financial accounting

For many students, bank reconciliations are a difficult topic because most people don’t do them anymore. Twenty years ago, before debit cards and online banking, there was only one way to keep track of how much money you had in the bank: keep a checkbook and reconcile it.

Clearly, online banking has not made us better at managing our bank accounts. In 2012, U.S. consumers . That’s approximately $135 per adult in the United States! Maybe we should consider going back to writing down all our transactions and balancing our checkbooks!

What is a bank reconciliation?

A bank reconciliation is a monthly process by which we match up the activity on the bank statement to ensure that everything has been recorded in the company’s or individual’s books. As we all engage in more automatic and electronic transactions, this is a critically important step to ensure that the cash balance is correct.

There are two parts to a bank reconciliation, the book (company) side and the bank side. When the reconciliation is completed, both balances should match.

What are we looking for?

There are a number of items that can cause differences between your book and bank balances. Here is a list of the most common items you’ll encounter when doing a bank reconciliation:

  1. Deposits in Transit – A deposit in transit is a deposit that has been submitted to the bank but has not get been recorded by the bank. The account holder has recorded the deposit in his records but the bank has not. This occurs because a deposit was submitted after the bank closed for the day or because of lag in electronic deposits. We see this a lot with credit card deposits because there is typically a 1-3 day lag in the time the card is processed and when the funds are deposited to the merchant’s account. Deposits in Transit must be added to the bank side of the reconciliation because they have been added to the book side when the deposits were recorded by the company.
  2. Outstanding Checks – These are checks that have been written by the company but have not yet cleared the bank. When a check is written it takes a few days to clear. Most businesses have a number of outstanding checks at the end of the month. Outstanding Checks should be subtracted from the bank side of the reconciliation because they were subtracted from the book balance when the checks were written.
  3. Bank Service Charges – These are amounts that the bank withdraws from the account as a charge for having the account. Bank service charges include regular monthly fees, overdraft fees, returned check fees and credit card processing fees. Typically, the company does not record these fees until the bank statement is received. Bank service charges are subtracted from the book balance since they are a decrease in the account balance and have not yet been recorded.
  4. Interest Earned – Some banks pay interest on account. The account holder does not know how much the interest will be until the bank statement is received. Interest earned is deposited into the account by the bank causing the balance to increase. Interest earned is added to the book balance to reflect the increase in the balance from the deposit of interest.
  5. Returned Checks – A returned check is an item that was originally deposited into the company’s account (usually a customer check) and later bounced. When this happens the bank withdraws the funds from the company’s account and sends a notice to the company. Returned checks should be subtracted from the book balance since the bank removed the amount from the balance when the check bounced.
  6. Recording Errors – A recording error occurs when the company incorrectly records a transaction or when the bank clears an item for the incorrect amount. This sometimes occurs when checks are written and an incorrect amount is entered into the system. Sometimes the bank clears the transaction for the wrong amount. Say the company wrote a check for $452.00 but the bank cleared the check for $450.00. There is now a $2 error in the books. Since the bank has cleaned the transaction, you must adjust the books to match. Recording errors should be added or subtracted from the book balance. If the item cleared the bank for less than the amount in the books, add the amount of the error. If the item cleared the bank for more than the amount in the books, subtract the amount of the error.
  7. Other Unrecorded Items – With the number of transactions that occur digitally or automatically, it’s easy to forget to record transactions, especially if they occur infrequently. Look for remaining items that cleared the bank that have not been recorded on the books. Other unrecorded items can be either deposits or withdrawals. All other unrecorded items should be recorded on the book side of the reconciliation. To determine if you should add or subtract the item, mimic what the bank did. If the bank added it to the account balance, do the same to the book balance. 

How to start

To do a bank reconciliation, you’ll need a copy of the bank statement and a copy of all of the outstanding items in the checking account through the ending date of the bank statement. For some businesses, including my own, the bank statement does not close at the end of the month. Sometimes the statement end date is based on the date the account was opened.

Once you have those two items, use a pencil or highlighter to mark off all the items that appear on both the bank statement and the check register. If an item appears on both, that means that the item was properly recorded and has cleared. After going through all the items, anything that remains unmarked is a an item that will need to be dealt with in the reconciliation.

Create two columns on a piece of paper or use a spreadsheet to do the calculations for you. My bank reconciliations look like a large T-account.

Start by writing the ending balance for the book and the bank under the appropriate column.

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I like to do the bank side first because it is generally easier than the book side. You are only dealing with outstanding checks and deposits in transit on the bank side. List the deposits in transit and the outstanding checks. Add the deposits in transit to the beginning balance and subtract the outstanding checks.

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The bank side is relatively easy to do. That is why I like to do that side first. It is more likely to be correct if you have an error in your reconciliation. Most students who have errors have them on the book side. Being confident in the bank side helps resolve errors on the book side.

On the book side, most items are fairly simple. Subtract bank service charges and add interest income. Subtract returned checks. Add unrecorded deposits and subtract unrecorded withdrawals. The last item, recording errors, requires a bit more thinking.

Let’s imagine that you recorded a check for $715, but the bank cleared that check for $751. The check was used to pay for utilities and was recorded to utilities expense for $715. If the check cleared for $751, what happened to your utilities expense? Did it increase or decrease? It increased because more was paid for utilities. If the expense increased, cash must have decreased. Therefore, cash must be adjusted down or decreased by $36. This would be subtracted from book side of the reconciliation.

Thinking about what is happening to your expenses can help you work your way through the problem.

Once you have worked through all the remaining items on the book side, compute the reconciled balance for the books.

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When you are finished, the reconciled balances should agree.

If they do not, take the difference between the two balances. Does that amount stick out in your mind. Check to see if there is a missing item for that amount that you might have forgotten to record. You may have forgotten multiple items. Place them in the reconciliation and see if you now balance.

If you do not have an item for that amount, take the difference and divide it by 2. Look for that amount. If that amount appears in your reconciliation, you added (or subtracted) the amount when you should have subtracted (or added) the amount. Reverse the sign and check your balance again.

Once you finish the bank reconciliation, there is one more step in the process. All the items that you recorded on the book side of the reconciliation must be recorded in the company’s accounting system. Prepare a journal entry (or several) to record those items. I usually record one large journal entry but you can also record a separate entry for each item in the reconciliation. Only record items on the book side!

Bank reconciliations become easier as you do more of them. Get all the practice you can. Here is the bank reconciliation problem I created for the video on this subject. You are provided with the check register and the bank statement. See if you can complete the reconciliation before watching the video.

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Related Videos:

How to do a bank reconciliation

Journal entries for the bank reconciliation

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If you are currently enrolled in an accounting course (which I sure hope you are because most people don’t browse my site for fun) you’ve probably heard some pretty terrible things about accounting. I remember when I took my first accounting course. I was scared to death before I walked in the door.

The textbooks certainly don’t help. My first accounting book was over 1,000 pages. The book was filled with lots of small text and complicated charts. Today’s accounting textbooks are certainly prettier but I’m not sure the text has gotten any more interesting or understandable. My goal is to help guide you through your accounting classes in an easy straightforward manner. In order to do that, we need to discuss what accounting is and what it is not.

What is accounting?

I would argue that accounting is the most important business class you will take. It doesn’t matter how great your product or service is if you can’t make the numbers work. Accounting is the language of business. It lets businesses communicate with investors, creditors and other stakeholders so they can make decisions about the business. Knowing this language makes you a powerful player in the business community.

There are two major branches of accounting: financial and managerial.

Financial accounting is what most people think of when they think of accounting. Financial accounting is based on communicating information to external users (users who are outside the company). This includes investors, creditors, customers, suppliers and various government agencies. Financial accounting is all about following the rules. It deals mostly with historical information.

Managerial accounting, also called cost accounting, deals with compiling information to allow managers to make decisions and plan for future business needs. In managerial accounting, we frequently deal with “what if” scenarios. There are very few rules in managerial accounting, but there are lots of best practices. It deals mostly with the present and future.

Accounting is NOT a math class

I can’t stress this enough. Accounting is not a math class. It may look like a math class because there are numbers, but the numbers are just part of the language.

Many students get instantly discouraged because they see numbers and think “Oh but I’m terrible at math.” At that instant, the brain switches off. I have had plenty of students who were “terrible at math” do extremely well in my classes. They lived by the mantra “accounting is not a math class.” The most complicated math you will encounter in financial or managerial accounting is division. I usually require my students to purchase a basic four function calculator like the one shown here because that is about as complicated as it gets.

It’s true. Accounting really is a language and you should try to learn it in the same way you would approach a language class. The biggest mistake students make is ignoring the terminology in the course. They focus on formulas but without the conceptual understanding of the terminology, they don’t know when to use the formulas. It’s like trying to write a sentence in Spanish without knowing any of the vocabulary. You may know that the adjective goes after the noun, but without knowing any nouns you can’t write a sentence.

On the flip side, I have students who had such a good conceptual understanding of the terminology, they didn’t need to know the formulas because the calculations came naturally once the concepts were known. That is actually how I learned accounting. With a thorough knowledge of the concepts, I did not memorize a single formula.

How to study for your financial accounting course

There are three areas you should focus on when learning new material in a financial accounting course:

  1. The terminology and concepts – This includes the account names and types. This is critical to your ability to do well in the course.
  2. Structure – similar to learning sentence structure when learning a language, there is a lot of structure in financial accounting. Journal entries have a particular structure, as do trial balances and financial statements. Learning the structure and what goes where is extremely important.
  3. Calculations – Notice that I put this last. This really is the least important of the three. If you can add, subtract, multiply, and divide you have all the math skills you need. When you understand the terminology, concepts, and structure you will barely notice the calculations.

For the account names and types, I recommend flashcards. I know it it seems old school but it really works. For each account, create a card. This is what I put on my cards:

flashcard

On the front, I have the name of an account. On the back, I put the type of account it is and if the normal balance is a debit or credit. On some cards, I put a description for the account. Some students confuse accounts receivable and accounts payable, so it might be a good idea to put a description to make the difference between the two accounts more clear. Each time you encounter a new account, create a card for it.

After you have completed each chapter in the course, take a single sheet of printer paper and make yourself a page of notes. You should be able to boil down each chapter into a single page of notes. the accounts are already covered with your flash cards. The notes page should contain key terms and examples of journal entries. This quick reference guide will save you time when completing assignments or just to refresh your knowledge when needed,

Having the flash cards and the single page of notes will make studying for each exam so much easier. Whatever you do, do NOT reread the chapters. Studies show you only retain about 20% of what you read. Your best bet is to do more problems and study your flash cards and quick notes.

Related Video:

Introduction to Financial Accounting: Objectives and Overview

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What Is a Weighted Average?

Most people know how to do a simple average, but have trouble with a weighted average. Weighted averages are all around us, although you may not have realized it. In most classes, your grade is calculated using a weighted average. Not all assignments count the same when calculating your final grade. Some assignments count more than others. Your professor is giving more weight to tests than to homework. Your final exam might have more weight than a regular exam.

In accounting, weight is given based on the number of units. Say we sold two units last month, one was $100 and one was $500. What is the average cost? $500 + $100 = $600 / 2 = $300. How would the average change if we sold two units at $100 and one at $500? The average would be closer to $100 because there are two units pulling the average down. $500 + $100 + $100 = $700 / 3 = $233.33. We gave more weight to the $100 units because there were more of them.

When dealing with large numbers of units, rather than adding them up individually, we can calculate the total cost of the units and divide by the total number of units. What if we had 20 units at $100 and 10 units at $500. You might notice that the ratio of $100 units to $500 units is still the same (2:1). Let’s do the calculation to confirm that the weighted average will be the same.

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The total cost of all the units is $7,000 and there are 30 units. Divide $7,000 by 30 and the weighted average is $233.33.

Weighted Average Periodic

Weighted average periodic is probably the easiest of all the inventory methods. Since the calculation is done at the end of the period, we figure out the total cost of goods available for sale and divide by the number of units. It is helpful to separate the purchases from the sales.

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Goods available for sale is 415 units with a total cost of $3,394.00. If we divide $3,394.00 by 415, we get a weighted average cost of $8.18 (rounded) per unit. The rest of the calculation is very simple at this point. The company sold 245 units. We will use $8.18 as the cost of each unit, therefore the total cost of goods sold is $2.004.10. There are 170 units remaining in ending inventory (415 – 245). We will use $8.18 as the cost of those units as well which gives is an ending inventory balance of $1,390.60.

If we add cost of goods sold and ending inventory, the total is $3,394.70. Because we rounded up when calculating cost per unit, we should expect our total to be a bit higher than goods available for sale. When doing weighted average, always make sure to tie back to goods available for sale.

Weighted Average Perpetual

If weighted average periodic is the easiest of all the methods, weighted average perpetual is the hardest. It is not that the method is hard, it is just annoying because you must calculate a new weighted average cost for each sale, based on the units available for sale at that time. When doing weighted average perpetual, do not separate the purchases and sales.

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Perpetual inventory systems require cost of goods sold to be calculated each time there is a sale. Therefore, at the time of each sale, we must calculate the weighted average cost of the units on hand at the time of the sale. On January 7, the company sold 100 units. We must calculate the average cost of the 225 units on hand as of that date.

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We calculate the average cost by taking total cost divided by the number of units on hand. This gives us a weighted average cost of $8.03 per unit. Does this make sense? The simple average would be $8.05, but there are twice as many units at $8.00, so the weighted average should be closer to $8.00 than it is to $8.10. Doing a mental check to make sure your numbers make sense is a great habit to start!

Now we can calculate the cost of the sale by taking the average cost per unit multiplied by the number of units sold.

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Next, calculate the value of the remaining units. There are 125 units left. We will assign $8.03 per unit because that is the weighted average cost of those units on January 7. We will use this figure in the calculation for January 17. For the sale on January 17, we need to do another weighted average calculation.

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Add the 50 units purchased on January 12 to the 125 units remaining and calculate the total cost of all those units. Then divide cost by the total number of units. The weighted average cost on January 17 is $8.09. The inclusion of the units costing $8.25 increased the weighted average cost slightly. Using $8.09 as the unit cost, calculate the cost of the sale.

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Cost of goods sold for the January 17 sale is $525.85.

One more sale on January 31, so we need to do this calculation one more time. Start with the remaining units at $8.09 then add in the additional purchases.

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Cost of goods sold for the January 31 sale is $660.80.

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We can now calculate total cost of goods sold for the month of January by adding cost of goods sold for each sale.

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The value of ending inventory is the number of units remaining multiplied by the average cost at the time of the last sale, in this case $8.26. Add cost of goods sold and ending inventory to see if it matches goods available for sale. In this case, there was some rounding so things may not be exact.

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Be patient when doing weighted average, especially under the perpetual method. Tie back to goods available for sale to ensure you did your calculations correctly. Do a quick mental check to make sure your weighted average cost per unit makes sense. If you take a few seconds to do these things, you will greatly increase the chance that your calculations are correct.

Related Video:

Weighted Average Inventory Calculation

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Last-in, first-out (LIFO) is an inventory method popular with companies that experience frequent increases in the cost of their product. LIFO is used primarily by oil companies and supermarkets, because inventory costs are almost always rising, but any business can use LIFO. Remember, there is no correlation between physical inventory movement and cost method.

To visualize how LIFO works, think of one of those huge salt piles that cities and towns keep to salt icy roads. The town gets a salt delivery and puts it on top of the pile. When the trucks need to be filled, does the town take the salt from the top or bottom of the pile? The trucks are filled from the top of the pile. The last delivery in is the first to be used. This is the essence of LIFO. When calculating costs, we use the cost of the newest (last-in) products first.

When costs are rising, LIFO will give the highest cost of goods sold and the lowest gross profit. LIFO will also result in lower taxes than the other inventory methods.

LIFO Using a Periodic Inventory System

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For all periodic methods we can separate the purchases from the sales in order to make the calculations easier. Under the periodic method, we only calculate inventory at the end of the period. Therefore, we can add up all the units sold and then look at what we have on hand.

LIFO2

We sold 245 units during the month of January. Using LIFO, we must look at the last units purchased and work our way up from the bottom. Start with the 50 units from January 26th and work up the list. We would then take the 90 units from January 22nd, and 50 units from January 12th. That gives us 190 units. We are still 55 short, so we will take 55 from January 3rd.

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The cost of goods sold for the 245 units, using LIFO, is $2,032.00. Now we need to look at the value of what is left in ending inventory. We have 20 units left from the January 3rd purchase and all the units from beginning inventory.

LIFO4

Gross profit (sales less cost of goods sold) under LIFO is $2,868.00. Under LIFO, our cost of goods sold is higher than it was under FIFO and our ending inventory is lower than under FIFO. Gross profit is lower under LIFO than FIFO, which would result in lower income taxes because overall profit would be lower.

Adding cost of goods sold and ending inventory gives us $3,394.00 which ties back to goods available for sale. Everything has been accounted for in our calculation.

LIFO Perpetual

Under a perpetual inventory system, inventory must be calculated each time a sale is completed. The method of looking at the last units purchased is still the same, but under the perpetual system, we can only consider the units that are on hand on the date of the sale.

LIFO1

Imagine you were actually working for this company and you had to record the journal entry for the sale on January 7th. We would do the entry on that date, which means we only have the information from January 7th and earlier. We do not know what happens for the rest of the month because it has not happened yet. Ignore all the other information and just focus on the information we have from January 1st to January 7th.

LIFO5

LIFO means last-in, first-out. Based on the information we have as of January 7th, the last units purchased were those on January 3rd. We will take the cost of those units first, but we still need another 25 units to have 100. Those units will come from beginning inventory.

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The cost of the January 7th sale is $807.50. Now, we can move on to the next sale, updating our inventory figures. There are no units remaining from the January 3rd purchase and 125 left in beginning inventory. Before the January 17th sale, we purchased 50 units on January 12th.

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We need 65 units for this sale. Since we are using LIFO, we must take the last units in, which would be the units from January 12th. Then we would take the remaining 15 units needed from beginning inventory.

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One more sale remaining. Again, we will update the remaining units before considering the sale.

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The company sold 80 units on January 31st. Which units should we use for cost using LIFO? The last units in were from January 26th, so we use those first, but we still need an additional 30. We take those from January 22nd.

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To calculate total cost of goods sold, add the cost of each of the sales.

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You could also add $807.50 plus $532.50 plus $673.00 which also equals $2,013.00.

You may have noticed that perpetual inventory gave you a slightly lower cost of goods sold that periodic did. Under periodic, you wait until the end of the period and then take the most recent purchases, but under perpetual, we take the most recent purchases at the time of the sale. Under periodic, none of the beginning inventory units were used for cost purposes, but under perpetual, we did use some of them. Those less expensive units in beginning inventory led to a lower cost of goods sold under the perpetual method. You will also notice that ending inventory is slightly higher. Look at the differences in the units that are left in ending inventory.

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Under perpetual we had some units left over from January 22nd, which we did not have under periodic.

When using a perpetual inventory system, dates matter! Make sure to only consider the units on hand at the time of the sale and work backwards accordingly.

Related Video

LIFO Calculations

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It could be argued that the statement of cash flow is the most important of all the financial statements. It is also the least understood. Understanding the purpose of the statement of cash flow is the key. Once you understand the purpose of the statement, wrapping your brain around how to complete it is much easier.

Most people have a difficult time understanding the concept of accrual accounting. I believe this is because most people live in a cash basis world. As individuals, we do not consider income when it is earned. We recognize our income when it is paid. We recognize expenses when they are paid. It is important to remember that most businesses do not operate that way. Most businesses recognize income when the work is done, whether or not the job has been paid for. These businesses recognize expenses when the cost is incurred, regardless of payment status. In business, we are frequently recording income and expenses when no money has changed hands.

This causes a problem for many people looking at the financial statements. Individuals think in terms of cash so when an individual sees a company with a profit of $500,000, he or she may think that there is an additional $500,000 worth of cash sitting in the bank at the end of the year. Cash might have only increased slightly. It could have even decreased! When that money is not there, the person may believe there is a problem with the income statement.

The purpose of the statement of cash flow is to explain the difference net income and the change in cash over the same period. If there was a $500,000 profit, the statement of cash flow explains why the increase in cash is not also $500,000. The statement begins with net income. Each line on the statement explains where cash is coming from, called a source of cash, or where cash is going, called a use of cash. The statement ends with the amount that cash has increased or decreased over the course of the period and the ending balance in cash.

Every source or use of cash can fit into one of three categories: operating activities, investing activities or financing activities.

Operating Activities

These are activities related to operations or the income statement. In other words, these are items related to income and expenses. There are two main types of operating activities: noncash and those related to current assets and current liabilities.

Noncash operating activities relate to items that appear on the income statement, yet cash was not affected by that item. The most common noncash item is depreciation. Think about the entry recorded for depreciation.

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The entry creates an expense, which appears on the income statement but no cash changes hands. On the income statement, the expense lowers net income but there is no corresponding decrease in cash. This leads to one of the differences between net income and change in cash.

Since the depreciation was subtracted on the income statement, we need to add it back to net income on the statement of cash flow. Adding it back removes it from net income, helping us get closer to the change in cash.

Other noncash items include amortization, gains and losses. While some cash may change hands when an asset is sold, the amount of cash received relates to the removal of the asset. The gain or loss on the transaction is considered to be a noncash part of the transaction. It is essentially there to balance the transaction.

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Notice that $5,000 in cash was received, not $2,000. We eliminate the $2,000 gain in the operating section. Later, we will see what happens to the $5,000.

Any noncash item that is added on the income statement, a gain for example, is subtracted on the statement of cash flows to remove it. Noncash items that are subtracted on the income statement are added back on the statement of cash flows.

Changes in current assets and current liabilities are the second type of operating item. Think of some common current assets and current liabilities: accounts receivable and accounts payable. Both of these items are linked to the income statement.

Current Assets and Changes in Cash

Accounts receivable is created when a company does work and creates revenue. The work has not yet been paid for. However, the income appears on the income statement. This could create a difference between net income and the change in cash. When trying to determine if there is an effect on the change in cash, we need to look at how much accounts receivable has changed. Let’s look at three different scenarios.

Example #1

2012 ending balance in Accounts Receivable was $230,000
2013 ending balance in Accounts Receivable was $230,000
Sales were $3,000,000

If Accounts Receivable was $230,000 at the end of 2012 and is still $230,000 at the end of 2013, that means that $3,000,000 worth of sales were collected in 2013.

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The amount of sales and the amount of cash collected are equal. Therefore, no timing difference exists. There difference between net income and cash is not affected by accounts receivable.

Example #2

2012 ending balance in Accounts Receivable was $330,000
2013 ending balance in Accounts Receivable was $230,000
Sales were $3,000,000

In this example, Accounts Receivable decreased by $100,000. Let’s see how this decrease affects the amount of cash collected.

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The company reported $3,000,000 in sales on the income statement but actually collected $3,100,000 in cash related to sales. The decrease in accounts receivable results in an increase in cash. That makes sense because when accounts receivable balances are paid (and the balance decreases), the company receives cash.

The $100,000 difference creates a positive change in cash. You could also say that the $100,000 decrease in accounts receivable is a $100,000 source of cash.

Example #3

2012 ending balance in Accounts Receivable was $230,000
2013 ending balance in Accounts Receivable was $330,000
Sales were $3,000,000

Now we have a $100,000 increase in accounts receivable. What effect do you think this has on cash? If accounts receivable is increasing, the company doesn’t have the cash. Let’s look at the calculation.

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Only $2,900,000 was collected over the course of the year but sales of $3,000,000 appear on the income statement. The $100,000 creates a negative change in cash. My change in cash in this case is less than net income because the company did not collect those funds.

You might be concerned at this point because this seems like a lot of work to do for every line of the cash flow statement. This is just to illustrate what happens. If accounts receivable increases, the change in cash decreases by the same amount. If accounts receivable decreases, the change in cash increases by the same amount.

When completing the statement of cash flow, calculate the change in the account balance. Ask yourself who has the money resulting from that change. Go back to example #2. Accounts receivable decreased by $100,000. Who has the $100,000? The company does because customers paid the additional $100,000. This results in an increase in cash. In example #3, the customers had the $100,000 because they had not paid their bills. This results in a decrease in cash for the company. This method works for all current assets and current liabilities.

All assets behave like accounts receivable. If the balance in prepaid expenses increases, more cash is trapped in that account, resulting in a decrease in cash. If the balance in inventory decreases, the company used up some of the previous inventory rather than spending cash to purchase more. Cash increases because of this.

Current Liabilities and Changes in Cash

Current liabilities, like accounts payable, react the opposite way that assets do. Again, we are examining the differences in current liabilities to determine how these changes affect the change in cash. Let’s run through a few examples just to get the hang of it.

Example #4

2012 ending balance in Accounts Payable was $150,000
2013 ending balance in Accounts Payable was $105,000
Expenses were $2,500,000

Accounts payable decreased by $45,000. Why did accounts payable decrease? Because the company paid all the current expenses and paid off some of last year’s balance. The company paid down debt. This has a negative impact on the change in cash. Let’s look at the full calculation to confirm.

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The company paid $45,000 more in cash than it recorded in expense. This causes a decrease in cash. It can also be said that the decrease in accounts payable is a use of cash.

Example #5

2012 ending balance in Accounts Payable was $150,000
2013 ending balance in Accounts Payable was $175,000
Expenses were $2,500,000

Now, accounts payable is increasing. The company charged more to accounts payable over the course of the year than the company paid off. The $25,000 difference is a source of cash. The company was able to write off expenses that it has not yet paid for.

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The company’s income statement shows expenses of $2,500,000 but the company only spent $2,475,000. It kept the $25,000. Because of the $25,000 increase in accounts payable, the change in cash increased by $25,000.

All current liabilities behave like accounts payable. When accounts payable decreases, cash decreases because cash was used to pay down the liability. When accounts payable increases, cash increases as well because the company used debt rather than cash to finance its activities.

Steps to Complete the Operating Section

  1. First calculate the change in the account balance.
  2. Ask yourself who has the cash from that change. If the company has the cash, it is an increase in cash.  If someone else has the cash, customers or vendors for example, it is a decrease in cash.
  3. Don’t forget to look for noncash items as you work your way down the balance sheet: depreciation, amortization, gains and losses.

Investing Activities

In this section, we are concerned with investments that the company has made. What do companies invest in? Long-term assets that will help with company increase revenue. This includes buildings, machinery, intangible assets, investments in other companies and other long-term investments.

In the investing section, we are not allowed to explain a difference in an account balance by listing “change in fixed assets.” The investing section requires us to explain each change. Let’s look at an example.

Example #1

2012 ending balance in Vehicles was $250,000
2013 ending balance in Vehicles was $235,000
In 2013 the company sold a vehicle which was originally purchased for $35,000 for $5,000. The vehicle had $33,000 of accumulated depreciation recorded at the time of sale.

When dealing with assets, we may not have all the transactions listed, but we will always have all the information we need to do the calculation. Let’s start with the beginning balance and run through the information we have so far.

CF8

This does not make sense because the account balance was $235,000. Clearly, something else happened which was not listed in the information. What would cause the balance in the vehicles account to increase? The company must have purchased another vehicle. How much was the new vehicle? It must have been $20,000.

CF9

Now that we have identified all the activity in the vehicles account and were able to reconcile the change in the balance. We now must figure out what we need to record. We must forget for a moment the vehicles and turn our attention to the cash that changed hands.

The company sold a vehicle. How much cash was received? $5,000. It does not matter that the vehicle originally cost $35,000. Now we are only concerned with cash. The company also purchased a vehicle. How much cash was paid? $20,000. On the statement of cash flow, we would record these two items.

CF10

Notice, we listed each item separately. We need to explain to the reader what happened.

You might have noticed that there was a gain on the sale of the vehicle. The vehicle had a book value of $2,000 ($35,000 cost – $33,000 accumulated depreciation). If $5,000 was received, there was a $3,000 gain. Remember when we discussed noncash items in the operating section. This gain would be listed in the operating section and subtracted from net income.

You should follow this procedure for all noncurrent assets on the balance sheet.

  1. Reconcile the beginning and ending balance in the account using the information you have in the problem.
  2. If the balance matches your reconciliation, you are finished. Record the items listed.
  3. If the balance does not match your reconciliation, there must have been additional activity that was not listed. This activity must be an asset purchase. Calculate how much the asset purchase was.
  4. In the statement of cash flow, list all transactions separately, as shown above.

Financing Activities

In our analysis of the balance sheet, we have covered current assets, current liabilities and long-term assets. The only items remaining are long-term liabilities and equity. Both of these items go into the financing section.

The financing section is similar to the investing section. We must explain what happened, not just list the changes in each account balance.

Example #1

2012 ending balance in Notes Payable was $95,000
2013 ending balance in Notes Payable $75,000
The company borrowed $35,000 in additional loans

Looking at this example, it is clear that there is information missing. The company borrowed additional money but the Notes Payable balance decreased. That just doesn’t make sense with the information we are given. There are two ways to work this calculation. we can reconcile the balance, similar to the method used in the investing section.

CF11

What is causing the balance to be $55,000 less than anticipated? Think about the reason that the balance in Notes Payable would decrease. Debts decrease when they are repaid. The company must have repaid $55,000 on the debt.

Here is how we would list this on the statement of cash flow in the financing section:

CF12

You should follow this procedure for all noncurrent liabilities on the balance sheet.

  1. Reconcile the beginning and ending balance in the account using the information you have in the problem.
  2. If the balance matches your reconciliation, you are finished. Record the items listed.
  3. If the balance does not match your reconciliation, there must have been additional activity that was not listed. Calculate the amount you are off and the reason for the change.
  4. In the statement of cash flow, list all transactions separately, as shown above.

Completing the Statement of Cash Flows

Whenever I am working on a cash flow statement, I use the balance sheet as a guide.

First, calculate how much each account has changed from the previous year.

Starting at the top of the balance sheet, I work my way through each account. The first account should be cash. We can skip that one since the purpose of the statement of cash flow is to match the change in cash. The next account is most likely accounts receivable. Determine which section accounts receivable would go into: operating, investing or financing (if you said operating, you are correct). Then ask yourself if the change in the balance is a source of cash or a use of cash. Add it to your statement.

Use this same procedure, explaining all the differences and adding them to the correct section of the cash flow statement. When you have explained all the differences, total each section and then add all three sections together to calculate your change in cash. The change in cash you calculate should equal the difference between your beginning and ending cash balance.

Related Videos

Cash Flow Statement Basics

Completing the Cash Flow Statement

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