Understanding The Changes In Cash

We often enhance our comprehension of a topic when we have to think through solutions to problems, so to help you really understand the cash flow statement, we've put together some questions for you to answer. As you formulate your response you will be learning to think about cash flows the way an accountant does.

  1. When Mary Smith invests her personal money into her new company, what will happen to her company's Cash account?

    Answer
    The Cash account increases, and because of the double entry system, the owner's equity account Mary Smith, Capital also increases.
  2. When a company purchases inventory (merchandise purchased in order to be resold) what will happen to its Cash account?

    Answer
    The Cash account decreases, and because of the double entry system, the asset account Inventory increases.
  3. What happens to the company's Cash account if it borrows money from the bank by signing a note payable?

    Answer
    The Cash account increases, and because of the double entry system, the liability account Notes Payable increases..
  4. What happens to a company's Cash account if it declares a dividend on its shares of stock?

    Answer
    It is assumed that the company pays the dividend and therefore the Cash account decreases. Because of the double entry system, the stockholders' equity account Retained Earnings also decreases.
  5. What is the effect on its Cash account when a company pays some of its Accounts Payable?

    Answer
    The Cash account decreases, and because of the double entry system, the liability account Accounts Payable is decreased.
  6. What is the effect on its Cash account when a company prepays a 6-month insurance premium?

    Answer
    The Cash account decreases, and because of the double entry system, the asset account Prepaid Insurance increases.
  7. What is the effect on its Cash account when a company sells merchandise, but allows the customer to pay in 30 days?

    Answer
    There is no effect on the Cash account. The transaction does, however, result in a debit to the asset account Accounts Receivable and a credit to the income statement account Sales, which has the effect of increasing sales and net income on the income statement. The transaction changes nothing on the statement of cash flows since there is no cash involved at this time (the cash will be received in 30 days).
  8. What is the effect on its Cash account when a company receives payment from one of its customers 30 days after the sale was recorded?

    Answer
    On the day the cash is received, the Cash account increases, and because of the double entry system, the asset account Accounts Receivable is decreased. (Be aware that this transaction has no effect on the income statement—there is no increase in Sales and no increase in net income.)
  9. If a company's Accounts Payable account decreased, what is the likely effect this will have on Cash?

    Answer
    If Accounts Payable decreased, we assume that the company paid some of its bills, therefore we assume that the Cash account also decreased.
  10. If the asset account Prepaid Insurance increased, what is the likely effect on Cash?

    Answer
    If the asset account Prepaid Insurance increased, we assume that the company paid an insurance premium that covered more than the current month. Therefore, we assume that the Cash account decreased. Consider the general journal entry for this transaction:

  11. If the asset account Land increased, what's the likely effect on Cash?

    Answer
    If the asset account Land increased, we assume that the company paid cash to purchase the land, therefore, the Cash account decreased. Consider the general journal entry for this transaction:

  12. If the asset account Land decreased, what's the likely effect on Cash?

    Answer
    The Cash account increased because we assume that the company receives cash from the sale of any and all assets. Consider the general journal entry for this transaction:

  13. If the liability account Bonds Payable increases, what is the likely effect on Cash?

    Answer
    The Cash account increases because we assume the company receives cash when it issues bonds.
  14. If the liability account Bonds Payable decreases, what is the likely effect on Cash?

    Answer
    The Cash account decreases because we assume that the company used cash or paid cash to repurchase/redeem/reduce its bonds that are outstanding.

Much of what you learned in the practice questions above is common sense. For example, when you use cash to buy a book, you now own the book (you've increased your "assets") but you also have less money (you've decreased your cash). Based on what you learned, you can make the following general assumptions:

  • When an asset (other than cash) increases, the Cash account decreases.
  • When an asset (other than cash) decreases, the Cash account increases.
  • When a liability increases, the Cash account increases.
  • When a liability decreases, the Cash account decreases.
  • When owner's equity increases, the Cash account increases.
  • When owner's equity decreases, the Cash account decreases.

Here's a Tip

For a change in assets (other than cash)—the change in the Cash account is in the opposite direction.


For a change in liabilities and owner's equity—the change in the Cash account is in the same direction.

Format of the Statement of Cash Flows

The statement of cash flows has four distinct sections:

  1. Cash involving operating activities
  2. Cash involving investing activities
  3. Cash involving financing activities
  4. Supplemental information.

Assuming that the cash flow statement is being prepared using the indirect method (the method used by most companies) the differences in a company's balance sheet accounts will provide much of the needed information. For example, if the statement of cash flows is for the year 2013, the balance sheet accounts at December 31, 2013 will be compared to the balance sheet accounts at December 31, 2012. The changes—or differences—in these account balances will likely be entered in one of the sections of the statement of cash flows.

Shown below is each of the four sections of the statement of cash flows, followed by a list of those balance sheet accounts which affect it.

1. Cash Provided From or Used By Operating Activities

This section of the cash flow statement reports the company's net income and then converts it from the accrual basis to the cash basis by using the changes in the balances of current asset and current liability accounts, such as:

Accounts Receivable
Inventory
Supplies
Prepaid Insurance
Other Current Assets
Notes Payble
Accounts Payable
Wages Payable
Payroll Taxes Payable
Interest Payable
Income Taxes Payable
Unearned Revenues
Other Current Liabilities

In addition to using the changes in current assets and current liabilities, the operating activities section has adjustments for depreciation expense and for the gains and losses on the sale of long-term assets.

2. Cash Provided From or Used By Investing Activities

This section of the cash flow statement reports changes in the balances of long-term asset accounts, such as:

Long-term Investments
Land
Buildings
Equipment
Furniture & Fixtures
Vehicles

In short, investing activities involve the purchase and/or sale of long-term investments and property, plant, and equipment.

3. Cash Provided From or Used By Financing Activities

This section of the cash flow statement reports changes in balances of the long-term liability and stockholders' equity accounts, such as:

Notes Payable (generally due after one year)
Bonds Payable
Deferred Income Taxes
Preferred Stock
Paid-in Capital in Excess of Par-Preferred Stock
Common Stock
Paid-in Capital in Excess of Par-Common Stock
Paid-in Capital from Treasury Stock
Retained Earnings
Treasury Stock

In short, financing activities involve the issuance and/or the repurchase of a company's own bonds or stock as well as short-term and long-term borrowings and repayments.

4. Supplemental Information

This section of the cash flow statement discloses the amount of interest and income taxes paid. Also reported are significant exchanges not involving cash. For example, the exchange of company stock for company bonds would be reported in this section.

Where To Enter The Balance Sheet Changes

Take a look at the summary below—it shows where the changes in balance sheet accounts should be entered on your statement of cash flows:

06X-table-01

Adjustments Within The Operating Activities Section

When we use the indirect method to prepare a statement of cash flows we begin with the net income figure from the company's income statement as our starting point. We then make adjustments to that figure to arrive at the cash amount.

If all of a company's revenues were cash sales (no credit sales), and if the company paid out cash for all of its expenses, then net income would equal the cash from operating activities. However, since some of the revenues and expenses on the income statement were not cash transactions, we must include depreciation, gain or losses on sales of assets, and the changes in current assets and current liabilities. These adjustments will be illustrated in the hypothetical story presented in Part 3.