 Hello and welcome to the session. This is Professor Farhad and the session would look at the operating section of the statement of cash flows This topic is covered in introductory accounting course Intermediate accounting where I have more explanation about this topic as well as the CPA exam It's an important topic on the CPA exam as always I would like to remind you to connect with me on LinkedIn if you haven't done so YouTube is where you would need to Subscribe I have 700 plus accounting auditing finance and tax lectures This is a list of all my courses including many CPA Questions if you like my recording, please like them share them put them in playlists subscribe if they benefit you It means they might benefit other people share the wealth connect with me on Instagram on my website You will find additional resources if you want to supplement your accounting education and or pass your CPA exam So simply put if you are looking to get those 10 To 15 extra points on the CPA exam to succeed and put the exam behind you. I strongly suggest you check out my website Also, if you'd like to learn about an introduction about the cash flow statement I do have a previous session check the description for the playlist and you can and you can see the previous Session so in this session, we're gonna talk about one section of the cash flow statement Which is the operating activities? Then in the next two session will devote one for investing and one for financing that then at the end I will work a comprehensive Example that will have all three sessions in one session this way you can put all this Statement of cash flow together. So in the prior session, we looked at the operating section And what I said is let's assume we are we are preparing an operating section for a restaurant What would the operating section involved when it involved the operating of the business? So The operating section will have to section an inflow of cash and an outflow of cash What constitute the outflow of cash? So as a restaurant, what do they spend money on whether they spend money on? They spend money on employees. They spend money on supplies. They spend money on goods goods to be sold They have to pay supplier for goods. They have to pay wages. They have to pay operating expenses They have to pay for the internet. They have to pay for the TV. They have to pay for the utilities They also have to pay taxes and fines for operating the business. They have to pay interest on their debt All of those are considered Operating activities outflow of cash. Now the business the restaurant. What's their inflow of cash? obviously their largest inflow of cash is Customers these people that attend the restaurant and they buy stuff cash sale from customers collection from customers if you sell on account It's collection from customers Receipts of dividend revenue if you have investments and stocks and they pay you dividend. That's an operating activity receipts of interest revenue if you have money in the bank and You receive interest from the bank. That's considered interest revenue That's also operating and you want to have more cash inflow than cash outflow So let's take a look at a skeleton of the statement of cash flow This is what the statement of cash flow would looks like and we're gonna look at an actual one actually build one We're gonna have three section operating It would list the inflows and the outflows then at the end we net them We either have a plus or a minus then we have the investing section again We're gonna list the inflows and the outflows will work on this section next time The third section is financing inflows and outflows the same thing You know, we're gonna have either a plus or a minus at the end then we net them all out net increase or decrease It's either plus or a minus then we add to the prior balancing cash then we find the ending cash Don't worry. We're gonna work with numbers, but to show you what it looks like what a statement of cash flow Looks like This is the I believe this is best buy. This is the best buy Cash flow statement. This is the operating section investing section financing section And at the end we'll talk about this later on so in this session We're only focusing on this section and let me just tell you what this section looks like this section look positive Operating cash flow for 2019 positive 2018 and positive positive 2017 it means they have a positive operating cash flow What did they do they net all these out which were which will which we will have to do that in this session So in this session, we're gonna be focusing on this Operating section specifically and hopefully I would remember I will come back and show you at the end what we did and why it makes Sense for that for that matter. So let's take a look at the steps in preparing the statement of cash flow First we have to compute net increase or decrease in cash We're gonna look at the each one each of these steps separately step two will compute the cash from operating activities We're focusing on this section on this step here and for this step We're gonna have five steps five sub steps, then we would look at compute net cash from investing This is the next session Financing will have a session then at the end we add the change to the beginning cash So those are the five steps to complete the whole cash flow statement I'm only focusing on this step for now. So Step one step one is pretty easy. All what we're looking to do is to look at the cash account And look at the difference between the beginning and the ending. So simply put this is the cash account and we started with The beginning balance December 31st 2018 12,000 December 31st 2019 17,000 All what we say here is the cash went up by 5,000 now, let me tell you something if if a company if that's all what they have in other words if Oh, that's all this is all the information that they have I can prepare a cash flow statement right now from this information alone because why we have 1 2 3 4 5 6 7 8 9 We only have 9 different activities and I can tell you which which which is which for example receipt from customers This is operating Receipts from the asset sale. This is investing. We'll see that later. All what I'm saying is it's easy to do so I can't prepare a cash flow statement now, but in a real company, you don't have nine transactions You have nine million cash transactions, which is a lot So that's why you have to prepare the cash flow statement to find out where did the cash came from? So but the first step is to find the difference between the beginning and the ending that's step one step two is To look at another step to another way to look at the cash flow statement Let's approach it from the accounting equation And what is the accounting equation if you remember assets equal to liabilities plus equity what we're going to do We're going to take assets and break them into two components cash is one type of asset and all assets together So cash plus non cash assets equal to liabilities plus equity That makes sense because assets is composed of cash and non cash Cash and non cash now what we can do is then we can just Eliminate the cash on one side if we put the cash by itself What we find out is liabilities the increase in liabilities plus the increase in equity Minus the decrease in non cash assets should should give us should give us should give us should give us The change in cash But this is basically the way we look at it from in the accounting equation So hopefully this makes sense to you, but you will see this is really what we're doing We're gonna look at the increase in liabilities the increase in equity and reduce in non cash assets And this is gonna give us the delta the change in cash And you will see how shortly not not in this session, but you will start to look at this process Okay, let's take a look at steps and up in in in step two So remember step two compute the operating section for the operating section. I use those five steps So I use those five steps, you know, it's it's not the rule a fast be rule or anything just I made them up Okay, what is a step one? I'm gonna go over the steps and we're gonna execute those steps to show you how to prepare a statement of cash flow operating section first We will start with net income or net loss either net income or net loss We're gonna always assume we have net income because we could also have net loss then the second step step number two We're gonna add non cash expenses What are non cash expenses? Expenses that we list on the income statement, but in reality, they don't consume cash What are we talking about here? Well, think about depreciation expense when you book Depreciation expense when you debit depreciation expense $10,000 you don't credit cash. Remember, you don't credit cash You credit accumulated depreciation $10,000 we call this we call this we call this a non cash expense non cash means we recorded the expense without Without incurring the cash without spending spending the cash another example is bad debt Expense when we debit bad that expense five thousand we credit allowance For bad That again the same concept. We did not we did not credit cash. We credited another account. So notice We did not credit cash. So those are called non cash Expenses non cash expenses. Okay, same thing with amortization as well as many non cash expenses So what we do with those we're gonna scan the income statement and any see we anytime we see any of these expenses We're gonna add them up. So we start with net income and add those non cash expenses Why you may be asking? Why are we adding caught cap non cash expenses because those expenses? reduced net income they did indeed reduce net income, but did not Reduce cash. So all we're looking for is our cash not net income reduce net income without reducing cash. Okay, three We're gonna deduct gains. Hold on a second So if we have a gains you are saying we are going to deduct the gains and the answer is yes. Why? think about it if We sell something for a game. Let's assume we bought a piece of land for a hundred thousand and we sold it for 120. Let's look at the journal entry. We debit that cash 120 we credited the land 100,000 and we have a gain of 20,000 so this is what the journal entry would look like we have cash of 120 credited the land and Credited the gain. Now what happened with this gain this gain increase net income by 20,000 that's good, but that we receive 20,000 dollar in cash and the answer is no We received 120 so hold on a second if we receive 120 why are we? Deducting the cash from the operating because this whole 120,000 because this whole 120,000 it's gonna go somewhere else It's gonna go into another section called investing. Therefore. We did not really get $20,000 in operating you receive 120 but this 120 will be counted somewhere else because buying and selling land is Not an operating activity. So that's why you do so now same thing with this example of land. Let's assume Let's assume we sold this land at a loss Let's assume we sold this land at a loss and let's assume we sold it for $80,000 so we debit that cash 20,000 Credited the land 100,000 and we have a loss a debit loss of 20,000 I should have put the debit after the land, but that's fine. Now what happened is this loss This loss this 20,000 oops this $20,000 loss this loss reduced my net income reduced my net income by 20,000 But did it reduce my cash? Did it reduce my cash by 20,000 and the answer? No, it reduced my my net income, but it did not reduce my cash What does that mean? It means if I did not reduce my cash I have to add it back because it reduced my net income because what I'm doing I want to know What's my cash net income? That's the purpose. So I have to add the back add back the losses So you're saying but I received $80,000 of cash. That's fine This $80,000 will be counted in the investing activity. We'll see later on Okay, so that's why I deduct the gain and add the losses another way to look at adding the losses if that makes if that makes it easier for you The losses are like a non-cash expense They reduce net income without reducing the cash if that makes it if that makes it easier for you to understand and the gain It's it's a revenue. I Think of it as a non cash revenue non cash So it increase our revenue, but it's a non cash revenue So it's increase our net income, but did not increase our cash So that's why we deducted because we're only looking for cash now after we are done with the income statement We have to analyze current assets and current liabilities Why current assets and current liabilities because current assets and current liabilities are Considered operating assets. We use them to operate. We use them to operate the asset We use them to operate to operate the business. So we're gonna analyze them How are we gonna analyze them? So I'm gonna delete everything and explain to you. How do you analyze? How we analyze current assets and current liabilities. So let's start with an account called account receivable Hopefully, we all know what account receivable is a counter receivable is Account receivable is an asset. It's a current It's a current asset It's a current asset and let's see what happened from year to year Let's assume our account receivable was $100 year one and in year two it became one. I'm sorry. This is year one in Year two it became 150 let's examine the change. So this is year two year two 150 so the net is a plus 50 or plus 50,000. What does that mean? It means I I Account receivable went up by 50,000. What does it mean really? What does it mean if it went up by? 50,000 it means that you we sold We sold 50,000 on account but Did not Receive the cash One more time. What does that mean? Well, it means if you look at your account receivable if we analyze account receivable The beginning was 100 the ending was 150. So the net change is 50 It means for the for this period of time. We sold 50,000 more on account. We sold 50,000 more on account than what we received from customers Well, what does that mean? It means if we sold more on account. It means those were non cash sales So simply put if account receivable went up. We're gonna deduct 50 from net income Why because we only want cash net income now the opposite is true if account receivable was 100 in year one Then account receivable went to 80 in year two. It means we collected $20. Why do I know we collected $20? Because if we went from If we went from 100 to 80 we went down 20. What does that mean? Why do account receivable goes down account receivable goes down when you collect Money and I'm looking for money. I'm looking for cash if my account receivable went down. It means I collected more cash What does that mean? It means I add 20 to net income I add $20 I collected in cash to my net income because I am converting I am Converting net income to cash net income to cash net income. Okay. I hope I hope this makes sense. Now, let's analyze Inventory let's analyze inventory. So before I analyze inventory. So account receivable account receivable up cash flow down account receivable down Cash flow up. So so we already kind of we already kind of established this We established this now. Let's let's look at inventory. Let's look at inventory and do the same thing with inventory Let's assume our inventory For year one was 100 our inventory for year two is 120. Okay, so our inventory went up By 20 What does that mean? What it means we bought inventory and we did not sell it That's one thing it means we bought inventory and we did not sell it notice because we have a net increase in inventory So if we bought inventory, we are going to assume We are going to assume that that inventory is purchased on credit. It doesn't have to don't worry about this assumption We're gonna take care of it when we analyze the liabilities, but Since inventory went up. So we say since inventory went up cash flow must have went down now if we started with 100 and and and and and for year one and in year two and In year two, let's see in year two. It's not erasing. I'm not sure why my eraser is not working So let me just cross this number in year two. It became 80. So Inventory went down by 20. What can we assume? Well, we could assume two things We sold the inventory or we purchased less inventory than the prior year. Well if inventory Went down. It means cash flow went up. So notice If inventory went down cash flow went up It's the same as a count receivable when one goes up the other one goes down when one goes up The other one goes down. Okay. I hope I hope this makes sense now We can take this rule and apply it to all to all current assets Let me give you an example a more kind of vivid example that illustrate this is prepaid Let's assume you have a prepaid account the prepaid was 100 in year one Then the prepaid became 120 in year two. Well, how do you your prepaid went up by 20? How do you acquire prepaid? Just listen to me prepaid we paid for them So if my prepaid went up my cash flow must have went down Okay, same thing as inventory same thing as a count receivable and the same thing happened if my prepaid goes from 100 To 80 my prepaid went down By 20 what does that mean? It means I am consuming Prepaid that I already purchased. So I'm not spending the money now. I already spend the money in the past and I'm expensing the prepaid now. Well as far as I know if my prepaid goes down It means I did not spend money this year. It means my cash flow. I can serve my cash flow by 20 simply put To make a general a general statement, so I mean erase everything. Hopefully it will erase. Let me try it one more time My eraser is not working. So let me just tell you real quick What happened if your current asset goes up? Your cash flow goes down if your current asset goes down your cash flow goes up Obviously current assets except of cash because we are analyzing cash. That's the whole purpose of this So this is what you need to know about current assets No, I cleared my screen. We can work on current liabilities current liabilities is easier to understand the relationship between current liabilities and and And cash, let's assume we have an account spayable We have Let's let's make it note spayable. Let's assume we have a note and we had $100 of loans year one and For year two we have $80 in year two So let's think about it. What happened to our loan our loan went down by $20 What does that mean? Why would your loan go down your loan go down when you? Pay it when you pay it. So if my if my note spayable goes down My cash flow goes down. Well, let's change the scenario. I have 100 in year one 120 in year two in year two now Mike my my liability went up by 20 Well, what does it mean if I have more loans? It means I have more Cash, so if my notes payable goes up. It means I have more cash so notice it's a positive relationship between Liabilities and your cash flow more liabilities means more cash less liabilities means less cash because if you have less liabilities To have less liabilities you have to pay them off to pay them off. You have to consume cash and that's why They go hand-in-hand and the same concept would apply to accounts payable. Just take notes payable think about accounts payable use the same thing Take it out use wages payable Exact same concept when your liabilities go up. It's good for your cash. It means you are not using cash You are not using your cash. Okay, and this is another Another another picture of what I just said, okay? So change in the balances current asset if it increase you subtract from that income simply put I like this current asset up cash flow down current asset down cash flow up Current liabilities up cash flow up current liabilities down cash flow down now No, I just said so it doesn't have to be current liabilities. I can say assets up cash flow down Assets down cash flow up liabilities up Cash flow up liabilities down Cash flow down so it doesn't have to be current this applies to all assets and all liabilities and the reason I say this because soon you will see we're gonna have to deal with Other assets other than current assets other than current assets if that make sense, okay? Now the best way obviously to illustrate this is to actually work an example and to work an example We need a two-year balance sheet to in order to complete a cash flow statement because we need two year of balance sheet Comparative balance sheet two years. We need this year income statement And we might need additional information if this information is is needed. It will be given in the problem. Okay? So let's take a look at this at this example. We have Genesis. We have their income statement Right here. We have the comparative balance sheet right here, and we have the additional information So we're gonna read this We're gonna read this this information To analyze the to analyze what we are giving so first we are giving the income statement This is their sales five hundred and twenty five hundred and ninety thousand minus cost of goods sold minus wage minus operating expenses minus interest expense minus depreciation gives us this number which is 43,000 now if we take the 43,000 we subtract the loss we add the gain We get our income before taxes and we take out the taxes we get an income of 38,000 So this is the income statement which we're gonna have to deal with pretty shortly because our starting point to complete The operating section is the income statement. So that's that Then we are giving additional information the accounts payable balance result from inventory purchases Purchases of 60,000 off-plant asset sold plant asset receive 15,000 from issuing stocks Those are additional information as they become necessary will deal with them. Okay? So step one is to compute your change in cash. We already did this So we're gonna have to explain this five thousand increase in cash now when we are dealing with the operating section We're gonna be dealing with current assets, which are these this section here and current liabilities this section here Those are the two sections that we're gonna be dealing with. Okay current assets not cash And we have three current assets and three current liabilities. Okay? So then we went then we compute the change Account receivable went up by twenty thousand inventory went up by fourteen thousand prepaid went up by two thousand Accounts payable went down by five thousand interest payable went down and income taxes payable went up So we compute the changes in the accounts that we're gonna be analyzing So this is the information that we're given now remember the five steps that I that I just showed you remember the five steps Let's go through the five steps again First so let me go through the five steps again, then we'll start to execute them. Okay? So start with net income add non-cash expenses the dog gain Add losses analyze current assets and current liabilities. So copy those steps down because I'm gonna be using those steps To prepare the cash flow the operating section of the cash flow statement So given this information given this information. Here's what I here's what I can do. Let me just Snap this snap this and I can show you what I'm gonna be doing. Let me snap it. Give me one second Okay, let me snap this this information So step one it says Step one it's it reads Start with net income. That's easy. I am giving net income. I'm giving net income of 38,000 so I'm gonna start with net income of 38,000 this is step one. This is my starting point Then it says add if you don't have the steps go back and get the steps It says go to the income statement and add any non-cash expenses. Well, I see depreciation expense of 24. So I'm gonna add 24,000 of Depreciation Expense now I will scan the income statement not only for depreciation expense. I scan it for Something other than depreciation expense such as bet that expense amortization expense so on and so forth. I don't see this So I'm done with step one I'm done with step two step three and four Step three it says if there's any gains, which we have subtract the gains subtract $16,000 of gains and we have losses at the losses at the losses So basically I went through step one. This is step one. This is step two This is step three and this is step four real quick I already finished four of the five steps four of the five steps and all what I'm doing is I'm saying All what I'm doing is I'm saying this depreciation expense reduce this number but without reducing cash Therefore add back 24,000 this loss reduce net income without reducing cash at 6,000 this is what I'm doing and this number increase net income without increasing cash reduce Net income by 16,000. This is what I'm doing. So let me show it to you on the on the On the PowerPoint. So basically this is what I have I have this is how you prepare the operating section cash flow from operating We start with net income step one Then I make adjustments to reconcile net income to net cash provided by operating activities Basically taking that income and turning net income into cash net income Add depreciation expense add the loss the dog the game. This is what I did I went through step one two three and four all what I'm left with is step five That's the only step that I need to do and basically step five You remember step five is to analyze current assets and current liabilities, and I told you current asset up Cash flow down so on and so forth, you know the rules and here's what I have so check it out I they already did all the computation for me. So I have all the computation all what I have to do now is Compute them is to put them together then I will I will show you a counter-seable went up if they are went up It means Subtract $20,000 from their income if if inventory went up inventory went up an increase in inventory Subtract 14,000 from their income prepaid went up Subtract deduct 2,000 of net income done Now I have to focus on my current liabilities Accounts payable. I'm gonna use a different color this way, you know, I'm dealing with another class of Account account payable accounts payable went down It means cash flow went down $5,000 Interest payable int payable went down It means my cash went down by $1,000 income taxes payable taxes Payable went down ups actually taxes payable went up an increase well if it increase it means I did not pay cash It means plus $10,000 cash if if income taxes payable went up It means I am booking income tax expense without paying the bill. Why because I'm crediting income taxes payable It means it's a positive cash. So simply put Here's the here's what I just did but here's how you present them on the cash flow statement Changes and accounts receivable It went up negative cash inventory went up negative cash prepaid went up negative cash Decreasing accounts payable negative $5,000 decrease interest payable negative an increase in taxes payable positive Remember those are liabilities and those are the assets Simply put I'm ready to put all my these are the steps again. This is what I just did starting with their income make the adjustments to depreciation depletion amortization loss Then gains so I did you know step one step two. It's you know, this is step one two three and four and Step five is analyze current assets and current liabilities. This is what I did And this is basically the final the final picture the final product This is the operating section starting with net income step one depreciation expense step two step three step four Step five. This is how I break them down and bottom line. What happened is the company made 38,000 and the cruel net income on a cash basis. They only made 20,000 it means they did not make as much cash as they thought from it as as much as net income from a cash perspective, so yes, they are at a profit But from a cash perspective, they are less than 38,000 less than net income. Let's go back to best buy I'm glad I remember because I started the illustration by showing you best buys Let's go back to best buy and show you what we just did Look at that intimidating cash flow statement for best buy and basically best buy starting with net earning net earning is net income Then they add back depreciation and amortization They add back something called restructuring charge, which is you don't have to worry about it's beyond the scope of this course But it's a non-cash expense. They add back stock compensation expense also a non-cash expense The third income tax is the same thing those are you're just not familiar with those but those are all non-cash expenses Then they analyze the changes and assets and liabilities receivable went down It's a plus it seems receivable went on because it's a plus merchandise inventory went up. It's a minus other assets went up It's a minus accounts payable when that went up. It's a plus So notice and this is what they come up with they come up with actually on a cash basis They did better than then the net incomes on a cash basis They earn two point four billion or two thousand four hundred from a net income perspective. They only earned one thousand four hundred and sixty four So basically you are done with this section data, please stop Thank you So from from a cash flow perspective they did better than net income As always if you if you like this recording, please like it share it put it in playlist Don't forget to visit my website for additional resources Share it with others specially these days with the corona virus if you're looking for additional resources check out my website. I Can help you pass the exam you only need maybe 10 to 15 extra points My resources will help you achieve it. Good luck study hard and stay safe