Accounting Principles-2b Corporations


Published on

Corporations, form a corporation, public corporation, private corporation, stockholders, corporation management, unlimited life, goverment regulations, double taxation, forming a corporation, advantages of corportations, disadvantages of corportations, stocks, forming a corporations, jose cintron, advance business consulting,

Published in: Business, Economy & Finance
1 Comment
No Downloads
Total views
On SlideShare
From Embeds
Number of Embeds
Embeds 0
No embeds

No notes for slide

Accounting Principles-2b Corporations

  1. 1. Accounting Principles 2 Jose Cintron, MBA-CPC http://mba4help.com
  2. 2. Corporation is created by lawA corporation is created by law, and its continued existence dependsupon the statutes of the state in which it is incorporated. As a legal entity,a corporation has most of the rights and privileges of a person.A corporation is subject to the same duties and responsibilities as aperson. For example, it must abide by the laws, and it must pay taxes.
  3. 3. Publicly held and PrivatelyClassification by ownership distinguishes between publicly held andprivately held corporations.Publicly held corporation may have thousands of stockholders. Itsstock is regularly traded on a national securities exchange such as theNew York Stock Exchange. Most of the largest U.S. corporations arepublicly held. Examples are IBM, Google, General Electric & Facebook.Privately held corporation usually has only a few stockholders, anddoes not offer its stock for sale to the general public.
  4. 4. Separate Legal ExistenceAs an entity separate and distinct from its owners, the corporation actsunder its own name rather than in the name of its stockholders. FordMotor Company may buy, own, and sell property. It may borrow money,and may enter into legally binding contracts in its own name. It may alsosue or be sued, and it pays its own taxes. The acts of its owners(stockholders) do not bind the corporation unless such owners are agentsof the corporation
  5. 5. Limited Liability of StockholdersCorporation is a separate legal entity, creditors have recourse only tocorporate assets to satisfy their claims. The liability of stockholders isnormally limited to their investment in the corporation. Even in the eventof bankruptcy, stockholders losses are generally limited to their capitalinvestment in the corporation.
  6. 6. Transferable Ownership RightsShares of capital stock give ownership in a corporation. These shares aretransferable units. Stockholders may dispose of part or all of their interestin a corporation simply by selling their stock.The transfer of ownership rights between stockholders normally has noeffect on the daily operating activities of the corporation.
  7. 7. Ability to Acquire CapitalIt is relatively easy for a corporation to obtain capital through theissuance of stock. Investors buy stock in a corporation to earn moneyover time as the share price grows, and because a stockholder has limitedliability and shares of stock are readily transferable. Also, individuals canbecome stockholders by investing relatively small amounts of money.
  8. 8. Continuous LifeSince a corporation is a separate legal entity, its continuance as a goingconcern is not affected by the withdrawal, death, or incapacity of astockholder, employee, or officer. As a result, a successful enterprise canhave a continuous and perpetual life.
  9. 9. Unlimited Life Hoshi Ryokan – founded in 718.The company was founded in Komatsu, Japan in 718.The firm is operated by the familys members, who represent its46th generation. Since then his family, who was known as Hoshi,have managed a hotel in Komatsu. The structure that standstoday is able to house 450 people, in its 100 rooms.
  10. 10. Corporation ManagementAs in Ford Motor Company, stockholders legally own the corporation.But they manage the corporation indirectly through a board of directorsthey elect. The board, in turn, formulates the operating policies for thecompany. The board also selects officers, such as a president.The chief executive officer (CEO) has overall responsibility formanaging the business.
  11. 11.
  12. 12. Government RegulationsA corporation is subject to numerous state and federal regulations. Statelaws usually prescribe the requirements for issuing stock, thedistributions of earnings permitted to stockholders, and the effects ofretiring stock. Federal securities laws govern the sale of capital stock tothe general public. They are required to make extensive disclosure oftheir financial affairs to the Securities and Exchange Commission (SEC).
  13. 13. Doble TaxationIn addition, stockholders must pay taxes on cash dividends (pro ratadistributions of net income). Thus, many argue that the government taxescorporate income twice (double taxation)—once at the corporate level,and again at the individual level.
  14. 14. Advantages vs. Disadvantages
  15. 15. Forming a CorporationThe initial step in forming a corporation is to file an application with theSecretary of State in the state in which incorporation is desired. Theapplication contains such information as: (1) the name and purpose of theproposed corporation; (2) amounts, kinds, and number of shares ofcapital stock to be authorized; (3) the names of the incorporators; and (4)the shares of stock to which each has subscribed.
  16. 16. Forming a CorporationAfter the state approves the application, it grants a charter. The issuanceof the charter creates the corporation. Upon receipt of the charter, thecorporation develops its by-laws. The by-laws establish the internal rulesand procedures for conducting the affairs of the corporation. They alsoindicate the powers of the stockholders, directors, and officers of theenterprise.The charter is often referred to as the articles of incorporation.
  17. 17. Forming a CorporationRegardless of the number of states in which a corporation has operatingdivisions, it is incorporated in only one state. It is to the companysadvantage to incorporate in a state whose laws are favorable to thecorporate form of business organization.Corporations engaged in interstate commerce must also obtain a licensefrom each state in which they do business.
  18. 18. Cost to IncorporateCosts incurred in the formation of a corporation are called organizationcosts. These costs include legal and state fees, and promotionalexpenditures involved in the organization of the business. Corporationsexpense organization costs as incurred.
  19. 19. Ownership Rights of StockholdersWhen chartered, thecorporation may beginselling ownership rights inthe form of shares of stock.When a corporation has onlyone class of stock, it iscommon stock.
  20. 20. Authorized StockThe charter indicates the amount of stock that a corporation isauthorized to sell. The total amount of authorized stock at the time ofincorporation normally anticipates both initial and subsequent capitalneeds. As a result, the number of shares authorized generally exceeds thenumber initially sold. If it sells all authorized stock, a corporation mustobtain consent of the state to amend its charter before it can issueadditional shares.
  21. 21. Authorized StockThe authorization of capital stock does not result in a formal accountingentry. This event has no immediate effect on either corporate assets orstockholders equity. However, the number of authorized shares is oftenreported in the stockholders equity section.
  22. 22. Issuance of StockA corporation can issue common stock directly toinvestors. Or it can issue the stock indirectlythrough an investment banking firm that specializesin bringing securities to market. Direct issue istypical in closely held companies. Indirect issue iscustomary for a publicly held corporation.
  23. 23. Issuance of StockIn an indirect issue, the investment banking firm may agree tounderwrite the entire stock issue. In this arrangement, the investmentbanker buys the stock from the corporation at a stipulated price andresells the shares to investors. The corporation thus avoids any risk ofbeing unable to sell the shares. Also, it obtains immediate use of the cashreceived from the underwriter. The investment banking firm, in turn,assumes the risk of reselling the shares, in return for an underwriting fee.
  24. 24. How does a corporation set the priceHow does a corporation set the price for a new issue of stock? Amongthe factors to be considered are: (1) the companys anticipated futureearnings, (2) its expected dividend rate per share, (3) its current financialposition, (4) the current state of the economy, and (5) the current state ofthe securities market. The calculation can be complex and is properly thesubject of a finance course.
  25. 25. Market Value of StockThe stock of publicly held companies is traded on organized exchanges.The interaction between buyers and sellers determines the prices pershare. In general, the prices set by the marketplace tend to follow thetrend of a companys earnings and dividends.
  26. 26. Capital StockThe trading of capital stock on securities exchanges involves the transferof already issued shares from an existing stockholder to another investor.These transactions have no impact on a corporations stockholdersequity.
  27. 27. Market Value of StockThe interaction between buyers and sellers determines the prices pershare. The prices set by the marketplace tend to follow the trend of acompanys earnings and dividends. But, factors beyond a companyscontrol, such as an changes in interest rates, and the outcome of apresidential election, may cause day-to-day fluctuations in market prices.
  28. 28. Market Value of StockA recent stock quote for PepsiCo, listed on the NYSE under the tickersymbol PEP, is shown below.Stock Volume High Low Close Net ChangePepsiCo 4,305,600 60.30 59.32 60.02 +0.41These numbers indicate that PepsiCos trading volume was 4,305,600shares. The high, low, and closing prices for that date were $60.30,$59.32, and $60.02, respectively. The net change for the day was anincrease of $0.41 per share.
  29. 29. Par and No-Par Value StocksPar value stock is capital stock to which the charter has assigned a valueper share.Par value was often immaterial relative to the value of the companysstock—even at the time of issue. Thus, its usefulness as a protectivedevice to creditors was questionable.No-par value stock is capital stock to which the charter has not assigneda value. No-par value stock is quite common today
  30. 30. Paid-in capital and retained earningOwners equity is identified by various names: stockholders equity,shareholders equity.Stockholders equity section of a corporations balance sheet consists oftwo parts: (1) paid-in (contributed) capital and (2) retained earnings(earned capital).Paid-in capital and retained earnings- Corporations can makedistributions of earnings (declare dividends) out of retained earnings inall states. However, in many states they cannot declare dividends out ofpaid-in capital.
  31. 31. Paid-in capital Retained EarningPaid-in capital is the total amount of cash and other assets paid in to thecorporation by stockholders in exchange for capital stock. As notedearlier, when a corporation has only one class of stock, it is commonstock.Retained earnings is net income that a corporation retains for future use.
  32. 32. Retained earningsNet income is recorded in Retained Earnings by a closing entry thatdebits Income Summary and credits Retained Earnings. For example,assuming that net income for ABC in its first year of operations is$130,000, the closing entry is:Income Summary 130,000Retained Earnings 130,000(To close Income Summary and transfer net income to retained earnings)
  33. 33. Journal entryABC Inc.s $9 par value common stock is actively traded at a marketvalue of $16 per share. ABC issues 5,280 shares to purchase landadvertised for sale at $86,740.Journalize the issuance of the stock in acquiring the land.Land 84,480 Common Stock 47,520 Paid-in cap. in excess of par value 36,960
  34. 34. Stockholders equity sectionIf Delta Robotics has a balance of$800,000 in common stock at the endof its first year, its stockholders equitysection is as follows.
  35. 35. Comparison of owners equity accountsThe following illustration compares the owners equity (stockholdersequity) accounts reported on a balance sheet for a proprietorship, apartnership, and a corporation.
  36. 36. Issuing Par Value Common Stock for CashPar value does not indicate a stocks market value. Therefore, the cashproceeds from issuing par value stock may be equal to, greater than, orless than par value. When the company records issuance of commonstock for cash, it credits to Common Stock the par value of the shares. Itrecords in a separate paid-in capital account the portion of the proceedsthat is above or below par value. Cash 1,000 Common Stock 1,000 (To record issuance of 1,000 shares of $1 par common stock at par)
  37. 37. Issuing Par Value Common Stock for CashIf ABC issues an additional 1,000 shares of the $1 par value commonstock for cash at $5 per share, the entry is:Cash 5,000Common Stock 1,000Paid-in Capital in Excess of Par Value 4,000(To record issuance of 1,000 shares of $1 par common stock)
  38. 38. Issuing Par Value Common Stock for CashThe total paid-in capital from these two transactions is $6,000, and thelegal capital is $2,000. Assuming Hydro-Slide, Inc. has retained earningsof $27,000,
  39. 39. Issuing No-Par Common Stock for CashWhen no-par common stock has a stated value, the entries are similar tothose illustrated for par value stockAssume that instead of $1 par value stock, Hydro-Slide, Inc. has $5stated value no-par stock and the company issues 5,000 shares at $8 pershare for cash.Cash 40,000Common Stock 25,000Paid-in Capital in Excess of Stated Value 15,000(To record issue of 5,000 shares of $5 stated value no-par stock)
  40. 40. No par No stated valueWhat happens when no-par stock does not have a stated value? In thatcase, the corporation credits the entire proceeds to Common Stock. Thus,if Hydro-Slide does not assign a stated value to its no-par stock, it wouldrecord the issuance of the 5,000 shares at $8 per share for cash asfollows.Cash 40,000Common Stock 40,000(To record issue of 5,000 shares of no-par stock)
  41. 41. Issuing Common Stock for ServicesCorporations also may issue stock for services (compensation toattorneys or consultants) or for noncash assets (land, buildings, andequipment). To comply with the cost principle, in a noncash transactioncost is the cash equivalent price. Thus, cost is either the fair market valueof the consideration given up, or the fair market value of theconsideration received, whichever is more clearly determinable.
  42. 42. Issuing Common Stock for ServicesAssume that attorneys have helped ABC Company incorporate. Theyhave billed the company $5,000 for their services. They agree to accept4,000 shares of $1 par value common stock in payment of their bill. Atthe time of the exchange, there is no established market price for thestock. In this case, the market value of the consideration received,$5,000, is more clearly evident.Organization Expense 5,000Common Stock 4,000Paid-in Capital in Excess of Par Value 1,000(To record issuance of 4,000 shares of $1 par value stock to attorneys)
  43. 43. Common Stock for LandAssume that ABC Inc. is an existing publicly held corporation. Its $5 parvalue stock is actively traded at $8 per share. The company issues 10,000shares of stock to acquire land recently advertised for sale at $90,000.The most clearly evident value in this noncash transaction is the marketprice of the consideration given, $80,000.Land 80,000Common Stock 50,000Paid-in Capital in Excess of Par Value 30,000(To record issuance of 10,000 shares of $5 par value stock for land)
  44. 44. Treasury StocksTreasury stock is a corporations own stock that it has issued andsubsequently reacquired from shareholders, but not retired. A corporationmay acquire treasury stock for various reasons: 1. To reissue the shares to officers and employees under bonus andstock compensation plans. 2. To signal to the stock market that management believes the stock isunderpriced, in the hope of enhancing its market value. 3. To have additional shares available for use in the acquisition of othercompanies. 4. To reduce the number of shares outstanding and thereby increaseearnings per share. 5. To rid the company of disgruntled investors, perhaps to avoid atakeover.
  45. 45. Treasury StocksCompanies generally account for treasury stock by the cost method. Thismethod uses the cost of the shares purchased to value the treasury stock.Under the cost method, the company debits Treasury Stock for the pricepaid to reacquire the shares.
  46. 46. Treasury StocksWhen the company disposes of the shares, it credits to Treasury Stockthe same amount it paid to reacquire the shares. To illustrate, assume thaton January 1, 2010, the stockholders equity section of Mead, Inc. has100,000 shares of $5 par value common stock outstanding (all issued atpar value) and Retained Earnings of $200,000. The stockholders equitysection before purchase of treasury stock is as follows.
  47. 47. Treasure StocksOn February 1, 2010, Mead acquires 4,000 shares of its stock at $8 pershare. The entry is:Feb. 1 Treasury Stock 32,000 Cash 32,000 (To record purchase of 4,000 shares of treasury stock at $8 per share)
  48. 48. Treasury StocksNote that Mead debits Treasury Stock for the cost of the sharespurchased. Is the original paid-in capital account, Common Stock,affected? No, because the number of issued shares does not change. Inthe stockholders equity section of the balance sheet, Mead deductstreasury stock from total paid-in capital and retained earnings. TreasuryStock is a contra stockholders equity account. Thus, the acquisition oftreasury stock reduces stockholders equity.
  49. 49. Treasure StocksIn the balance sheet, Mead discloses both the number of shares issued(100,000) and the number in the treasury (4,000). The differencebetween these two amounts is the number of shares of stock outstanding(96,000). The term outstanding stock means the number of shares ofissued stock that are being held by stockholders.
  50. 50. Sale of treasury stocksIf the selling price of the treasury shares is equal to their cost, thecompany records the sale of the shares by a debit to Cash and a credit toTreasury Stock. When the selling price of the shares is greater than theircost, the company credits the difference to Paid-in Capital from TreasuryStock.Mead sells for $10 per share the 1,000 shares of its treasury stock,previously acquired at $8 per share. The entry is as follows.July 1 Cash 10,000 Treasury Stock 8,000 Paid-in Capital from Treasury Stock 2,000 (To record sale of 1,000 shares of treasury stock above cost)
  51. 51. Treasury Stocks Below CostSale of Treasury Stock Below CostWhen a company sells treasury stock below its cost, it usually debits toPaid-in Capital from Treasury Stock the excess of cost over selling price.Thus, if Mead, Inc. sells an additional 800 shares of treasury stock onOctober 1 at $7 per share, it makes the following entry.Oct. 1 Cash 5,600 Paid-in Capital from Treasury Stock 800 Treasury Stock 6,400 (To record sale of 800 shares of treasury stock below cost)
  52. 52. Preferred StocksTo appeal to more investors, a corporation may issue an additional classof stock, called preferred stock. Preferred stock has provisions that giveit some preference or priority over common stock. Typically, preferredstockholders have a priority as to (1) distributions of earnings(dividends) and (2) assets in the event of liquidation. However, theygenerally do not have voting rights.Cash 120,000Preferred Stock 100,000Paid-in Capital in Excess of Par Value–Preferred Stock 20,000(To record the issuance of 10,000 shares of $10 par value preferredstock)
  53. 53. Preferred Tocks DividendsPreferred stockholders have the right to receive dividends beforecommon stockholders. For example, if the dividend rate on preferredstock is $5 per share, common shareholders will not receive anydividends in the current year until preferred stockholders have received$5 per share. The first claim to dividends does not, however, guaranteethe payment of dividends. Dividends depend on many factors, such asadequate retained earnings and availability of cash.
  54. 54. Cumulative DividendPreferred stock often contains a cumulative dividend feature. This meansthat preferred stockholders must be paid both current-year dividends andany unpaid prior-year dividends before common stockholders receivedividends. When preferred stock is cumulative, preferred dividends notdeclared in a given period are called dividends in arrears.
  55. 55. The stockholders equity section
  56. 56. Usefulness of the Statement of Cash FlowsThe balance sheet, income statement, and retained earnings statementprovide only limited information about a companys cash flows (cashreceipts and cash payments). For example, comparative balance sheetsshow the increase in property, plant, and equipment during the year. Butthey do not show how the additions were financed or paid for.
  57. 57. Statement of Cash FlowsCash flow from operations Cash generated by selling goods & servicesCash flow from investing activities Cash used/generated by changes in long-term assetsCash flow from financing activities Cash used/generated by changes in equity & debt.
  58. 58. Non-cash items•Non-cash items (depreciation, amortization) are expenses that do nothave to be ―paid‖ to outside entities. In the indirect method,depreciation has already been subtracted to compute net income, sowe must add it back to compute cash from operations.
  59. 59. Usefulness of the Statement of Cash Flows The income statement shows net income. But it does not indicate the amount of cash generated by operating activities. The retained earnings statement shows cash dividends declared but not the cash dividends paid during the year. None of these statements presents a detailed summary of where cash came from and how it was used.
  60. 60. Usefulness of the Statement of Cash FlowsThe statement of cash flows reports the cash receipts, cash payments, andnet change in cash resulting from operating, investing, and financingactivities during a period. Help investors, creditors, and others assess:1. The entitys ability to generate future cash flows. Investors can makepredictions of the amounts, timing, and uncertainty of future cash flows..2. The entitys ability to pay dividends and meet obligations. If a Co.does not have adequate cash, it cannot pay employees or dividends.3. The reasons for the difference between net income and net cashprovided (used) by operating activities.4. The cash investing and financing transactions during the period.during the period.
  61. 61. Cash Flow Statement
  62. 62. Classification of Cash Flows Statement of cash flows classifies cash receipts and cash payments as; 1. Operating activities include the cash effects of transactions thatcreate revenues and expenses. They thus enter into the determination ofnet income.2. Investing activities include (a) acquiring and disposing ofinvestments and property, plant, and equipment, and (b) lending moneyand collecting the loans.3. Financing activities include (a) obtaining cash from issuing debt andrepaying the amounts borrowed, and (b) obtaining cash fromstockholders, repurchasing shares, and paying dividends.
  63. 63. Classification of Cash Flows
  64. 64. Cash flow operatingCompanies classify as operating activities some cash flows related toinvesting or financing activities. For example, receipts of investmentrevenue (interest and dividends) are classified as operating activities. Soare payments of interest to lenders. Why are these considered operatingactivities? Because companies report these items in the incomestatement, where results of operations are shown.
  65. 65. Why do differences exist?Company Net Income Net Cash Provided by OperatingKohls Corporation $ 1,083 $ 1,234Wal-Mart Stores, Inc. 11,284 20,164J. C. Penney Inc. 1,153 1,255Costco Corp. 1,082 2,076Target Corporation 2,849 4,125The differences are explained by differences in the timing of thereporting of revenues and expenses under accrual accounting versuscash. Under accrual accounting, companies report revenues when earned,even if cash hasnt been received, and they report expenses whenincurred, even if cash hasnt been paid.
  66. 66. Format of the Statement of Cash Flows
  67. 67. Preparing the Statement of Cash FlowsCompanies prepare the statement of cash flows differently from the threeother basic financial statements. (not from trial balance)The statement of cash flows deals with cash receipts and payments. As aresult, the company must adjust the effects of the use of accrualaccounting to determine cash flows.
  68. 68. Statement of cash flowThe information to prepare this statement usually comes from threesources: 1. Comparative balance sheets. Information in the comparative balancesheets indicates the amount of the changes in assets, liabilities, andstockholders equities from the beginning to the end of the period.2. Current income statement. Information in this statement helpsdetermine the amount of cash provided or used by operations during theperiod.3. Additional information. Such information includes transaction datathat are needed to determine how cash was provided or used during theperiod.
  69. 69. Statement of cash flowsinvolves three major steps
  70. 70. Indirect and Direct MethodsIn order to perform step 1, a company must convert net income from anaccrual basis to a cash basis.The indirect method adjusts net income for items that do not affect cash.A great majority of companies (98.8%) use this method, as shown in thenearby chart.1 Companies favor the indirect method for two reasons: (1)It is easier and less costly to prepare, and (2) it focuses on the differencesbetween net income and net cash flow from operating activities.
  71. 71. Cash flow -TeamworkThe net income for Adcock Co. for 2010 was $279,013. For 2010depreciation on plant assets was $65,978, and the company incurred aloss on sale of plant assets of $13,993. Compute net cash provided byoperating activities under the indirect method.
  72. 72. SolutionCash flows from operating income Net income $279,013 Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense $65,978 Loss on sale of plant assets 13,993 79,971 Net cash provided by operating activities $358,984
  73. 73. Cashflow -TeamworkThe T accounts for Equipment and the related Accumulated Depreciationfor ABC Company at the end of 2010 are shown here. Equipment Accumulated DepreciationBeg. bal. 80,201 Disposals 20,876 Disposals 5,947 Beg. bal. 47,452Acquisitions 42,657 Depr. exp. 13,918End. bal. 101,982 End. bal. 55,423In addition, ABC Companys income statement reported a loss on thesale of equipment of $5,071. What amount was reported on the statementof cash flows as "cash flow from sale of equipment"?
  74. 74. Solution Original cost of equipment sold $20,876 Less: Accumulated depreciation 5,947 Book value of equipment sold 14,929 Less: Loss on sale of equipment 5,071Cash received from sale of equipment $9,858
  75. 75. Cash flow –TeamworkClassify each item as an operating, investing, or financing activity.Assume all items involve cash unless there is information to the contrary.(a) Purchase of equipment.(b) Sale of building.(c) Redemption of bonds.(d) Depreciation.(e) Payment of dividends.(f) Issuance of capital stock.
  76. 76. Solution(a) Purchase of equipment. Investing activity(b) Sale of building. Investing activity(c) Redemption of bonds. Financing activity(d) Depreciation. Operating activity(e) Payment of dividends. Financing activity(f) Issuance of capital stock. Financing activity
  77. 77. Operating ActivitiesDetermine Net Cash Provided/Used by Operating Activities byConverting Net Income from an Accrual Basis to a Cash Basis
  78. 78. Depreciation ExpenseDepreciation is similar to any other expense in that it reduces net income.It differs in that it does not involve a current cash outflow; that is why itmust be added back to net income to arrive at cash provided by operatingactivities.Income statement reports depreciation expense of $9,000. Althoughdepreciation expense reduces net income, it does not reduce cash.
  79. 79. Loss on Sale of EquipmentCompanies must eliminate from net income all gains and losses relatedto the disposal of plant assets, to arrive at cash provided by operatingactivities. Income statement reports a $3,000 loss on the sale of equipment (bookvalue $7,000, less $4,000 cash received from sale of equipment).
  80. 80. Changes in Noncash Current AssetsDeduct from net income increases in current asset accounts, and add tonet income decreases in current asset accounts, to arrive at net cashprovided by operating activities.Accounts receivable decreased by $10,000 (from $30,000 to $20,000)during the period. For Computer Services this means that cash receiptswere $10,000 higher than revenues. Had $507,000 in revenues (asreported on the income statement), but it collected $517,000 in cash.
  81. 81. Changes in Noncash Current AssetsTo adjust net income to net cash provided by operating activities, thecompany adds to net income the decrease of $10,000 in A/R When the Accounts Receivable balance increases, cash receipts arelower than revenue earned under the accrual basis. Therefore, thecompany deducts from net income the amount of the increase in accountsreceivable, to arrive at net cash provided by operating activities.
  82. 82. Increase in Merchandise Inventory.Inventory balance increased $5,000 (from $10,000 to $15,000) duringthe period. The change in the Merchandise Inventory account reflects thedifference between the amount of inventory purchased and the amountsold. This means that the cost of merchandise purchased exceeded thecost of goods sold by $5,000. As a result, cost of goods sold does notreflect $5,000 of cash payments made for merchandise. The companydeducts from net income this inventory increase of $5,000 during theperiod, to arrive at net cash provided by operating
  83. 83. Increase in Prepaid ExpensesComputer Services prepaid expenses increased during the period by$4,000. This means that cash paid for expenses is higher than expensesreported on an accrual basis. In other words, the company has made cashpayments in the current period, but will not charge expenses to incomeuntil future periods (as charges to the income statement). To adjust netincome to net cash provided by operating activities, the company deductsfrom net income the $4,000 increase in prepaid expenses
  84. 84. Decrease in Prepaid ExpensesIf prepaid expenses decrease, reported expenses are higher than theexpenses paid. Therefore, the company adds to net income the decreasein prepaid expenses, to arrive at net cash provided by operating activities
  85. 85. Changes in Current LiabilitiesAdd to net income increases in current liability accounts, and deductfrom net income decreases in current liability accounts, to arrive at netcash provided by operating activities.Accounts Payable increased by $16,000 (from $12,000 to $28,000)during the period. That means the company received $16,000 more ingoods than it actually paid for.
  86. 86. Decrease in Income Taxes PayableA change in the Income Tax Payable account reflects the differencebetween income tax expense incurred and income tax actually paid.Computer Services Income Tax Payable account decreased by $2,000.That means the $47,000 of income tax expense reported on the incomestatement was $2,000 less than the amount of taxes paid during theperiod of $49,000. to adjust net income to a cash basis, the companymust reduce net income by $2,000
  87. 87. Conversion to Net Cash Provided by Operating Activities—Indirect MethodThe statement of cash flows prepared by the indirect method starts withnet income. It then adds or deducts items to arrive at net cash providedby operating activities.1. Noncash charges such as depreciation, amortization, and depletion.2. Gains and losses on the sale of plant assets.3. Changes in noncash current asset and current liability accounts.
  88. 88. Convert net income to net cashprovided by operating activities
  89. 89. Cash from Operating Activities- TeamABCs Photo Plus reported net income of $73,000 for 2010. Included inthe income statement were depreciation expense of $7,000 and a gain onsale of equipment of $2,500. ABCs comparative balance sheets show thefollowing balances. 12/31/09 12/31/10Accounts receivable $17,000 $21,000Accounts payable 6,000 2,200Calculate net cash provided by operating activities for ABCs Photo Plus.
  90. 90. SolutionCash flows from operating activities Net income $73,000Adjustments to reconcile net income to net cashprovided by operating activities: Depreciation expense $7,000 Gain on sale of equipment (2,500) Increase in accounts receivable (4,000)Decrease in accounts payable (3,800) (3,300)Net cash provided by operating activities $69,700
  91. 91. Cash flow from operatingWhy does GMs cash provided by operating activities drop soprecipitously when the companys sales figures decline?
  92. 92. Cash Flow - Team workThe net income for ABC Co. for 2010 was $273,229. For 2010depreciation on plant assets was $69,321, and the company incurred aloss on sale of plant assets of $10,249. Compute net cash provided byoperating activities under the indirect method.
  93. 93. SolutionCash flows from operating income Net income $273,229 Adjustments to reconcile net income to net cash provided by operating activities Depreciation expense $69,321 Loss on sale of plant assets 10,249 79,570 Net cash provided by operating activities $352,799
  94. 94. ConclusionA company can use a cash flow statement to predict future cash flow,which helps with matters in budgeting. For investors, the cash flowreflects a companys financial health: basically, the more cash availablefor business operations, the better. However, this is not a hard and fastrule. Sometimes a negative cash flow results from a companys growthstrategy in the form of expanding its operations.