ACCT1005: Financial Accounting - Cash Flows & Errors

Faculty of Social Sciences

ACCT1005: Financial Accounting

Session 4 – Cash Flows & Errors

  • University of the West Indies, Mona
  • Mona School of Business and Management

Statement of Cash Flows

  • Definition: The Statement of Cash Flows depicts/explains the way cash has changed during an accounting period.
  • Overview: It shows where cash came from (inflow) and how it was used (outflow).
  • Three categories of cash flows:
    1. Operating Activities
    2. Investing Activities
    3. Financing Activities (Most Important)

Categories of Cash Flows

Operating Activities

  • Definition: Operating Activities are the main revenue-producing activities of the entity that are not investing or financing activities.
  • Components: Include cash received from customers and cash paid to suppliers and employees.

Investing Activities

  • Definition: Investing Activities involve the acquisition and disposal of non-current assets and other investments that are not considered to be cash equivalents.
  • Definition of Cash and Cash Equivalents: Comprises cash on hand and demand deposits, alongside short-term, highly liquid investments that are readily convertible to a known amount of cash, and that are subject to an insignificant risk of changes in value.

Financing Activities

  • Definition: Financing Activities are activities that alter the equity capital and borrowing structure of the entity.

Cash Account Examination

  • Example Breakdown of a Cash A/C:
    • Bal. b/f: $1,720
    • Bal. b/d: $7,750
    • Various transactions (marked a, b, c, d, g, h, i, j) showing inflows and outflows need to be re-examined to identify operating, investing, and financing activities, along with the overall change in cash.

Notes to the Financial Statements

  • Description: Includes accounting policies & other explanatory information not reflected in the financial statements, such as a pending lawsuit.

Using Financial Information

Evaluating Solvency

  • Definition: Ability of the business to meet financial obligations as they become due, specifically relating to short-term debt paying ability.
  • Measures of Short-term debt paying ability:
    1. Working Capital
    2. Current Ratio

Working Capital

  • Definition: Working capital is the money available to meet your current, short-term obligations.
  • Importance: Impacts many aspects of business, from paying employees and vendors, to planning for sustainable long-term growth.
  • Calculation:
    ext{Working Capital (Net Working Capital)} = ext{Current assets} - ext{Current liabilities}

Evaluating Profitability

  • Definition: Profitability assesses the increase in owners/shareholders' equity, resulting from revenues exceeding expenses.
  • Key Metrics:
    1. Net Income % or Net Profit Margin: Shows how much profit is generated on every dollar of sales calculated as:
      ext{Net Profit Margin} = rac{ ext{Net Income}}{ ext{Total Revenue}}
      OR
      ext{Net Profit Margin} = rac{ ext{Net Income}}{ ext{Net Sales Revenue}}
    2. Return on Owner’s Equity: Measures the net profits generated by the business based on each dollar of owner’s investment contributed by the proprietor, given by:
      ext{Return on Owner’s Equity} = rac{ ext{Net Income}}{ ext{Average Owner’s Equity}}

Errors Not Affecting Balancing of Trial Balance (TB)

  1. Error of Omission:

    • Scenario: Purchased a motor car on account from Used Wheels Ltd. for $450,000 but made no record of the transaction.
    • Journal Entry:
      Dr Motor Car $450,000
      Cr A/Cs Payable – Used Wheels Ltd. $450,000

  2. Error of Commission (wrong account of same class):

    • Scenario: Sold goods to B. Marks for $23,000 but debited the account of D. Marks instead.
    • Journal Entry:
      Dr B. Marks $23,000
      Cr D. Marks $23,000

  3. Error of Principle (wrong class of account):

    • Scenario: Bought a computer for $54,000 for business use and debited purchases & credited cash.
    • Journal Entry:
      Dr Computer Equipment $54,000
      Cr Purchases $54,000

  4. Error of Original Entry (incorrect figure from source documents):

    • Scenario: Sold goods on credit to S. Greaves for $5,640 and entered the amount as $4,640.
    • Journal Entry:
      Dr A/Cs Receivable-S. Greaves $1,000
      Cr Sales Revenue $1,000

Compensating Errors

  1. Compensating Error (errors that cancel or balance each other):
    (a) Purchases over-stated by $2,000 & Sales over-stated by $2,000.

    • Journal Entry:
      Dr Sales Revenue $2,000
      Cr Purchases $2,000
      (b) Electricity Expense over-stated by $500 & Rent Expense under-stated by $500.
    • Journal Entry:
      Dr Rent Expense $500
      Cr Electricity Expense $500

  2. Error of Complete Reversal of Entries (correct amount, but wrong side of account):

    • Scenario: Paid cash of $13,000 to A. Sherman but debited Cash & credited A. Sherman.
    • Journal Entry:
      Dr A/Cs Payable - A. Sherman $26,000
      Cr Cash $26,000

Introducing the Suspense Account

  • Definition: A suspense account is a temporary resting place for an entry that will end up somewhere else once its final destination is determined.
  • Usage: If the total Debits > total Credits, open a Suspense Account with a Credit Balance and vice versa.
  • Purpose: Allows the Trial Balance to function temporarily while searching for errors.

Final Accounts Preparation

  • Objective: Prepare final accounts, including errors, while someone searches for errors.
  • Correction of Errors: Errors should be corrected through double entry and not by crossing out, as this is illegal.

Errors Affecting Balancing of Trial Balance (TB)

  1. Posting Incorrectly:

    • Single-Sided Entry (Incomplete Double Entry):
      • Scenario: Lodged cash of $42,000 in the current account but only debited cash/bank.
      • Journal Entry:
        Dr Suspense A/C $42,000
        Cr Capital A/C $42,000
    • Double-Sided Error (Posting using only Drs or Crs):
      • Scenario: Bought stationery & supplies for $12,000 but debited both Stationery & Supplies and Cash accounts.
      • Journal Entry:
        Dr Suspense A/C $24,000
        Cr Cash A/C $24,000

  2. Mathematical Errors:

    • Slide Error: (Zero(s) added or left off)
      • Scenario: Bought stationery & supplies for $1,000 but debited Supplies $100 and credited Cash $1,000.
      • Journal Entry:
        Dr Supplies A/C $900
        Cr Suspense A/C $900

Mathematical Errors Continued

  • Transposition Error: (Two digits are “switched”)
    • Scenario: Paid utilities expense of $2,650 but debited Utilities Expense $2,650 & credited Cash $6,250.
    • Journal Entry:
      Dr Cash A/C $3,600
      Cr Suspense A/C $3,600
  • Note: Both slide & transposition errors are always divisible by 9.