PC Inventory Software

Cash Flows Frompome By Gautam Koppala

Cash Flows:

A revenue or expense stream that changes a cash account over a given period in your Project. Cash inflows usually arise from one of three activities – financing, operations or investing – although this also occurs as a result of donations or gifts in the case of personal finance. Cash outflows result from expenses or investments. This holds true for both Projects and personal finance.
Because many people view cash as indicative of a business’s financial well-being, a great deal of attention is directed toward cash, cash management, cash availability, and a range of other issues surrounding cash and cash equivalents. The third major financial statement, the Statement of Cash Flows, represents an effort to present the management of cash in a manner that can be understood by the various interested parties.

Over the years this interest in cash has gone through an evolution, from a relatively simple Sources and Uses of Cash statement to the Cash Flow Statement to today’s Statement of Cash Flows in a form that addresses the interests of management, lenders, and investors in the same document.

The Statement of Cash Flows summarizes the changes in the Balance Sheet during the reporting period, separated into transactions reflecting operating activities, investing activities, and financing activities. It identifies where the company got the funds it used and what it did with them, and it facilitates assessment of management’s effectiveness in directing the business.

The results of the Statement of Cash Flows reflect the change in the cash balances of the company. If an item, or a total, is negative, it represents cash outflow; if positive, it reflects inflows. On the following pages we present and describe the basic elements of the Statement of Cash Flows.

For internal management each contributor to cash flow may be computed separately as part of an effort to track amounts and causes and consequences. This detailed approach is known by some as the Direct Method Cash Flow Statement; the one presented in Exhibit below is known as the Indirect Method Cash Flow Statement.

The simple structuring of cash flows in Exhibits below  helps you recognize the double entry nature of bookkeeping entries and the effect that a transaction has on cash resources. It demonstrates clearly the relationship of cash to other accounts on the Balance Sheet and permits you to test the effect of a transaction before you undertake it.

Exhibit: Statement of Changes in Financial Position (Cash Flow Statement)

If you include cash and cash equivalents in your generation of the table in Exhibit , the two columns will be equal. If you exclude cash and cash equivalents, the difference in the two columns is the change in liquid assets. If this table is produced as part of the planning process, the difference between the columns (and it will generally be negative) is the cash generated (+) or the cash needed (–) for the period being projected.

Exhibit: Alternative View of Cash Flow Statement

An accounting statement called the “statement of cash flows”, which shows the amount of cash generated and used by a company in a given period. It is calculated by adding noncash charges (such as depreciation) to net income after taxes. Cash flow can be attributed to a specific project, or to a business as a whole. Cash flow can be used as an indication of a Projects financial strength.

In projects, as in personal finance, cash flows are essential to solvency. They can be presented as a record of something that has happened in the past, such as the sale of a particular product, or forecasted into the future, representing what a Projects or a person expects to take in and to spend. Cash flow is crucial to an projects survival. Having ample cash on hand will ensure that creditors, employees and others can be paid on time. If a project or person does not have enough cash to support its operations, it is said to be insolvent, and a likely candidate for bankruptcy should the insolvency continue.

The statement of a Project’s cash flows is often used by analysts to gauge financial performance. Companies with ample cash on hand are able to invest the cash back into the Project in order to generate more cash and profit.

Fig: Cash Flows

Cash Flow Per Share:

A measure of a firm’s financial strength, calculated as follows:

Many analysts, as well as some of the greatest investors of all time, place more weight on cash flow per share than earnings per share(EPS). Because EPS is more easily manipulated, its reliability can at times be questionable. Cash, on the other hand, is difficult – if not impossible – to fake. You either have cash or you don’t. Therefore, cash flow per share is a useful measure for the strength of a firm and the sustainability of its business model.

Cash Flow Return on Investment (CFROI):

A valuation model that assumes the stock market sets prices based on cash flow, not on corporate / Projects/ Operations performance and earnings.

It’s valuable to consider as many models as possible when looking at the stock market. Financial theory is similar to scientific theory; no model can be entirely proved or disproved, and a diversity of opinions is encouraged

The Essentials Of Cash Flow:

If operations reports earnings of billion, does this mean it has this amount of cash in the bank? Not necessarily. Financial statements are based on accrual accounting, which takes into account non-cash items. It does this in an effort to best reflect the financial health of a company. 

Projects are all about trade, the exchange of value between two or more parties, and cash is the asset needed for participation in the economic system. For this reason – while some industries are more cash intensive than others – no Project can survive in the long run without generating positive cash flow per share for its shareholders. To have a positive cash flow, the company’s long-term cash inflows need to exceed its long-term cash outflows.

An outflow of cash occurs when a project transfers funds to another party (either physically or electronically). Such a transfer could be made to pay for employees, suppliers and creditors, or to purchase long-term assets and investments, or even pay for legal expenses and lawsuit settlements. It is important to note that legal transfers of value through debt – a purchase made on credit – is not recorded as a cash outflow until the money actually leaves the company’s hands.

A cash inflow is of course the exact opposite; it is any transfer of money that comes into the Project’s possession. Typically, the majority of Projects cash inflows are from customers, lenders (such as banks or bondholders) and investors who purchase company equity from the company. Occasionally cash flows come from sources like legal settlements or the sale of Operations real estate or equipment.

Cash Flow vs Income
It is important to note the distinction between being profitable and having positive cash flow transactions: just because a project is bringing in cash does not mean it is making a profit (and vice versa).

For example, say a manufacturing company is experiencing low product demand and therefore decides to sell off half its factory equipment at liquidation prices. It will receive cash from the buyer for the used equipment, but the manufacturing company is definitely losing money on the sale: it would prefer to use the equipment to manufacture products and earn an operating profit. But since it cannot, the next best option is to sell off the equipment at prices much lower than the company paid for it. In the year that it sold the equipment, the company would end up with a strong positive cash flow, but its current and future earnings potential would be fairly bleak. Because cash flow can be positive while profitability is negative, investors should analyze income statements as well as cash flow statements, not just one or the other.

What Is the Cash Flow Statement?
There are three important parts of a Project’s financial statements: the balance sheet, the income statement and the cash flow statement. The balance sheet gives a one-time snapshot of a Project’s ASSETS(see Reading the Balance Sheet). And the income statement indicates the Project’s profitability during a certain period (see Understanding The Income Statement).

The cash flow statement differs from these other financial statements because it acts as a kind of corporate checkbook that reconciles the other two statements. Simply put, the cash flow statement records the company’s cash transactions (the inflows and outflows) during the given period. It shows whether all those lovely REVENUES booked on the income statement have actually been collected. At the same time, however, remember that the cash flow does not necessarily show all the company’s expenses: not all expenses the company accrues have to be paid right away. So even though the company may have incurred liabilities it must eventually pay, expenses are not recorded as a cash outflow until they are paid (see the section “What Cash Flow Doesn’t Tell Us” below).

The following is a list of the various areas of the cash flow statement and what they mean:

Cash flow from operating activities – This section measures the cash used or provided by a Project’s normal operations. It shows the Project’s ability to generate consistently positive cash flow from operations. Think of “normal operations” as the core business of the Project. For example, Microsoft’s normal operating activity is selling software.
Cash flows from investing activities – This area lists all the cash used or provided by the purchase and sale of income-producing assets. If Microsoft, again our example, bought or sold companies for a profit or loss, the resulting figures would be included in this section of the cash flow statement.
Cash flows from financing activities- This section measures the flow of cash between a firm and its owners and creditors. Negative numbers can mean the Project is servicing debt but can also mean the Project is making dividend payments and stock repurchases, which investors might be glad to see.

When you look at a cash flow statement, the first thing you should look at is the bottom line item that says something like “net increase/decrease in cash and cash equivalents”, since this line reports the overall change in the Project’s cash and its equivalents (the assets that can be immediately converted into cash) over the last period. If you check under current assets on the balance sheet, you will find cash and cash equivalents (CCE or CC&E). If you take the difference between the current CCE and last year’s or last quarter’s, you’ll get this same number found at the bottom of the statement of cash flows.

In the sample Microsoft annual cash flow statement (from June 2004) shown below, we can see that the business ended up with about .5 billion more cash at the end of its 2003/04 fiscal year than it had at the beginning of that fiscal year (see “Net Change in Cash and Equivalents”). Digging a little deeper, we see that the Company had a negative cash outflow of .7 billion from investment activities during the year (see “Net Cash from Investing Activities”); this is likely from the purchase of long-term investments, which have the potential to generate a profit in the future.Generally, a negative cash flow from investing activities are difficult to judge as either good or bad – these cash outflows are investments in future operations of the Company (or another Company); the outcome plays out over the long term.

The “Net Cash from Operating Activities” reveals that Microsoft generated .6 billion in positive cash flow from its usual business operations – a good sign. Notice the Project has had similar levels of positive operating cash flow for several years. If this number were to increase or decrease significantly in the upcoming year, it would be a signal of some underlying change in the Project’s ability to generate cash.

Digging Deeper into Cash Flow
All companies and its Projects provide cash flow statements as part of their financial statements, but cash flow (net change in cash and equivalents) can also be calculated as net income plus depreciation and other non-cash items.

Generally, a Project’s principal industry of operation determine what is considered proper cash flow levels; comparing a Project’s cash flow against its industry peers is a good way to gauge the health of its cash flow situation. A Project not generating the same amount of cash as competitors is bound to lose out when times get rough.

Even a Project that is shown to be profitable according to accounting standards can go under if there isn’t enough cash on hand to pay bills. Comparing amount of cash generated to outstanding debt, known as the operating cash flow ratio, illustrates the Project’s ability to service its loans and interest payments. If a slight drop in a Project’s quarterly cash flow would jeopardize its loan payments, that Project carries more risk than a Project with stronger cash flow levels. Hence, we always require a Project Manager with finance acumen.

Unlike reported earnings, cash flow allows little room for manipulation. Every Company of its consolidated Project filing reports with the Securities and Exchange Commission (SEC) is required to include a cash flow statement with its quarterly and annual reports. Unless tainted by outright fraud, this statement tells the whole story of cash flow: either the Project has cash or it doesn’t.

What Cash Flow Doesn’t Tell Us
Cash is one of the major lubricants of Project activity, but there are certain things that cash flow doesn’t shed light on. For example, as we explained above, it doesn’t tell us the profit earned or lost during a particular period: profitability is composed also of things that are not cash based. This is true even for numbers on the cash flow statement like “cash increase from sales minus expenses”, which may sound like they are indication of profit but are not.

As it doesn’t tell the whole profitability story, cash flow doesn’t do a very good job of indicating the overall financial well-being of the Project. Sure, the statement of cash flow indicates what the Project is doing with its cash and where cash is being generated, but these do not reflect the Project’s entire financial condition. The cash flow statement does not account for liabilities and assets, which are recorded on the balance sheet. Furthermore accounts receivable and accounts payable, each of which can be very large for a Project, are also not reflected in the cash flow statement.

In other words, the cash flow statement is a compressed version of the Project’s checkbook that includes a few other items that affect cash, like the financing section, which shows how much the Project spent or collected from the repurchase or sale of stock, the amount of issuance or retirement of debt and the amount the Project paid out in dividends.

Cash accounting:

An accounting method which reports expenditures and revenues when the actual cash outflow or inflow has occurred.

Cash discount:

A reduction, usually expressed as a percentage, in the price of a product or the amount of a bill if payment is made promptly and in cash.

Cash market:

The market in which commodities,

Cash payment:

In international trade transactions, this refers to the portion paid by the importer prior to shipment (usually 15% of the total sales price or invoice value). It is mandatory for the extension of most medium and long-term guarantee/insurance and trade financing facilities.

Cash with order (CWO):

A payment technique whereby the buyer pays for the goods when ordering them, with the transaction being binding on both parties.

Concluded Note:
Like so much in the world of finance, the cash flow statement is not straightforward. You must understand the extent to which a Project relies on the capital and the extent to which it relies on the cash it has itself generated. No matter how profitable a Project may be, if it doesn’t have the cash to pay its bills, it will be in serious trouble.

At the same time, while investing in a Project that shows positive cash flow is desirable, there are also opportunities in companies that aren’t yet cash-flow positive. The cash flow statement is simply a piece of the puzzle. So, analyzing it together with the other statements can give you a more overall look at a Project’ financial health. Remain diligent in your analysis of a Project’s cash flow statement and you will be well on your way to removing the risk of one of your stocks falling victim to a cash flow crunch.

The flow of cash payments to or from a firm during a given period of time. Expenditures are sometimes referred to as “negative” cash flows.

Statement of Cash Flows

(Note: The Separate POME Chapter of Cash Flows illustrated more in detail about this)

The third financial statement that George needs to understand is the Statement of Cash Flows. This statement shows how GG Org’s cash amount has changed during the time interval shown in the heading of the statement. George will be able to see at a glance the cash generated and used by his company’s operating activities, its investing activities, and its financing activities. Much of the information on this financial statement will come from GG Org’s balance sheets and income statements.

The three financial reports that Koppala introduced to George—the income statement, the balance sheet, and the statement of cash flows—represent one segment of the valuable output that good accounting software can generate for business owners.

Koppala now explains to George the basics of getting started with recording his transactions.

Double Entry System

The field of accounting—both the older manual systems and today’s basic accounting software—is based on the 500-year-old accounting procedure known as double entry. Double entry is a simple yet powerful concept: each and every one of a company’s transactions will result in an amount recorded into at least two of the accounts in the accounting system.

The Chart of Accounts

People develop accounting systems to make it easier to process accounting transactions and to generate financial statements and other financial information. To process the accounting transactions such as those in the preceding section, accountants have developed a systematic account numbering system that helps assure that transactions are properly reflected in the financial statements.

Such a systematic numbering system, called the chart of accounts, provides a shorthand entry control system for assuring that related transactions are accumulated together. Properly constructed, the chart of accounts should lead directly to the production of financial statements, making it easy to close the books each period, produce financial statements, and provide consistent information for analysis and interpretation. Thus, the accounting system and the processing of transactions contribute to the timely and effective management of the operations.

The numbering system in a well-constructed chart of accounts reflects the same sequence as appears in the financial statements, beginning with cash, the first Balance Sheet Asset account, and continuing through taxes, an expense reflected at the bottom of the Income Statement. The result of such a structure is that as the accountant closes the books for the period, these basic financial statements will be automatically prepared.

A typical chart of accounts might be constructed like the one in Exhibit below As you can see, the structure of the numbering system leads directly to the presentation of financial statements.

1000s are Assets
2000s are Liabilities
3000 are Equity accounts
4000s are Revenues
5000s are Cost of Sales accounts
6000s are Operating Expenses
7000s are Other Income and Expense accounts
8000s are Taxes

This type of structure makes it very easy for the accountants and Project Managers to review the results of the accounting period and report to management, and to other interested parties, the summarized results and the reasons behind them.

As a company becomes more complicated, with divisions or subsidiaries, with multiple departments, or with other specialized reporting interests, the accounts within each category may be expanded by inserting numbers or adding additional digits to permit reporting by smaller or more specific units.

For example, Peachtree Accounting Software, an inexpensive PC-based accounting software package, permits a chart of accounts numbering system of up to 15 characters, both letters and numbers. Such a chart of accounts permits as much detail as any smaller business might want or need.

In fact, the availability of 15 characters would permit such detail as would be needed to track the costs of a specific project or activity within a department within a facility within a division within a subsidiary within a company. At the same time, by sorting on specific digits within the account code, management could determine how much was spent on a particular expense category, such as Telephone or Delivery.

As an example of a 15-digit account number consider the following:

AAA

= Company, subsidiary, division or affiliate

BBBB

= Account number

CCC

= Department or responsibility

DDDDD

= Project, territory, class of trade

With this type of structure a company can identify spending activity in almost any combination of ways to provide all Project Managers with the information they need to manage their area and level of responsibility.

The Accounting Cycle

Accountants collect financial information as it occurs but report it based on predetermined accounting time periods, generally months, quarters, and years. It could, however, be reported for any time period that management or some interested party decided was important.

Where:

Exhibit: Chart of Accounts

Consider a purchase of ,000 of special widgets needed for a special project.

The Project Manager would place an order with the local office of Specialty Widget Corporation Based Projects  for the supplies. This action would have no impact on the accounting system.

When the supplies are shipped, Specialty Widget issues an invoice for ,000. On Specialty Widget’s books this transaction is recorded as:

Dr (Debit)

Cr (Credit)

Sales

,000.00

Accounts Receivable

,000.00

Cost of Sales

700.00

Inventory

700.00

You will recognize that Specialty Widget has achieved a 0 contribution to profit on this transaction. The difference between sales and cost of sales is known as gross profit.

On the purchasing company’s books, the same transaction appears as:

Supplies Expense

,000.00

Accounts Payable

,000.00

The supplies are not generally treated as inventory because they are not for resale, are not held for use in some future time period, and are not to be stored for use as part of the product to be sold.

When the purchasing company pays for the supplies, after 30 days or whatever credit period was determined in negotiation between the two companies, the respective entries are as follows:

On the books of the purchasing company:

Accounts Payable

,000.00

Cash

,000.00

And on the books of the Specialty Widget Corporation Based Projects :

Cash

,000.00

Accounts Receivable

,000.00

You can see from this example that each entry is balanced. Following these entries to the financial statements highlights some additional important considerations.

On the books of Specialty Widget, the Sales exceed the Cost of Sales by an amount that, were this the only transaction of the month, would result in a profit of 0. This profit, when closed to Retained Earnings during the closing process, would assure that the Balance Sheet balanced because the increase in assets of 0 (the absolute difference between the increase in Accounts Receivable [later transferred to Cash] and the decrease in Inventory) is equal to the increase in Retained Earnings.

On the books of the purchasing company, the ,000.00 in Supplies Expense, were it the only transaction of the month, would result in a reported loss of ,000.00. This amount, when closed to Retained Earnings at the end of the month, would result in balancing the Balance Sheet, as the decrease in Cash of ,000.00 would equal the decrease in Retained Earnings of ,000.00.

In traditional accounting education, each of these transactions would be recorded in an appropriate journal, a book of transactions that would be summarized as the first steps in the monthly closing process. In practice today, these journals are generally automatically recorded and summarized within the computerized accounting system. Let’s see how this would look for an ordinary individual. If you pay all your bills by check and record all transactions in your checkbook, the checkbook is the journal, and you could prepare personal financial statements every month using the checkbook as the basis for all your closing entries.

If you analyze your business, you will recognize a series of journals that you can visualize as the accounting system:

Sales Journal—Records all sales orders.
Cash Receipts Journal—Records all cash receipts. The Cash Receipts Journal should confirm deposit information appearing in the bank statement.
Purchases Journal—Records all purchase orders that have been fulfilled. It records obligations before they have been paid. Payments appear in the Cash Disbursements Journal.
Cash Disbursements Journal—Records all payments made. The difference between the cash disbursements journal summary and the cash receipts journal summary is the net entry to Cash on the Balance Sheet.
Payroll Journal—Records all payroll transactions. The amounts entered into the payroll journal also show up as transactions in the cash disbursements journal.
General Journal—Records all adjusting entries, summary totals from the other journals, and all transactions that do not affect cash receipts or cash disbursements. The general journal provides the link to the financial statements for all accounting activities that do not pass through the other journals or other detailed records of the company.

Because each accounting period is supposed to provide a complete and accurate summary of financial transactions and financial conditions, it is sometimes necessary to recognize the financial effects of transactions that have not yet happened or are not yet complete. Consider the partial completion of some production. You would need to record the value of the work completed to date, even though it is not yet finished. The accounting for value added to work in process needs to be recorded, but for the next period, you need to undo, or reverse, this entry in order to record the final value of the now completed product. Such an entry, and there are many of them, is handled in the accounting system as a reversing journal entry, that is, an entry that will be reversed in the next accounting period. Each period will then have the right amounts in it. The first entry, in the first period, records the work completed to date. The second set of entries, in the following period, will record a negative amount for the work completed earlier and the full value of the completed product. The net of these two parts equals the value added in the second period.

Therefore, reversing journal entries are part of the general journal and are normally recorded separately, permitting their immediate (at the beginning of the next accounting period) reversal, setting the stage for the next accounting cycle.

There are also some transactions that occur every accounting period. These can be summarized in a series of standard journal entries that simplify the accounting process. For example, the depreciation of Fixed Assets occurs every month, generally recognized as one-twelfth of the annual depreciation amount. (Sometimes a company recognizes depreciation based on the number of days in a month or some other predictable amount.)

Therefore, also in the General Journal, standard journal entries are recorded every month, providing a basis for the recognition of all relevant financial consequences in the appropriate accounting period.

Closing Procedures

At the end of each accounting period, all the transactions for that period are entered, even if the entry takes place after the last day of the accounting period. Accounting is more interested in accuracy than in getting everything done as quickly as possible. This sometimes creates conflicts between the accountants and the operating Project Managers. Operating Project Managers want to know as soon as possible what the results were and what happened. After all, it is easier to make corrections in practices if you know about the problems soon enough. Think about training a puppy. To change a behavior, you must educate the puppy while he still remembers what you are training him about.

To satisfy both the accountants and the Project Managers, a closing schedule is established that brings most of the relevant accounting information to the accounting department quickly. The few transactions that are missed are generally not material. That is, they do not significantly affect the final results.

As soon as the last of the transactions are recorded, the accountants summarize the general journal, perhaps automatically as part of the computerized accounting system, making closing journal entries that bring the current period to a close. These entries bring the Income Statement balances for the period back to zero by transferring the net amount to the equity side of the Balance Sheet, creating a balance between the assets and the liabilities. At this time, the system is ready to start the next period’s Income Statement.

To begin the process of setting up George’s accounting system, he will need to make a detailed listing of all the names of the accounts that GG Org, Inc. might find useful for reporting transactions. This detailed listing is referred to as a chart of accounts.

Because of the double entry system all of GG Org’s transactions will involve a combination of two or more accounts from the balance sheet and/or the income statement. Koppala lists out some sample accounts that George will probably need to include on his chart of accounts:

Balance Sheet accounts:

Asset accounts (Examples: Cash, Accounts Receivable, Supplies, Equipment)
Liability accounts (Examples: Notes Payable, Accounts Payable, Wages Payable)
Stockholders’ Equity accounts (Examples: Common Stock, Retained Earnings)

Income Statement accounts:

Revenue accounts (Examples: Service Revenues, Investment Revenues)
Expense accounts (Examples: Wages Expense, Rent Expense, Depreciation Expense)

To help George really understand how this works, Koppala illustrates the double entry with some sample transactions that George will likely encounter.

Sample Transactions #1:

On December 1, 2007 George starts his business GG Org, Inc. The first transaction that George will record for his company is his personal investment of ,000 in exchange for 5,000 shares of GG Org’s common stock. GG Org’s accounting system will show an increase in its account Cash from zero to ,000, and an increase in its stockholders’ equity account Common Stock by ,000. Both of these accounts are balance sheet accounts. There are no revenues because no delivery fees were earned by the company, and there were no expenses.

After George enters this transaction, GG Org’s balance sheet will look like this:

GG Org, Inc.
Balance Sheet
December 1, 2006

Assets

Liabilities & Stockholders’ Equity

Cash

$ 20,000

Liabilities

Stockholders’ Equity

Common Stock

$ 20,000

Total Assets

$ 20,000

Total Liabilities & Stockholders’ Equity

$ 20,000

Koppala asks George if he can see that the balance sheet is just that—in balance. George looks at the total of ,000 on the asset side, and looks at the ,000 on the right side, and says yes, of course, he can see that it is indeed in balance.

Koppala shows George something called the basic accounting equation, which, he explains, is really the same concept as the balance sheet, it’s just presented in an equation format:

Assets

=

Liabilites

+

Stockholders’ (or Owner’s) Equity

,000

=

+

,000

The accounting equation (and the balance sheet) should always be in balance.

Debits and Credits:

Did the first sample transaction follow the double entry system and affect two or more accounts? George looks at the balance sheet again and answers yes, both Cash and Common Stock were affected by the transaction.

Koppala introduces the next basic accounting concept: the double entry system requires that the same dollar amount of the transaction must be entered on both the left side of one account, and on the right side of another account. Instead of the word left, accountants use the word debit; and instead of the word right, accountants use the word credit. (The terms debit and credit are derived from Latin terms used 500 years ago.)

Debit means left.

Credit means right.

George asks Koppala how he will know which accounts he should debit—meaning he should enter the numbers on the left side—and which accounts he should credit—meaning he should enter the numbers on the right side. Koppala points back to the basic accounting equation and tells George that if he memorizes this simple equation, it will be easier to understand the debits and credits.

Memorizing the simple accounting equation will

help you learn the debit and credit rules.

Let’s take a look at the accounting equation again:

Assets

=

Liabilites

+

Stockholders’ (or Owner’s) Equity

Assets are on the left side (or debit side) of the accounting equation, so assets have their account balances on the left side. To increase an asset’s balance, you put more on the left side of the asset account. In accounting jargon, you debit the asset account. To decrease an asset you credit the account, that is, you enter the amount on the right side.

Liabilities and stockholders’ equity are on the right side (or credit side) of the accounting equation, and liabilities and equity have their account balances on the right side. To increase the balance in a liability or stockholders’ equity account, you put more on the right side. In accounting jargon, you credit the liability or the equity account. To decrease a liability or equity, you debit the account, that is, you enter the amount on the left side.

As with all rules, there are exceptions, but Koppala’s advice of using the accounting equation will be helpful with the majority of George’s transactions.

Since many transactions involve cash, Koppala suggests that George memorize how the Cash account is affected when a transaction involves cash: if GG Org receives cash, the Cash account is debited; when GG Org pays cash, the Cash account is credited.

When a company receives cash, the Cash account is debited.

When the company pays cash, the Cash account is credited.

Koppala refers to the example of December 1. Since GG Org received ,000 in cash from George in exchange for 5,000 shares of common stock, one of the accounts for this transaction is Cash. Since cash was received, the Cash account will be debited.

In keeping with double entry, two (or more) accounts need to be involved. Because the first account (Cash) was debited, the second account needs to be credited. All George needs to do is find the right account to credit. In this case, the second account is Common Stock. Common stock is part of stockholders’ equity, which is on the right side of the accounting equation. As a result, it should have a credit balance, and to increase its balance the account needs to be credited.

Accountants indicate accounts and amounts using the following format:

Account Name

Debit

Credit

Cash

20,000

Common Stock

20,000

Accountants usually first show the account and amount to be debited. On the next line, the account to be credited is indented and the amount appears further to the right than the debit amount shown in the line above. This entry format is referred to as a general journal entry.

(With the decrease in the price of computers and accounting software, it is rare to find a small business still using a manual system and making entries by hand.

Sample Transaction #2:

Koppala illustrates for George a second transaction. On December 2, GG Org purchases a used Project van for ,000 by writing a check for ,000. The two accounts involved are Cash and Vehicles (or Delivery Equipment). When the check is written, the accounting software will automatically make the entry into these two accounts.

Koppala explains to George what is happening within the software. Since the company pays ,000, the Cash account is credited. (Accountants consider the checking account to be Cash, and the TIP you learned is that when cash is paid, you credit Cash.) So we know that the Cash account will be credited for ,000 and we know the other account will have to be debited for ,000. We need only identify the best account to debit. In this case we choose Vehicles (or Delivery Equipment) and the entry is:

Account Name

Debit

Credit

Vehicles

14,000

Cash

14,000

The balance sheet will look like this after the vehicle transaction is recorded:

GG Org, Inc.
Balance Sheet
December 2, 2006

Assets

Liabilities & Stockholders’ Equity

Cash

$   6,000

Liabilities

Vehicles

14,000

Stockholders’ Equity

Common Stock

$ 20,000

Total Assets

$ 20,000

Total Liabilities & Stockholders’ Equity

$ 20,000

The balance sheet and the accounting equation remain in balance:

Assets

=

Liabilites

+

Stockholders’ (or Owner’s) Equity

,000

=

+

,000

As you can see in the balance sheet, the asset Cash decreased by ,000 and another asset Vehicles increased by ,000.

Liabilities and stockholders’ equity were not involved and did not change.

Sample Transaction #3:

The third sample transaction also occurs on December 2 when George contacts an insurance agent regarding insurance coverage for the vehicle GG Org just purchased. The agent informs him that ,200 will provide insurance protection for the next six months. George immediately writes a check for ,200 and mails it in.

Let’s consider this transaction. Using double entry, we know there must be a minimum of two accounts involved—one (or more) of the accounts must be debited, and one (or more) must be credited.

Since a check is written, we know that one of the accounts involved is Cash. Since cash was paid, the Cash account will be credited. (Take another look at the last TIP.) While we have not yet identified the second account, what we do know for certain is that the second account will have to be debited.

At this point we have most of the entry—all we are missing is the name of the account to be debited:

Account Name

Debit

Credit

???

1,200

Cash

1,200

We know the transaction involves insurance, and a quick look through the chart of accounts reveals two possibilities:

Prepaid Insurance (an asset account reported on the balance sheet) and Insurance Expense (an expense account reported on the income statement)

Assets include costs that are not yet expired (not yet used up), while expenses are costs that have expired (have been used up). Since the ,200 payment is for an expense that will not expire in its entirety within the current month, it would be logical to debit the account Prepaid Insurance. (At the end of each month, when 0 has expired, 0 will be moved from Prepaid Insurance to Insurance Expense.)

The entry in the general journal format is:

Account Name

Debit

Credit

Prepaid Insurance

1,200

Cash

1,200

After the first three transactions have been recorded, the balance sheet will look like this:

GG Org, Inc.
Balance Sheet
December 2, 2006

Assets

Liabilities & Stockholders’ Equity

Cash

$   4,800

Liabilities

Prepaid Insurance

1,200

Stockholders’ Equity

Vehicles

14,000

Common Stock

$ 20,000

Total Assets

$ 20,000

Total Liabilities & Stockholders’ Equity

$ 20,000

Again, the balance sheet and the accounting equation are in balance and all of the changes occurred on the asset/left/debit side of the accounting equation. Liabilities and Stockholders’ Equity were not affected by the insurance transaction.

Sample Transaction #4:

The fourth transaction occurs on December 3, when a customer gives GG Org a check for to deliver two parcels on that day. Because of double entry, we know there must be a minimum of two accounts involved—one of the accounts must be debited, and one of the accounts must be credited.

Because GG Org received , it must debit the account Cash. It must also credit a second account for . The second account will be Service Revenues, an income statement account. The reason Service Revenues is credited is because GG Org must report that it earned (not because it received ). Recording revenues when they are earned results from a basic accounting principle known as the revenue recognition principle. The following tip reflects that principle.

Revenues accounts are credited when the company earns a fee (or sells merchandise) regardless of whether cash is received at the time.

Here are the two parts of the transaction as they would look in the general journal format:

Account Name

Debit

Credit

Cash

10

Service Revenues

10

Sample Transaction #5

Let’s assume that on December 3 the company gets its second customer—a local company that needs to have 5 work packages immediately. George’s price of 0 is very appealing, so George’s company is hired to deliver the work packages. The customer tells George to submit an invoice for the 0, and they will pay it within seven days.

George delivers the work packages on December 3 as agreed, meaning that on December 3 GG Org has earned 0. Hence the 0 is reported as revenues on December 3, even though the company did not receive any cash on that day. The effort needed to complete the job was done on December 3. (Depositing the check for 0 in the bank when it arrives seven days later is not considered to take any effort.)

Let’s identify the two accounts involved and determine which needs a debit and which needs a credit.

Because GG Org has earned the fees, one account will be a revenues account, such as Service Revenues. (If you refer back to the last TIP, you will read that revenue accounts —such as Service Revenues—are usually credited, meaning the second account will need to be debited.)

In the general journal format, here’s what we have identified so far:

Account Name

Debit

Credit

???

250

Service Revenues

Account Name

Debit

Credit

Accounts Receivable

250

Service Revenues

250

Again, reporting revenues when they are earned results from the basic accounting principle known as the revenue recognition principle.

Sample Transaction #6

For simplicity, let’s assume that the only expense incurred by GG Org so far was a fee to a temporary help agency for a person to help George in completing the work packages on December 3. The temp agency fee is and is due by December 12.

If a company does not pay cash immediately, you cannot credit Cash. But because the company owes someone the money for its purchase, we say it has an obligation or liability to pay. Most accounts involved with obligations have the word “payable” in their name, and one of the most frequently used accounts is Accounts Payable. Also keep in mind that expenses are almost always debited.

The accounts and amounts for the temporary help are:

Account Name

Debit

Credit

Temporary Help Expense

80

Accounts Payable

80

Expenses are (almost) always debited.

If a company does not pay cash right away for an expense or for an asset, you cannot credit Cash. Because the company owes someone the money for its purchase, we say it has an obligation or liability to pay. The most likely liability account involved in business obligations is Accounts Payable.

Revenues and expenses appear on the income statement as shown below:

GG Org, Inc.
Income Statement
For the Three Days Ended December 3, 2006

Service Revenue

$ 260

Temporary Help Expense

80

Net Income

$ 180

After the entries through December 3 have been recorded, the balance sheet will look like this:

GG Org, Inc.
Balance Sheet
December 3, 2006

Assets

Liabilities & Stockholders’ Equity

Cash

$   4,810

Liabilities

Accounts Receivable

250

Accounts Payable

$        80

Prepaid Insurance

1,200

Stockholders’ Equity

Vehicles

14,000

Common Stock

20,000

Retained Earnings

180

Total Stockholders’ Equity

20,180

Total Assets

$ 20,260

Total Liabilities & Stockholders’ Equity

$ 20,260

Notice that the year-to-date net income (bottom line of the income statement) increased Stockholders’ Equity by the same amount, 0. This connection between the income statement and balance sheet is important. For one, it keeps the balance sheet and the accounting equation in balance. Secondly, it demonstrates that revenues will cause the stockholders’ equity to increase and expenses will cause stockholders’ equity to decrease. After the end of the year financial statements are prepared, you will see that the income statement accounts (revenue accounts and expense accounts) will be closed or zeroed out and their balances will be transferred into the Retained Earnings account. This will mean the revenue and expense accounts will start the new year with zero balances—allowing the company “to keep score” for the new year.

Koppala suggested that perhaps this introduction was enough material for their first meeting. She wrote out the following notes, summarizing for George the important points of their discussion:

1. When a company pays cash for something, the company will credit and will have to debit a second account. Assuming that a company prepares monthly financial statements—

If the amount is used up or will expire in the current month, the account to be debited will be an expense account. (Advertising Expense, Rent Expense, Wages Expense are three examples.)
If the amount is not used up or does not expire in the current month, the account to be debited will be an asset account. (Examples are Prepaid Insurance, Supplies,, Prepaid Advertising, Prepaid Association Dues, Land, Buildings, and Equipment.)
If the amount reduces a company’s obligations, the account to be debited will be a liability account. (Examples include Accounts Payable, Notes Payable, Wages Payable, and Interest Payable.)

2. When a company receives cash, the company will debit Cash and will have to credit another account. Assuming that a company will prepare monthly financial statements—

If the amount received is from a cash sale, or for a service that has just been performed but has not yet been recorded, the account to be credited is a revenue account such as Service Revenues or Fees Earned.
If the amount received is an advance payment for a service that has not yet been performed or earned, the account to be credited is Unearned Revenue.
If the amount received is a payment from a customer for a sale or service delivered earlier and has already been recorded as revenue, the account to be credited is Accounts Receivable.
If the amount received is the proceeds from the company signing a promissory note, the account to be credited is Notes Payable.
If the amount received is an investment of additional money by the owner of the corporation, a stockholders’ equity account such as Common Stock is credited.

Determining the Cash Flows of a Project

For all of the years of the capital project evaluation, usually six or seven, all of the income and expenses associated with the project activity need to be determined. The evaluation is concerned only with the incremental activity, not the already existing fixed costs that will be allocated to the sales and operations involved. The choice of a useful life limited to six or seven years recognizes the difficulty of estimating results too far into the future. It also recognizes that the present value interest factors beyond six or seven years are sufficiently low that the present value of cash flows then is probably modest.

In many cases incremental revenues are easy to determine. The analyst needs to be aggressive in seeking out the costs because they are much more difficult to identify.

This difficulty is compounded by the fact that the Project Manager who is recommending the project is usually optimistic and positive about all aspects of the project; he or she may leave out expenses and other costs, generally inadvertently. Nevertheless, determining the cash flows associated with a project, and taking all elements into account, may be difficult. The consequence will be optimistic projections of profits and cash flows resulting from the investment.

For each year, the revenues and costs are computed and structured into an Income Statement format, accounting for depreciation as an expense before computing the after-tax profit associated with the project. The depreciation is then added back to the after-tax profit because it is a non-cash expense and we are concerned with cash flows. These cash flows are then adjusted for time in computing the return on investment, as we will see shortly.

Determining the Terminal Cash Flows

As noted above, the normal time frame for evaluation is generally six or seven years, even though the equipment or other acquisition will last longer than that. The time value of cash flows after the six or seven years, when the discount rate is applied, will be relatively small, and the uncertainty that far out is substantial. Therefore, for evaluation purposes, the assessment is terminated at the end of this time.

On termination of the investment, whenever it occurs, the Projects may incur removal and disposal expenses. If the environment has been changed, there may be restoration costs. Additionally, there are salvage or sales values that may be significant and may involve recovery of some portion of the original investment. And the working capital will be recovered as well. All of these cash flows as well as the projected cash flows of this final year must be taken into account in computing the terminal cash flow.

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Tags: Cash, Flows, Frompome, Gautam, Koppala