financial statements and audits. |
| IASB / IFRS | International Accounting Standards Board / International Financial Reporting Standards | Sets international standards. No legal enforcement power but widely adopted outside the U.S. Growing convergence with GAAP. |
Management's Role
- Prepares the financial statements
- Takes legal responsibility for disclosures
Independent Auditors' Role
- "Audit" financial statements for accuracy and completeness
- Publicly traded companies must have audits by an independent firm
- An audit opinion is assurance, not a guarantee
LO5: Key Financial Ratios
Return on equity (profitability) and debt-to-equity (risk)
Return on Equity (ROE)
Measures profitability — how efficiently equity is used to generate profit
- Higher ROE = more profitable use of owner capital
- Compare to prior periods and industry peers
- Nike's ROE declined in FY2020 vs. prior year
Debt-to-Equity Ratio
Measures credit risk / solvency — how much debt is used relative to equity
- Higher D/E = more leveraged, more financial risk
- Solvency: ability to remain in business and avoid bankruptcy
- Nike's D/E ratio increased between 2018 and 2020
LO1: Balance Sheet Structure
Assets, liabilities, and stockholders' equity components
Assets
Resources expected to provide future economic benefits. Must be owned/controlled by the company and have measurable monetary value.
Current Assets (due within 1 year) — listed by liquidity
- • Cash — currency, deposits, cash equivalents
- • Marketable securities — short-term investments
- • Accounts receivable — amounts owed by customers
- • Inventory — goods purchased or produced for sale
- • Prepaid expenses — rent, insurance paid in advance
Noncurrent Assets (long-term)
- • Long-term financial investments
- • PP&E — land, buildings, equipment (net of depreciation)
- • Operating lease ROU assets
- • Intangibles — patents, trademarks, goodwill
Reported at historical cost (reliable but may undervalue). Some assets (marketable securities) reported at fair value.
Liabilities
Obligations to external parties. Recognized when: (1) future sacrifice probable, (2) amount known/estimable, (3) obligating event occurred.
Current Liabilities (due within 1 year)
- • Accounts payable — owed to suppliers for credit purchases
- • Accrued liabilities — expenses recorded but unpaid
- • Short-term borrowings — short-term bank debt
- • Deferred (unearned) revenue — cash received, service not yet delivered
- • Current maturities of LT debt — portion of LT debt due this year
Noncurrent Liabilities
- • Long-term debt — repaid beyond 1 year
- • Operating lease obligations (long-term portion)
- • Other LT liabilities — warranties, deferred tax
Stockholders' Equity
Contributed Capital:
- • Common stock — par/stated value of shares issued
- • Additional paid-in capital — amount received above par
- • Treasury stock — cost of repurchased shares (deducted)
Earned Capital:
- • Retained earnings — cumulative income not paid as dividends
- • AOCI — accumulated other comprehensive income
Retained Earnings Formula
Net income increases retained earnings; a net loss decreases it. Reported in the stockholders' equity section of the balance sheet.
LO2: Transaction Analysis & FSET
Financial Statement Effects Template and the Jana Juice example
Financial Statement Effects Template (FSET)
The FSET captures each transaction's effect on the balance sheet and income statement simultaneously. The balance sheet must always remain in balance: Assets = Liabilities + Equity.
| Transaction | Balance Sheet | Income Statement | |||||
|---|---|---|---|---|---|---|---|
| Cash Asset | + Noncash Asset | = Liabilities | + Contrib. + Earned Capital | Revenues | − Expenses | = Net Income | |
| e.g., Sell inventory for cash | +2,400 | −600 Inv. | — | +1,800 RE | +2,400 | +600 | +1,800 |
Jana Juice — 15 Transactions (May)
Jana Juice is a startup energy drink company. Transactions 1–15 occurred in May (first month of operations).
| # | Transaction | Key Account Effects |
|---|---|---|
| 1 | Issued 500 shares of stock for $10,000 cash | Cash +10,000 | Common Stock +10,000 |
| 2 | Borrowed $4,000 (note payable, repay May 31 + $40 interest) | Cash +4,000 | Notes Payable +4,000 |
| 3 | Paid $1,800 security deposit for store rental | Cash −1,800 | Security Deposit +1,800 |
| 4 | Purchased $2,000 inventory on account | Inventory +2,000 | Accounts Payable +2,000 |
| 5 | Paid $900 for newspaper advertising in May | Cash −900 | Advertising Expense +900 | RE −900 |
| 6 | Paid $1,500 on accounts payable | Cash −1,500 | Accounts Payable −1,500 |
| 7 | Sold $600 of inventory for $2,400 cash | Cash +2,400 | Inventory −600 | Revenue +2,400 | COGS +600 |
| 8 | Sold $700 of inventory on account for $2,900 | AR +2,900 | Inventory −700 | Revenue +2,900 | COGS +700 |
| 9 | Paid $1,300 in wages to employees | Cash −1,300 | Wages Expense +1,300 | RE −1,300 |
| 10 | Received $300 for 3-month online health membership (June–Aug) | Cash +300 | Unearned Revenue +300 (liability — not yet earned) |
| 11 | Collected $1,200 from customers on account | Cash +1,200 | Accounts Receivable −1,200 |
| 12 | Repaid $4,000 note payable + $40 interest | Cash −4,040 | Notes Payable −4,000 | Interest Expense +40 | RE −40 |
| 13 | Paid $800 for 4-month insurance policy (prepaid) | Cash −800 | Prepaid Insurance +800 |
| 14 | Paid $700 rent for May | Cash −700 | Rent Expense +700 | RE −700 |
| 15 | Paid $400 dividends to shareholders | Cash −400 | Retained Earnings −400 (no effect on net income) |
LO3: The Income Statement
Reporting financial performance for a period
Income Statement Format
Revenues = increases in net assets from business activities.
Expenses = outflow or use of assets to generate revenues.
Nonoperating items (interest revenue/expense) are segregated because they relate to financing/investing, not core operations.
Jana Juice Income Statement (May)
Revenue = txn 7 ($2,400) + txn 8 ($2,900) = $5,300.
COGS = txn 7 ($600) + txn 8 ($700) = $1,300.
LO4: Accrual Accounting
Revenue and expense recognition principles; retained earnings articulation
Revenue Recognition
Recognize revenue when goods or services are transferred to the customer — not when cash is received.
Example:
Target sells $140,000 of goods in May (collecting $130,000 cash; $10,000 promised in June).
Revenue recognized in May = $140,000
(Not $130,000 — delivery, not cash receipt, triggers recognition)
Expense Recognition (Matching Principle)
Recognize expenses when assets decrease (or liabilities increase) as a result of generating revenue — match costs to the revenue they helped earn.
Example:
Target bought $80,000 of inventory; sold $70,000 worth for $120,000 during May (paid $65,000; owes $15,000).
COGS recognized in May = $70,000
(The $70,000 sold, not the $65,000 paid)
Retained Earnings Articulation
Net income from the income statement flows into retained earnings in the Statement of Stockholders' Equity, linking the income statement to the balance sheet across periods (articulation).
(Target Corporation, year ended January 29, 2022 — $ millions)
LO5: Equity Transactions & Statement of Stockholders' Equity
Dividends, stock issuances, and equity reconciliation
Key Points
- Dividends reduce retained earnings but have no effect on net income — they are a distribution of profit, not an expense
- The Statement of Stockholders' Equity reconciles beginning and ending equity balances
- Total equity = Contributed Capital + Earned Capital
- Retained earnings begins at zero for a new company and accumulates over time
Jana Juice — Statement of Stockholders' Equity (May)
| Item | Contrib. Capital | Earned Capital (RE) | Total |
|---|---|---|---|
| Balance, May 1 | $— | $— | $— |
| Common stock issued | 10,000 | — | 10,000 |
| Net income | — | 1,060 | 1,060 |
| Cash dividends | — | (400) | (400) |
| Balance, May 31 | $10,000 | $660 | $10,660 |
Jana Juice — Balance Sheet (May 31)
LO6: Journal Entries & T-Accounts
Debits, credits, and double-entry accounting
T-Account Format
A graphic representation of an account used to record increases and decreases.
Debit (Dr)
Always on the Left
Credit (Cr)
Always on the Right
Double-entry accounting: Every transaction affects at least two accounts. Total debits must always equal total credits.
Normal Balances Summary
| Account Type | Normal Balance | Increase via | Decrease via |
|---|---|---|---|
| Assets | Debit | Debit (Dr) | Credit (Cr) |
| Expenses | Debit | Debit (Dr) | Credit (Cr) |
| Dividends | Debit | Debit (Dr) | Credit (Cr) |
| Liabilities | Credit | Credit (Cr) | Debit (Dr) |
| Equity | Credit | Credit (Cr) | Debit (Dr) |
| Revenues | Credit | Credit (Cr) | Debit (Dr) |
Journal Entry Format
Record debits first; credits are indented. Example: Jana Juice Transaction 7 (sold inventory for cash):
Amounts are then posted from journal entries to the corresponding T-accounts in the general ledger.
LO7: Liquidity Ratios
Measuring a company's ability to pay short-term obligations
Liquidity is the ability to pay debts when due. The larger current assets are relative to current liabilities, the more liquid the company.
Net Working Capital
Positive NWC = can cover short-term obligations from current assets. Negative NWC signals potential liquidity problems.
Current Ratio
Ratio > 1 means current assets exceed current liabilities. Benchmark varies by industry. Declining trend signals worsening liquidity.
Quick Ratio
Quick Assets = Cash + Marketable Securities + Accounts Receivable (excludes inventory and prepaid expenses — less liquid). More conservative than current ratio.
Operating Cycle
The time between paying cash for goods/services and receiving cash from customers. The amount of working capital needed depends on the length of the operating cycle — longer cycles require more working capital.
Example: Cash → Buy inventory → Sell on credit → Collect from customer → Cash (cycle repeats)
LO1: The Accounting Cycle
Steps from transaction to financial statements; Jana Juice June transactions
Abbreviated Accounting Cycle
A systematic process repeated each fiscal period for accumulating and reporting financial data:
Accounting Documents
General Journal
Tabular, chronological record where business activities are captured as debits and credits. Each entry shows date, accounts, amounts, and description.
General Ledger (Chart of Accounts)
Listing of all accounts and their running balances. Accounts grouped by element: Assets, Liabilities, Equity, Revenues, Expenses.
Jana Juice — June Transactions (1–12)
June is Jana Juice's second month of operations. These are the regular (pre-adjustment) transactions.
| # | Transaction | Key Account Effects |
|---|---|---|
| 1 | Signed 2-year note; borrowed $12,000 at 12% annual interest | Cash +12,000 | Notes Payable +12,000 |
| 2 | Purchased and installed fixtures & equipment for $10,200 cash | Cash −10,200 | Fixtures & Equipment +10,200 |
| 3 | Paid $800 for newspaper advertising in June | Cash −800 | Advertising Expense +800 |
| 4 | Paid $500 to suppliers for May inventory (accounts payable) | Cash −500 | Accounts Payable −500 |
| 5 | Purchased $2,600 inventory on account | Inventory +2,600 | Accounts Payable +2,600 |
| 6 | Sold $600 of inventory for $3,100 cash | Cash +3,100 | Inventory −600 | Sales Revenue +3,100 | COGS +600 |
| 7 | Sold $1,100 of inventory on account for $4,400 | Accounts Receivable +4,400 | Inventory −1,100 | Sales Revenue +4,400 | COGS +1,100 |
| 8 | Received $600 for 3-month online membership (July–Sept) | Cash +600 | Unearned Revenue +600 (liability — not yet earned) |
| 9 | Paid $1,400 wages to employees | Cash −1,400 | Wages Expense +1,400 |
| 10 | Received $2,000 cash from credit customers | Cash +2,000 | Accounts Receivable −2,000 |
| 11 | Paid $700 rent for June | Cash −700 | Rent Expense +700 |
| 12 | Declared and paid $100 cash dividends | Cash −100 | Retained Earnings −100 (no effect on net income) |
LO2: Adjusting Entries
Deferrals, accruals, depreciation, and income taxes
Why adjust?
- Accrual accounting requires matching revenues and expenses to the correct period
- Adjustments occur after all regular transactions, before financial statements
- Almost never affect Cash
- Always affect at least one BS account and one IS account
Two broad types:
Deferrals
Amount was already recorded in a BS account. Adjustment moves it to IS. Decreases BS, increases IS.
Accruals
Amount was NOT previously recorded. Adjustment adds it to both BS and IS. Increases both.
Unadjusted Trial Balance (June 30, before adjustments)
| Account | Debit | Credit |
|---|---|---|
| Cash | $10,460 | |
| Accounts Receivable | $4,100 | |
| Inventory | $1,600 | |
| Prepaid Insurance | $800 | |
| Security Deposit | $1,800 | |
| Fixtures and Equipment | $10,200 | |
| Accounts Payable | $2,600 | |
| Unearned Revenue | $900 | |
| Long-term Notes Payable | $12,000 | |
| Common Stock | $10,000 | |
| Retained Earnings | $560 | |
| Sales Revenue | $7,500 | |
| Cost of Goods Sold | $1,700 | |
| Wages Expense | $1,400 | |
| Rent Expense | $700 | |
| Advertising Expense | $800 | |
| Totals | $33,560 | $33,560 |
Jana Juice June Adjustments (a–g)
1 month of the May $300 three-month membership is earned in June
Unearned Revenue (−L): $100 → Sales Revenue (+R, +SE): $100
$300 ÷ 3 months = $100/month
1 month of the 4-month insurance policy ($800) expires in June
Insurance Expense (+E, −SE): $200 → Prepaid Insurance (−A): $200
$800 ÷ 4 months = $200/month
Equipment ($10,200) depreciates over 5 years straight-line
Depreciation Expense (+E, −SE): $170 → Accumulated Depreciation (+XA, −A): $170
$10,200 ÷ 5 yrs ÷ 12 mo = $170/month
Bank credited $60 interest to Jana Juice checking account; will deposit on July 5
Interest Receivable (+A): $60 → Interest Income (+R, +SE): $60
Interest earned in June, cash received in July
Employees earned $550 in last week of June, to be paid July 6
Wages Expense (+E, −SE): $550 → Wages Payable (+L): $550
Expense incurred in June, cash paid in July
June interest on $12,000 note at 12% annual rate (paid on 1st of each month)
Interest Expense (+E, −SE): $120 → Interest Payable (+L): $120
$12,000 × 12% × 1/12 = $120
Income before taxes = $2,020; tax rate 25% = $505; taxes paid following month
Income Tax Expense (+E, −SE): $505 → Income Tax Payable (+L): $505
$2,020 × 25% = $505
Accumulated Depreciation — Contra Asset Account
Instead of reducing the Equipment account directly, depreciation is accumulated in a separate contra asset account. On the balance sheet: Fixtures & Equipment $10,200 − Accumulated Depreciation ($170) = Net book value $10,030. The contra account lets users see both the original cost and total depreciation taken.
LO3: Financial Statements from Adjusted Accounts
Income statement, equity statement, balance sheet, and cash flows (June)
Income Statement (June)
Statement of Stockholders' Equity (June)
| Item | Contrib. | Earned (RE) | Total |
|---|---|---|---|
| Balance, June 1 | $10,000 | $660 | $10,660 |
| Net income | — | 1,515 | 1,515 |
| Cash dividends | — | (100) | (100) |
| Balance, June 30 | $10,000 | $2,075 | $12,075 |
Statement of Cash Flows (June)
Balance Sheet (June 30)
LO4: Closing Temporary Accounts
Zeroing out income statement accounts; post-closing trial balance
Permanent vs. Temporary Accounts
Permanent (Balance Sheet)
Assets, Liabilities, Equity — carry balances forward each period. Never closed.
Temporary (Income Statement + Dividends)
Revenues, Expenses, Dividends — reset to zero at end of each period. Balances transferred to Retained Earnings.
Two Closing Entries
- Close revenue accounts: Debit each revenue account (zero it out); Credit Retained Earnings for total revenues.
- Close expense accounts: Credit each expense account (zero it out); Debit Retained Earnings for total expenses.
Note: Dividends are already debited to RE when declared (transaction 12), so they don't need a separate closing entry in this example.
Jana Juice Closing Entries (June 30)
Retained Earnings after closing:
Post-Closing Trial Balance (June 30)
Only permanent (balance sheet) accounts remain. All temporary accounts have zero balances.
| Account | Debit | Credit |
|---|---|---|
| Cash | $10,460 | |
| Accounts Receivable | $4,100 | |
| Inventory | $1,600 | |
| Prepaid Insurance | $600 | |
| Interest Receivable | $60 | |
| Security Deposit | $1,800 | |
| Fixtures and Equipment | $10,200 | |
| Accum. Depreciation—Fixtures | $170 | |
| Accounts Payable | $2,600 | |
| Unearned Revenue | $800 | |
| Wages Payable | $550 | |
| Interest Payable | $120 | |
| Income Tax Payable | $505 | |
| Notes Payable | $12,000 | |
| Common Stock | $10,000 | |
| Retained Earnings | $2,075 | |
| Totals | $28,820 | $28,820 |
LO5: Levels & Flows Analysis
Using balance sheet levels and income statement flows together
Levels (Balance Sheet)
Represent the stock of resources at a point in time. A snapshot.
Examples: Cash on hand, Inventory balance, Accounts Receivable, Accounts Payable
Flows (Income Statement / SCF)
Represent the change in resources over a period of time. Activity during the period.
Examples: Sales Revenue, COGS, Wages Expense, Cash from Operations
The Relationship
This relationship is fundamental to accounting. It underlies the accounting equation and connects the balance sheet to the income statement and cash flow statement across periods.
Example: Office Supplies
A service business has office supplies on hand. Given balance sheet levels and purchase data, calculate the expense (flow):
| Known Information | Amount |
|---|---|
| Supplies on hand, July 1 (beginning level) | $2,400 |
| Supplies purchased during Q3 (flow in) | $5,700 |
| Supplies on hand, Sept 30 (ending level) | $1,900 |
| Supplies used as expense (flow out) = $2,400 + $5,700 − $1,900 | $6,200 |
LO1: Purpose & Classification of Cash Flows
Why the SCF matters and how transactions are categorized
Purpose of the Statement of Cash Flows
- Shows how a company generates and uses cash — fills the gap between accrual net income and actual cash
- Helps assess ability to settle liabilities and pay dividends
- Helps determine the company's need for outside financing
- Permits users to observe and assess management's investing and financing policies
Three Activity Categories
Operating Activities
Selling goods or rendering services — primary day-to-day business activities
Inflows:
Cash from customers, interest received, dividends received
Outflows:
Payments to suppliers, employees, interest paid, taxes paid
Investing Activities
Acquiring and disposing of long-term assets and investments
Inflows:
Sale of PP&E, sale of investments, collection of loans made
Outflows:
Purchase of PP&E, purchase of investments, loans made to others
Financing Activities
Receiving/returning cash to shareholders; borrowing/repaying creditors
Inflows:
Issuance of stock, proceeds from borrowing
Outflows:
Dividends paid, repurchase of stock, repayment of loans
Cash Equivalents
Short-term, highly liquid investments that are:
- Easily convertible to a known cash amount
- Close enough to maturity that market value isn't sensitive to interest rate changes
- Generally maturity of 3 months or less
Examples: money market accounts, T-bills, commercial paper
Usefulness of Classifications
Three companies each generate $100,000 of cash, but from different sources:
- From operations → recurring, can sustain the company
- From selling assets → not likely to recur; will replacements be needed?
- From borrowing → repayment required; increases debt burden
LO2: Operating Activities — Direct Method
Examining and classifying individual cash transactions
Direct Method
Examine all cash transactions that occur during the period and group them by activity (operating, investing, financing). Lists each cash receipt and payment category directly.
Jana Juice May Transaction Classification
| Transaction | Category |
|---|---|
| Issued stock for $10,000 cash | Financing |
| Borrowed $4,000 on note payable | Financing |
| Paid $1,800 security deposit | Operating |
| Purchased $2,000 inventory on account (no cash yet) | — |
| Paid $900 for advertising | Operating |
| Paid $1,500 to suppliers (accounts payable) | Operating |
| Sold drinks for $2,400 cash | Operating |
| Sold drinks on account — $2,900 (no cash yet) | — |
| Paid $1,300 wages | Operating |
| Received $300 for 3-month membership (cash in) | Operating |
| Collected $1,200 from credit customers | Operating |
| Repaid $4,000 note + $40 interest ($4,040 total) | Financing ($4,000) / Operating ($40) |
| Paid $800 for 4-month insurance policy | Operating |
| Paid $700 rent | Operating |
| Paid $400 dividends | Financing |
Operating Cash Flows — Direct Method (May)
Net operating cash flow is negative in May because Jana Juice is a startup investing in its business. This is normal — operating cash flows typically turn positive as the business matures.
LO3: Operating Activities — Indirect Method
Reconciling accrual net income to cash from operations
Direct vs. Indirect
Both methods report the same cash from operations — they just present it differently.
- Direct: lists each cash receipt/payment category directly
- Indirect: starts with net income, adjusts for noncash items and WC changes
- Indirect is used by >95% of companies (easier, less disclosure required)
Why Adjust Net Income?
Net income (accrual basis) ≠ cash from operations because:
- Revenue recognized ≠ cash collected (changes in AR, unearned revenue)
- Expenses incurred ≠ cash paid (changes in AP, wages payable, prepaid)
- Depreciation expense reduces income but requires no cash
Key Adjustment Rules
| Adjustment | Rule | Logic |
|---|---|---|
| Depreciation expense | Add back to net income | Non-cash expense — reduces income but never reduces cash |
| Increase in current asset (e.g., AR, Inventory) | Subtract from net income | Cash collected < revenue recognized (or cash paid > expense) |
| Decrease in current asset | Add to net income | Collected more cash than recognized as revenue (or paid less than expensed) |
| Increase in current liability (e.g., AP, wages payable) | Add to net income | Incurred expense but haven't paid cash yet |
| Decrease in current liability | Subtract from net income | Paid more cash than what was expensed this period |
| Gains on asset sales (investing) | Subtract from net income | Gain is part of investing, not operating; remove to avoid double-counting |
| Losses on asset sales (investing) | Add to net income | Loss is part of investing, not operating; remove to avoid double-counting |
Jana Juice June — Indirect Method Reconciliation
Net income here ($1,414) reflects Ch4's assumptions; the result ($2,300 cash from operations) matches the direct method.
LO4: Investing & Financing Activities
Analyzing balance sheet changes to identify investing and financing cash flows
Investing Activities
Cause changes in noncurrent asset accounts not already captured in operating activities.
Analysis rule:
Asset increases → cash outflow (bought something)
Asset decreases → cash inflow (sold something)
Jana Juice June (Investing):
Equipment increased from $0 to $10,200 → Cash outflow: $(10,200)
Financing Activities
Cause changes in financing liabilities and stockholders' equity accounts not in operating activities.
Analysis rule:
Liability or equity increases → cash inflow (borrowed or issued stock)
Liability or equity decreases → cash outflow (repaid debt or paid dividends)
Jana Juice June (Financing):
Notes payable +$12,000 → +$12,000 inflow
Dividends paid → −$100 outflow
Jana Juice — Complete Statement of Cash Flows (June, Indirect Method)
Net change in cash = $2,300 + (−$10,200) + $11,900 = $4,000. Ending cash = $6,460 + $4,000 = $10,460 ✓ (matches balance sheet).
LO5: Noncash Activities & Supplemental Disclosures
Gains, losses, noncash transactions, and required disclosures
Gains and Losses on Asset Sales
FASB requires investing and financing items be reported at gross cash amounts:
Gain
Asset sold for more than book value → recorded as a special revenue. The gain is removed from operating activities and the full proceeds appear in investing activities.
Loss
Asset sold for less than book value → recorded as a special expense. The loss is removed from operating activities and proceeds appear in investing activities.
In the indirect method, gains are subtracted and losses are added back when converting to cash from operations.
Noncash Investing & Financing Activities
Significant transactions that affect long-term assets, liabilities, or equity but do not directly affect cash:
- Issue stock in exchange for land (no cash changes hands)
- Purchase a building by signing a long-term note payable
- Convert bonds payable into common stock
Required disclosure:
These transactions must be disclosed supplementally to the statement of cash flows even though they don't appear in the main body.
Three Required Supplemental Disclosures
Required when indirect method is used. Discloses actual cash paid for interest and income taxes during the period, since these don't appear separately in the indirect format.
A schedule of all significant investing and financing transactions that did not involve cash. Required so users can see the full picture of capital structure changes.
Disclosure of which short-term investments the company treats as cash equivalents. Necessary because companies have some flexibility in classification.
LO6: Cash Flow Ratios
Liquidity and capital adequacy using the statement of cash flows
OCFCL
Operating Cash Flow to Current Liabilities
Purpose: Measures the ability to liquidate current liabilities from operating cash flows
Higher is better. Rising trend is favorable. CVS Health showed steadily improving OCFCL and compared favorably to Rite Aid and Walgreens Boots.
OCFCX
Operating Cash Flow to Capital Expenditures
Purpose: Measures ability to fund capital investments from operations; assesses if a firm can replace and expand PP&E
Ratio > 1.0 is healthy — indicates operations generate enough cash to fund capital spending. CVS Health's ratio was well above 1.0.
FCF
Free Cash Flow
Purpose: Cash remaining after maintaining and expanding PP&E; available for debt repayment, dividends, acquisitions, or investment
Positive FCF = generating cash above maintenance needs. A key indicator of financial health and growth capacity.
Target Corporation Example
| Item | FY 2021 ($M) |
|---|---|
| Net earnings | $6,946 |
| Cash from operating activities | $8,625 |
| Capital expenditures | $(3,544) |
| Free Cash Flow (8,625 − 3,544) | $5,081 |
| Cash used in financing (dividends + buybacks + debt) | $(8,071) |
Target generated $8,625M from operations, spent $3,544M on capex, leaving $5,081M of free cash flow which it used primarily to return cash to shareholders via dividends and buybacks.