Notes on The Statement of Cash Flows: Prairie Proud Case (Chapter 1)

Operating Activities

• Definition: Cash flows that arise directly from running the business to earn profit. They include cash received from selling goods/services and cash paid for expenses such as supplies, wages, advertising, rent, insurance, etc.

• Prairie Proud example (month ended Sep 30, 2023):

  • Cash received from customers: $10{,}000$

  • Cash paid to employees and suppliers: $5{,}000$

  • Net cash provided by operating activities: $5{,}000$

  • Interpretation: Operating cash flow equals cash inflows minus cash outflows related to earning income.

Investing Activities

• Definition: Cash flows from buying and selling productive resources with long lives (e.g., buildings, land, equipment), investments, and lending to others.

• Prairie Proud example:

  • Cash used to buy equipment: $-40{,}000$

  • Net cash used in investing activities: $-40{,}000$

• Interpretation: Negative investing cash flow indicates cash outlay for long-term assets.

• Practical note: The negative number reflects the company’s plan to invest in equipment, which is common for startups or expansion.

Financing Activities

• Definition: Cash flows involving external financing activities with owners and lenders, including:

  • Borrowing from banks

  • Repayment of bank loans

  • Cash contributions from shareholders (contributed capital)

  • Dividends paid to shareholders

• Prairie Proud example:

  • Capital contributed by shareholders: $30{,}000$

  • Cash dividends paid to shareholders: $-1{,}000$

  • Cash borrowed from the bank: $20{,}000$

  • Net cash provided by financing activities: $30{,}000 - 1{,}000 + 20{,}000 = 49{,}000$

Cash Flow Totals and Change in Cash

• Change in cash:

  • = Net cash from operating + Net cash from investing + Net cash from financing

  • = $5{,}000 + (-40{,}000) + 49{,}000 = 14{,}000$

• Beginning cash (Sep 1, 2023): $0$

• Ending cash (Sep 30, 2023): $14{,}000$

• Cash balance on the balance sheet equals Ending Cash on the Statement of Cash Flows: $Ending ext{ Cash} = 14{,}000$

Reading the Statement of Cash Flows: Key Conventions

• Parentheses indicate negative cash flows; a positive number indicates a cash inflow.

• The statement is divided into three sections: Operating, Investing, Financing.

• It shows the net change in cash for the accounting period and reconciles beginning and ending cash balances.

Notes to the Financial Statements

• Rationale: The four basic financial statements are not complete without notes that explain how amounts were derived and what other information may affect decisions.

• Notes provide detail and context for the numbers presented in the primary statements.

Relationships Among the Financial Statements ( Exhibit 1.7 )

• How the four statements connect:
  1) Net income from the Income Statement is a component in determining ending Retained Earnings on the Statement of Retained Earnings.
  2) Retained Earnings from the Statement of Retained Earnings is reported on the Balance Sheet.
  3) Cash on the Balance Sheet is equal to Ending Cash reported on the Statement of Cash Flows.

• Takeaway: The statements are interrelated; changes in one statement affect others.

Exhibit 1.7: Relationships Among the Financial Statements (Prairie Proud)

• Income Statement (For the Month Ended Sep 30, 2023)

  • Net income: $2{,}000$

• Statement of Retained Earnings (For the Month Ended Sep 30, 2023)

  • Beginning Retained Earnings: (given as $0$ here)

  • Add: Net Income: $2{,}000$

  • Subtract: Dividends: $-1{,}000$

  • Ending Retained Earnings: $1{,}000$

• Balance Sheet (As of Sep 30, 2023)

  • Assets: Cash $14{,}000$, Accounts Receivable $1{,}000$, Supplies $3{,}000$, Equipment $40{,}000$, Total Assets $58{,}000$

  • Liabilities and Shareholders' Equity: Include Accounts Payable, Note Payable, Contributed Capital, and Retained Earnings (Ending RE from SRE: $1{,}000$)

  • Total Liabilities and Shareholders' Equity: $58{,}000$

• Statement of Cash Flows (For the Month Ended Sep 30, 2023)

  • Net cash from Operating Activities: $5{,}000$

  • Net cash from Investing Activities: $-40{,}000$

  • Net cash from Financing Activities: $49{,}000$

  • Change in Cash: $14{,}000$

  • Beginning Cash: $0$

  • Ending Cash: $14{,}000$

Exhibit 1.8: Summary of Four Basic Financial Statements

• Purpose and structure of each statement:

  • Income Statement

  • Purpose: Report the financial performance of the business during the current accounting period.

  • Structure: Revenues and Expenses (e.g., Sales revenue, wages expense, supplies expense, rent expense).

  • Statement of Retained Earnings

  • Purpose: Track earnings retained in the business during the current period and added to prior periods.

  • Formula:

    • Beginning Retained Earnings + Net Income (this period) – Dividends (this period) = Ending Retained Earnings

  • Net income is from the Income Statement; Dividends are distributions this period.

  • Balance Sheet

  • Purpose: Present the financial position of a business at a point in time.

  • Structure: Assets, Liabilities, Shareholders' Equity (with the equation: $ext{Assets} = ext{Liabilities} + ext{Shareholders' Equity}$)

  • Examples of assets: Cash, receivables, supplies, equipment.

  • Examples of liabilities: Accounts payable, notes payable.

  • Shareholders' Equity components: Contributed capital, retained earnings.

  • Statement of Cash Flows

  • Purpose: Report the cash inflows and outflows during the current period.

  • Categories: Operating Cash Flows, Investing Cash Flows, Financing Cash Flows.

  • Net change in cash:
    $ext{Change in Cash} = ext{Operating CF} + ext{Investing CF} + ext{Financing CF}$

  • Beginning cash, ending cash, and the reconciliation to the cash balance on the Balance Sheet.

Self-Study Practice 1.1 (Illustrative Practice)

• For each account, indicate (a) the type of account (A = asset, L = liability, SE = shareholders' equity, R = revenue, E = expense), and (b) whether it is reported on the income statement (I/S), statement of retained earnings (SRE), balance sheet (B/S), or statement of cash flows (SCF).

  1. Land

  2. Advertising Expense

  3. Accounts Receivable

  4. Service Revenue

  5. Contributed Capital

  6. Notes Payable

• Typical answers (based on standard accounting treatment):

  • 1) Land: Type A; Reported on B/S; Category: Asset (A).

  • 2) Advertising Expense: Type E; Reported on I/S; Category: Expense (E).

  • 3) Accounts Receivable: Type A; Reported on B/S; Category: Asset (A).

  • 4) Service Revenue: Type R; Reported on I/S; Category: Revenue (R).

  • 5) Contributed Capital: Type SE; Reported on B/S; Category: Shareholders' Equity (SE).

  • 6) Notes Payable: Type L; Reported on B/S; Category: Liability (L).

• Note: Check the chapter’s solutions to confirm exact placements for any special definitions used in the chapter.

Practical Implications and Takeaways

• Net income is not the same as cash flow because accrual accounting records revenues when earned and expenses when incurred, not when cash is received or paid.

• The statement of cash flows provides a bridge from the income statement and balance sheet to cash, highlighting how operations, investing, and financing activities affect cash.

• External users (e.g., banks) closely study cash flows to assess liquidity and solvency; investors may use cash flow trends to gauge the sustainability of earnings and financing needs.

• Notes and exhibits connect the numbers across statements, reinforcing how a single period’s activities reflect in multiple reports.

• Practical takeaway: A startup or expanding business may show negative investing cash flow due to heavy equipment purchases, while still being financially viable if operating cash flow and financing activities generate enough cash overall (as seen in Prairie Proud’s positive overall change in cash).

Key Formulas and Concepts (Re-cap)

• Net Income on the Income Statement:

  • $ext{Net Income} = ext{Revenues} - ext{Expenses}$

  • Example: $11{,}000 - 9{,}000 = 2{,}000$

• Ending Retained Earnings on the Statement of Retained Earnings:

  • $ext{Ending Retained Earnings} = ext{Beginning Retained Earnings} + ext{Net Income} - ext{Dividends}$

  • Example: Beginning RE = 0, Net Income = $2{,}000$, Dividends = $1{,}000$ → Ending RE = $1{,}000$

• Change in Cash on the Statement of Cash Flows:

  • $ext{Change in Cash} = ext{Cash Flows from Operating} + ext{Cash Flows from Investing} + ext{Cash Flows from Financing}$

  • Example: $5{,}000 + (-40{,}000) + 49{,}000 = 14{,}000$

• Ending Cash on the Balance Sheet equals Ending Cash on the Statement of Cash Flows:

  • $ext{Ending Cash}<em>{BS} = ext{Ending Cash}</em>{SCF} = 14{,}000$