Midterm-ay2020-module-for-students_ia3.docx

Title of Module Topic

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INTERMEDIATE ACCOUNTING 3 I. Cash and Accrual Basis

LEARNING OBJECTIVES 1. Understand cash basis accounting 2. Understand accrual basis accounting 3. Differentiate cash and accrual basis of accounting 4. Prepare adjustments in converting the cash basis financial statements to accrual basis DEFINITION OF TERMS Accrual basis Income is recognized when earned and expense recognized when incurred regardless of when collected and paid. Accrued expense Expenses already incurred but not yet paid, a payable. Accrued income Income already earned but not yet collected, a receivable. Cash basis Income is recognized when received regardless of when earned, and expense is recognized when paid regardless of when incurred. Deferred income Unearned income or pre-collected income, a liability. Prepaid expense Expenses paid in advance but not yet incurred, an asset. COMPARISON Points of Comparison Principle Recording Books and accounts Trial balance Error detection Profit or loss Financial position Legality Suitability

ACCRUAL BASIS Double Entry Accounting equation; Duality ALL accountable Complete books and all types of accounts Arithmetical accuracy Easier More reliable Truthfulness and fair presentation ascertained Acceptable legal evidence in court For business of all size and type

CASH BASIS Single Entry None CASH transactions only Cash, personal, creditors and debtors accounts only Not possible and arithmetical accuracy compromised Complicated Incomplete and mainly estimates Incomplete; truthfulness and fair presentation compromised Not acceptable Small size and sole proprietorship

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When analyzing how books are kept, one must remember that a company may use double-entry but not apply accrual basis of accounting, i.e. Accrual basis of accounting is always a double-entry system but not all double-entry system is in accrual basis. ACCOUNTING

INTERMEDIATE ACCOUNTING 3

DC PALACIO

Preparing financial statements from a cash basis record keeping could prove to be tedious, however, basic knowledge of the effects of transactions on the elements of financial statements is the key. This is where the basic unit of record, the T-account, becomes expedient. Review the following T-accounts: Accounts Receivable Deferred income DR CR DR CR Beginning balance Collections Beginning balance Credit sales Sales return & Earned Customer advance Allowance payment Sales discounts Ending balance Write-off Ending balance To compute for Accrual sales 1) Add up all: a. Cash sales b. Credit sales c. Earned income from advance payments Note that unearned income may not necessarily be the same as the main source of revenue, in such case, each item is presented separately on the income statement. 2) Only discounts from collections of accounts receivable, does not include cash and trade discounts. Accounts Payable DR CR Payments Beginning balance Purchase returns & Credit purchases allowances Purchase discounts Ending balance

Prepaid Expenses DR CR Beginning balance Advance payments Incurred/Used to suppliers Ending balance

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To compute for Accrual Purchases 1) Add up all: a. Cash purchases b. Credit purchases c. Incurred prepayments Note that prepaid expenses may not necessarily be for the purchase of merchandise, e.g. prepaid interest, in such case, each item is presented separately on the income statement. 2) Only purchase discounts taken within the discount period for payment of Accounts payable.

INTERMEDIATE ACCOUNTING 3

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PROBLEM ILLUSTRATION Illustration 1:

DC PALACIO

Tad Company began the current year with accounts receivable of 1,000,000 and allowance for doubtful accounts of 80,000. During the year, the following events occurred: Accounts written off 120,000 Doubtful accounts expense 200,000 At the end of the year, the entity showed a balance in accounts receivable of 1,680,000 and sales of 2,700,000 under the cash basis of accounting. Compute for sales under Accrual basis. Beginning balance Accounts written off Cash Sales ? Ending balance

Accounts Receivable DR CR 1,000,000 120,000 2,700,000 3,500,000 1,680,000

Illustration 2: Floyd Company reported the following balances at end of each of year: 2019 2018 Inventory 2,600,000 2,900,000 Accounts payable 750,000 500,000 The entity paid suppliers 4,900,000 during the year ended December 31, 2019. Compute for the cost of goods sold in 2019. Beginning balance Payments Purchases ? Ending balance Beginning inventory Purchases Available for sale Ending inventory Cost of goods sold

Accounts Payable DR CR 500,000 4,900,000 5,150,000 750,000 2,900,000 5,150,000 8,050,000 2,600,000 5,450,000 =======

Illustration 3: Build-it Company began business operations on January 1, 2019. During the year, the accounting records are kept on a double entry system but on a cash basis of accounting. The entity decided to use the accrual basis.

INTERMEDIATE ACCOUNTING 3

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On December 31, 2019, the account balances are: Cash 840,000 Purchases 4,200,000 Expenses 560,000 Notes payable 200,000 DC PALACIO

Sales Share capital

4,400,000 1,000,000

a. Merchandise inventory on December 31, at cost, 500,000. b. On December 31, accounts receivable amounted to 100,000 and accounts payable totaled 80,000. c. Accrued expenses on December 21, 20,000. d. The purchases included merchandise in the amount 10,000 bought for the president. The president had not reimbursed the entity. e. The sales included 25,000 deposit given by a customer for merchandise to be delivered in 2020. f. It is estimated that 5% of the outstanding accounts receivable on December 31 may turn out to be uncollectible. g. Expenses included the following: i. 25,000 for office supplies of which 5,000 is unused as of December 31. ii. 100,000 for the purchase of equipment on July 1, 2019. It was estimated that this property would have an estimated useful life of 10 years without residual value. iii. 20,000 for a one-year insurance premium on a fire insurance policy dated October 1, 2019 h. The notes payable comprised a noninterest-bearing not of 100,000, dated August 1, 2019, due on February 1, 2020 and a one-year not of 100,000, dated September 1, 2019, bearing an interest of 12% payable at maturity.

INTERMEDIATE ACCOUNTING 3

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Prepare adjusting entries, income statement and statement of financial position. Adjusting entries: a. Merchandise inventory, end 500,000 Income summary 500,000 b. Accounts receivable 100,000 Purchases 80,000 Sales 100,000 Accounts payable 80,000 c. Expenses 20,000 Accrued expenses 20,000 d. Receivable from president 10,000 Purchases 10,000 e. Sales 25,000 Advances from customers 25,000 f. Doubtful accounts expense 5,000 Allowance for doubtful accounts 5,000 g. i. Office supplies 5,000 Expenses 5,000 ii. Equipment 100,000 Expenses 100,000 Depreciation Expense 5,000 Accumulated depreciation 5,000 iii. Prepaid insurance 15,000 Insurance expense 15,000 h. Interest expense 4,000 Interest payable 4,000 DC PALACIO

Build-it Company Income Statement For the year ended December 31, 2019 Sales Cost goods sold Purchases Less: Inventory, end Gross income Expenses: Expenses Doubtful accounts Depreciation Interest expense Net income

4,475,000 4,270,000 500,000 460,000 5,000 5,000 4,000

3,770,000 705,000

474,000 231,000

Build-it Company Statement of Financial Position December 31, 2019 ASSETS Current Assets Cash 840,000 Accounts receivable (Note 1) 95,000 Receivable from officer 10,000 Inventory 500,000 Prepayments (Note 2) 20,000 Noncurrent assets Equipment 100,000 Less: Accumulated Depreciation 5,000 Total Assets LIABILITIES AND EQUITY Current liabilities Accounts payable 80,000 Notes payable 200,000 Accrued expenses 20,000 Advances from customers 25,000 Interest payable 4,000 Equity Share capital 1,000,000 Retained earnings 231,000 Total Liabilities and Equity

95,000 1,560,000

329,000 1,231,000 1,560,000

Note 2: 100,000 Office supplies 5,000 ( 5,000) Prepaid insurance 15,000 95,000 Total prepayments 20,000 ====== =====

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TRY THIS  Activity I.1 Balabag Company provided the following data at year-end: 2018 INTERMEDIATE ACCOUNTING 3

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Note 1: Accounts receivable Allowance for doubtful accounts Net realizable value

1,465,000

2019 DC PALACIO

Accounts receivable Accounts payable Merchandise inventory

1,200,000 1,500,000 1,700,000

Other information provided were: Sales returns, 100,000 was paid to customers Accounts written off Cash receipts, 500,000 were advances from customer Sales discounts Purchase returns, 50,000 was received from suppliers Cash payments to trade creditors Purchase discounts

1,350,000 1,850,000 1,280,000 350,000 100,000 8,000,000 300,000 250,000 5,000,000 150,000

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Required: Under accrual basis of accounting, compute for the following: 1. Gross sales 2. Net sales 3. Gross purchases 4. Net purchases 5. Cost of goods sold

INTERMEDIATE ACCOUNTING 3

DC PALACIO

Title of Module Topic

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INTRMEDIATE ACCOUNTING 3 II. Single Entry

LEARNING OBJECTIVES 1. Understand the concept of single entry system in contrast to double entry system. 2. Identify records kept under a single entry. 3. Determine net income using the single entry method. 4. Able to prepare financial statements based on single entry records. DEFINITION OF TERMS Cashbook A major record under the single entry system, maintained to show all cash receipts and disbursements. Double entry system A system of bookkeeping where every entry to an accounts requires a corresponding and opposite entry to a different account. Single entry system A system of record keeping in which transactions are not analyzed and recorded in double entry framework. COMPARISON Refer to the previous topic. FINANCIAL STATEMENTS PREPARATION Financial statement preparation using a single-entry bookkeeping will require the following to verify existence of management assertions and acquire reliable information and measurement of assets, liabilities, equity, income and expense.  Physical and documentary verification  Physical count of inventory and assets  Consultation with creditors and debtors Income  Compute income using Sales Formula  Accounting for the change in Accounts Receivable (T-Account)  Accounting for the change in the beginning and ending balances of unearned income

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Expenses  Compute income using Purchases Formula  Accounting for the change in Accounts Payable (T-Account)  Accounting for change in advances to suppliers  Accounting for the changes in the beginning and ending balances of: o Other payables o Interest payable o Salaries payable Net income or loss computation  NET ASSETS APPROACH OR CAPITAL MAINTENANCE APPROACH INTERMEDIATE ACCOUNTING 3

DC PALACIO

Accounting for the change in beginning and ending balances of Capital or Retained Earnings account  Adjust the balances reflecting only earnings by deducting and adding nonincome generating transactions o Withdrawal o Additional investment o Dividend o Issuance of shares of stocks o Other non-operating income o Other comprehensive income 

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PPROPRIETORSHIP AND PARTNESHIP Capital, end Capital, beg Net increase (decrease) Add/(Deduct): Withdrawals Additional investments Net income (loss)

 CORPORATION Retained earnings, end Retained earnings, beg Net increase (decrease) Add/(Deduct): Dividends declared OR paid Decreases other than profit or loss Increases other than profit or loss Net Income (loss)

xxx xxx xxx ( xxx) xxx xxx ======= xxx xxx xxx xxx xxx xxx xxx =======

PROBLEM ILLUSTRATION Illustration 1: Velcro Company reported the following increase in account balances during the current year: Assets 8,900,000 Liabilities 2,700,000 Share capital 6,000,000 Share premium 600,000

Compute for the Net income or loss. Increase in assets INTERMEDIATE ACCOUNTING 3

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There were no changes in retained earnings other than for a dividend payment of 1,300,000.

8,900,000 DC PALACIO

Increase in liabilities Net increase in net assets Add/(Deduct): Share capital Share premium Dividends Net income

2,700,000 6,200,000 (6,000,000) ( 600,000) 1,300,000 900,000 ========

Observe the following: 1. Since retained earnings is unknown, changes in equity is examined. 2. The resulting figure after deducting known increases in net assets is the change in retained earnings or deficit of (400,000), Dividends is added back to compute for net income. Illustration 2: Easy company reported that the beginning and ending total liabilities were 840,000 and 1,000,000, respectively. At year-end, owner’s equity was 2,600,000 and total assets were 200,000 larger than at the beginning of the year. During the year, the new share capital issued exceeded dividends by 240,000. Compute for the Net income or loss for the year. Increase in assets Increase in liabilities Net increase in equity Share capital issued in excess of dividend Net loss

200,000 160,000 40,000 (240,000) (200,000) =======

Illustration 3: Civic Company provided the following data obtained from the single entry records for 2019: December 31 1,600,000 1,200,000 2,000,000 960,000 1,120,000 480,000 1,040,000 40,000 40,000

January 1 1,200,000 400,000 1,600,000 1,600,000 1,200,000 720,000 1,200,000 80,000 120,000

Cash receipts Accounts receivable (after sales discount of 100,000) INTERMEDIATE ACCOUNTING 3

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Cash Notes receivable Accounts receivable Merchandise inventory Equipment Notes payable Accounts payable Accrued interest payable Unearned rent income

3,000,000 DC PALACIO

Notes receivable Cash sales Rent income Sale of equipment costing 200,000 and carrying amount of 100,000 Investment Cash payments Accounts payable Notes payable Cash purchases Interest expense Expenses Equipment Withdrawals

960,000 800,000 80,000 120,000 600,000 1,520,000 1,280,000 600,000 160,000 800,000 400,000 400,000

Accounts receivable of 120,000 were written off as uncollectible. Returns of 320,000 were made on merchandise sales. Allowances of 80,000 were received on merchandise purchases. Compute for (a) net income or loss and (b)prepare an income statement. a) Capital, Dec.31 Add (deduct): Capital, Jan.1 Investment Withdrawals Net income

5,280,000 (3,880,000) ( 600,000) 400,000 1,200,000 ========

b) Income statement

Accrual Gross Sales:

Credit sales Cash sales Total

5,700,000 800,000 6,500,000 ========

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Accounts receivable, Jan.1 Notes receivable, Jan.1 Collections of accounts receivable Collections of notes receivable Sales discounts Accounts written off Sales returns Sales on account ? Accounts receivable, Dec.31 Notes receivable, Dec.31

Receivables DR CR 1,600,000 400,000 3,000,000 960,000 100,000 120,000 320,000 5,700,000 2,000,000 1,200,000

Payables Notes payable, Jan.1 Accounts payable, Jan.1 INTERMEDIATE ACCOUNTING 3

CR 720,000 1,200,000

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DR

DC PALACIO

Payment of accounts payable Payment of notes payable Purchase allowance Purchases on account ? Notes payable, Dec.31 Accounts payable, Dec.31 Accrual Gross Purchases:

Jan.1 balance Rent received Rent earned ? Dec.31 balance

1,520,000 1,280,000 80,000 2,480,000 480,000 1,040,000 Credit purchases Cash sales Total

Unearned rent income DR CR 120,000 80,000 160,000 40,000

Equipment, Jan.1 Add: Acquisitions 100,000 Total 20,000 Less: Equipment, Dec.31 Carrying amount of asset sold Depreciation

2,480,000 600,000 3,080,000 ======= Accrued Interest payable DR CR 80,000 160,000 120,000

Jan.1 balance Interest paid Interest incurred ? Dec.31 balance

40,000

1,200,000 400,000

Sales price Less: Carrying amount

1,600,000

Gain on sale

1,120,000 100,000 380,000 =======

120,000

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Civic Company Income Statement For the year ended December 31, 2019

INTERMEDIATE ACCOUNTING 3

6,500,000 ( 100,000)

800,000 120,000 380,000 120,000

Note 2 Inventory, Jan.1 Purchases

1,420,000 1,200,000

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Note 1 Sales Sales discounts

6,080,000 3,640,000 2,440,000 180,000 2,620,000

1,600,000 3,080,000

DC PALACIO

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Net sales (Note 1) Cost of goods sold (Note 2) Gross income Other income (Note 3) Total income Expenses: Expenses Bad debts Depreciation Interest expense Net income

160,000 20,000 180,000 ======

Purchase allowance ( 80,000) Goods available Inventory, Dec.31 Cost of goods sold

3,000,000 4,600,000 ( 960,000) 3,640,000 ========

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Note 3 Rent income Gain on sale of equipment Total other income

( 320,000) 6,080,000 ========

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Sales returns Net sales

TRY THIS INTERMEDIATE ACCOUNTING 3

DC PALACIO

INTERMEDIATE ACCOUNTING 3

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LEARNING OBJECTIVES 1. Define prior period errors. 2. Understand accounting treatment of prior period errors.

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 Activity II.1 Pharmacology Co., a sole proprietorship, did not have complete records on double entry basis. Available records established that the assets and liabilities on January 1, 2019 were: Cash 200,000 Accounts receivable 420,000 Allowance for doubtful accounts 20,000 Equipment 350,000 Accumulated depreciation – equipment 100,000 Prepaid supplies 40,000 Accounts payable 250,000 Accrued salaries payable 10,000 Merchandise inventory 700,000 Note payable 200,000  A summary of checkbook transactions for the current year showed the following: Deposits for the year 3,930,000 Checks drawn during the year 3,360,000 Bank service charge 10,000  The following information related to accounts payable: Purchases on account during the year 2,280,000 Returns of merchandise 70,000 Payments of accounts by check 2,200,000  Information about accounts receivable is as follows: Accounts written off 30,000 Accounts collected 1,720,000 Accounts receivable on December 31, 2019 (50,000 is estimated uncollectible) 450,000  Checks drawn during the year included checks for the following: Salaries 400,000 Supplies 75,000 Taxes 45,000 Drawings 240,000 Miscellaneous expenses 35,000 Note payable 120,000 Other operating expenses 245,000  Cash sales for the year are assumed to account for all cash received other that collected on accounts.  Equipment is to be depreciated at the rate of 10% per annum.  Other financial information on December 31, 2019: Merchandise inventory 650,000 Supplies on hand 20,000 Accrued salaries payable 15,000 Required: Prepare an income statement for 2019 and a statement of financial position on December 31, 2019. Title of Module : INTERMEDIATE ACCOUNTING 3 Topic : III. Error Correction

DC PALACIO

3. Distinguish counterbalancing errors and non-counterbalancing errors. 4. Prepare correcting entries of prior period errors. DEFINITION OF TERMS Prior period errors Omissions and misstatements in the entity’s financial statements for one or more periods arising from a failure to use or misuse of reliable information. CHARACTERISTICS  Omissions and misstatements for one or more period  Failure to use or misuse of reliable information  Errors in the form of  Recognition  Failure to record sales and expenses  Mistake in applying accounting policies  Measurement  Mathematical errors  Failure to include installation costs in a capex  Presentation  Failure to present the current portion of a long-term debt  Oversight  Disclosure  Failure to disclose material non-adjusting subsequent events  Misinterpretation of fact  Fraud  Intentional misrepresentation of facts ACCOUNTING  Retrospective or Retroactive application  Prior year statements are restated  Adjustment to beginning balance of Retained Earnings  Financial position errors  Improper classification >> Reclassification entry  Income statement errors  Improper classification >> Reclassification entry when current period error >> Otherwise, no reclassification entry

INTERMEDIATE ACCOUNTING 3

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Combined financial position and income statement errors  Counterbalancing  Automatically corrected over two periods  Affects two periods – prior and current  Errors including misstatement of o Inventory, purchases and sales o Prepayments / Deferrals o Accruals

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DC PALACIO

Effects Incorrect IS for two successive periods Incorrect BS for the first period Correct BS at end of second period Non-counterbalancing  Not corrected in the next accounting period  Subsequent period not affected  Effects o IS for prior period incorrect o BS for prior period and succeeding period incorrect until no adjustment is made

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o o o

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PROBLEM ILLUSTRATION Illustration 1: Boyle Company reported the following net income: 2018 3,000,000 2019 4,000,000 In an audit for the current year, the following errors are discovered: a. December 31, 2018 inventory understated 20,000 b. December 31, 2019 inventory overstated 18,000 c. Depreciation 2018 understated 4,000 d. Insurance premium for a three-year period was charged to Expense on January 1, 2018. No prepayment was recorded 15,000 e. A fully depreciated machinery was sold on December 31, 2019 but the sale was not recorded until 2020. The cost of the machinery is 200,000 and the proceeds from sale amounted to 32,000 Prepare the (a) adjusting journal entries and (b) compute for the corrected net income or loss.

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20,000 20,000 18,000 18,000 4,000 4,000 5,000 5,000 10,000 32,000 200,000 200,000 32,000

b) Net income or loss Net income INTERMEDIATE ACCOUNTING 3

2018 3,000,000

2019 4,000,000 DC PALACIO

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a) Adjusting entries a. Inventory, Jan.1 Retained earnings b. Income summary Inventory, Dec.31 c. Retained earnings Accumulated depreciation d. Prepaid insurance Insurance expense Retained earnings e. Cash Accumulated depreciation Machinery Gain on sale of machinery

Dec. 31, 2018 inventory understated Dec. 31, 2019 inventory overstated 2018 Depreciation understated Prepaid insurance, unrecorded Dec.31, 2018 Gain on sale of machinery Corrected net income

20,000

(20,000) (18,000)

(4,000) 10,000

(5,000)

3,026,000

32,000 3,989,000

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TRY THIS  Activity III.1 1. Refer to Illustration 1, at what amount will the net income or loss on the following year, 2020 be adjusted or affected?

INTERMEDIATE ACCOUNTING 3

DC PALACIO

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Observe the following: 1. Adjusting entries for inventory, Jan.1 and Dec.31, notice how understatement in beginning inventory is adjusted to the retained earnings account while ending inventory is adjusted in the income summary account.  WHY? 2018 books are already closed, while 2019 is the current reporting period and books are still open for adjustments.  Ergo: Errors of the previous periods are adjusted in Retained earnings, Errors of the current period are adjusted in Income Summary, only when errors are discovered prior to closing of books. 2. In the computation of corrected Net income, beginning inventory is an adjustment both on the previous and current year, this is what we call counterbalancing errors. Errors that correct itself after two succeeding periods. 3. Prepaid insurance is also a counter-balancing period, however in the illustration, the period covered is three years. Retained earnings account in particular will be corrected on its own after three years. 4. The rest of the errors are non-counterbalancing and affects only a particular period.

2. Refer to Illustration 1, assume that books for 2019 are closed, how much is the total adjustment on retained earnings beginning balance. 3. Refer to Illustration 1, assume that these errors have not yet been detected, at what amount is the ending balance of retained earnings for the year 2020 overstated or understated.  Activity III.2 The Company revealed the following errors in the financial statements: December 31, 2018 inventory overstated 35,000 December 31, 2019 inventory understated 10,000 Depreciation 2018 overstated 25,000 Depreciation 2019 understated 8,000 December 31, 2018 prepaid insurance understated 5,000 December 31, 2019 unearned rent income overstated 4,000 December 31, 2019 accrued salaries understated 20,000 Required: 1. Prepare adjusting journal entries on December 31, 2019. 2. What is the effect of errors on the following? a. Net income for 2018 b. Net income for 2019 c. Retained earnings on December 31, 2019 d. Working capital on December 31, 2019

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INTERMEDIATE ACCOUNTING 3 IV. Statement of Cash Flows

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LEARNING OBJECTIVES 1. Understand the nature and purpose of statement of cash flows 2. Understand the classifications of cash flows as operating, investing and financing. 3. Able to prepare a statement of cash flows using the direct and indirect method. DEFINITION OF TERMS Cash INTERMEDIATE ACCOUNTING 3

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Title of Module Topic

DC PALACIO

Comprises of cash on hand and demand deposits. Cash Equivalents Short-term highly liquid investments that are readily convertible to known amount of cash and which are subject to an insignificant risk of change in value. Cash Flows Inflows and out flows of cash and cash equivalents. Financing activities The cash flows derived from the equity capital and borrowings of the entity. Investing activities The cash flows derived from the acquisition and disposal of long-term assets and other investments not included in cash equivalent. Operating activities The cash flows derived primarily from the principal revenue producing activities of the entity. THE STATEMENT OF CASH FLOWS A component of financial statements summarizing the operating, investing and financing activities of an entity. It provides detailed information about the cash receipts and cash payments of entity during a period. It explains the nature of change in an entity’s cash and cash equivalents.

INTERMEDIATE ACCOUNTING 3

DC PALACIO

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 Investing Activities o This involves transactions or changes on non-operating assets or non-current assets. o Examples:  Cash acquisition of PPE  Cash receipts from sale of equity instrument  Financing activities o Transactions involving movement on the equity of owners and equity of creditors other than those of short-term debts. o Examples:

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Parts or Components  Operating activities o Transactions and other events that enter into the determination of net income or loss. o Involves the transactions or changes on Working capital: Current assets less Current liabilities o Examples:  Cash receipts from sale of goods and rendering of services  Cash payments to suppliers of goods and services

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Cash receipts from issuance of shares of stocks Cash payments to bondholders

Methods Both methods used in the preparation of the statement of cash flows are similar except for the presentation of the operating activities. PAS 7, encourages the use of direct method.  Direct method o A method of computing net cash provided by operating activities in which the income statement is reconstructed on a cash basis from top to bottom. o Operating activities is presented in the same manner as the investing and financing activities, i.e.  Cash receipts and cash disbursements are accounted for separately  Indirect method o A method of computing the net cash provided by operating activities that starts with net income and adjusts it to a cash basis. o Operating activities is presented by showing the effects of increases and decrease of the working capital and noncash transactions on net income or loss. Other matters  Trading securities o Cash flows arising from the purchase and sale of dealing or trading securities are classified as operating activities. Similarly, with cash advances and borrowings made by financial institutions since they relate to the main revenue producing activity.  Interests o Interest paid and interest received shall be classified as operating cash flows. Alternatively, interest paid may be classified as financing cash flow as it is a cost of borrowing funds, while interest received may be classified as investing as a return on investment.  Dividends o Dividend received shall be classified as operating cash flow, alternatively, may be classified as investing cash flow because it is a return on investment. o Dividend paid shall be classified as financing cash flow because it is a cost of obtaining financial resources, alternatively, may be classified as operating cash flow.  Income taxes o Separately disclosed as cash flows from operating activities unless they can be specifically identified with investing and financing activities.

PROBLEM ILLUSTRATION Illustration 1:

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Refer to Illustration 3 of Cash and Accrual topic: Prepare the statement of cash flow using the Indirect method.

INTERMEDIATE ACCOUNTING 3

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Build-it Company Statement of Cash Flow For the year ended December 31, 2019 DC PALACIO

Cash flows from operating activities: Income before taxes Adjustment for noncash transactions: Depreciation Operating income before working capital changes Increase in receivables Increase in inventories Increase in prepayments Increase in accounts payable Increase in notes payable Increase in other current liabilities Net cash used in operating activities Cash flows from investing activities: Purchase of equipment Net cash used in investing activities Cash flows from financing activities: Proceeds from issuance of shares Net cash provided by financing activities Net increase in cash and cash equivalents Cash and cash equivalents, Jan.1 Cash and cash equivalents, Dec.31

231,000 5,000 236,000 (105,000) (500,000) (20,000) 80,000 200,000 49,000 (60,000) (100,000) (100,000) 1,000,000 1,000,000 840,000 0 840,000

Observe the following: 1. Notice that operating activities begin with the net income and adjusted for noncash transactions, and partially convert to cash basis income. 2. After adjusting the net income, increases and decreases from working capital are accounted. Increases in current assets are always a deduction while increases in current liabilities always have a direct effect. a. Increases in receivables may mean that there were lesser collections made during the year. b. Increases in inventory may mean that there were more purchases than sales that was made for the year. c. Increases in prepayments may mean more disbursement made for prepaid expenses for the year. d. Increases in payable may mean that the company was able to maximize its credit and lesser cash purchases were made. e. Increase in note payable may mean additional borrowings for the year, ergo additional cash. 3. Notice the terms used at every end result of the activities, “provided by” and “used in”. Provided by means that cash inflows are greater than cash outflows, while used in is the vice versa. Illustration 2:

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Refer to Illustration 3 of Single Entry topic: Prepare the statement of cash flow using the Direct method.

INTERMEDIATE ACCOUNTING 3

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Civic Company Statement of Cash Flow For the year ended December 31, 2019

DC PALACIO

Cash flows from operating activities: Cash received from customers Cash paid to suppliers Cash paid for operating expenses Interest paid Net cash provided by operating activities Cash flows from investing activities: Proceeds from sale of equipment Purchase of equipment Net cash used in investing activities Cash flows from financing activities: Additional investment from owner Cash withdrawals made by owner Net cash provided by financing activities Net increase in cash and cash equivalents Cash and cash equivalents, Jan.1 Cash and cash equivalents, Dec.31

4,840,000 (3,400,000) (800,000) (160,000) 480,000 120,000 (400,000) (280,000) 600,000 (400,000) 200,000 400,000 1,200,000 1,600,000

Observe the following: 1. The presentation of investing and financing activities are the same with that of indirect method 2. PAS 7, prefers direct method because it openly depicts the cash flows from operating activities, it is not vague like that of indirect method.

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TRY THIS  Activity IV.1 Refer to Activity II.1 Pharmacology Company, prepare the statement of cash flows using the same information. You may use any method.

INTERMEDIATE ACCOUNTING 3

DC PALACIO