Archive for May 2012

Application of Income Statement in Financial Reporting

By | Published Wednesday, May 30, 2012



The cash flow statement tells the actual amount of collected revenues in terms of cash. Since the income statement is prepared on the bases of accrual accounting it may not tell the exact value of the revenue generated by a firm and in the same way income statement show some expenses that are not paid in reality. Cash flow statement is applied to find out the actual generated cash and actual cash that are spent in different activities of the firm. Due to the above mentioned usefulness cash flow statement is reviewed by the investors and businessmen to get an idea of financial position of the firm on the bases of cash. 

The cash generated for the operating activities of the cash flow statement is used to compare to the net income of the firm if this cash is greater than the net income the earnings of the company are considered to be of high grade. For the investors that believe that cash is king cash flow statement is a tool to show cash inflow and outflow from a company. It also shows that if a company is able to increase its dividend as a company that generates more cash is able to increase the amount of dividends for the share holders. The cash flow statements also show the ability of a company to pay its debt, reduce loan or to acquire another company on the bases of its cash generation. In some firms the future financial modals of a company are based on the information acquired from the cash flow statement.
Cash flow statement can also be used to predict the future cash flows of a company. It also helps in crafting and designing the budget of a company on the bases of generated cash.

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Preparation of Cash Flow Statement by Indirect Method with example

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In order to prepare the cash flow statement by indirect method lets assume to take data from the first year of operations of a company say ABC. Suppose Company ABC started at January 2007, with issuing its 60,000 shares in the market where the value of each share was $1 and the value of total common stock of the Company ABC was $60,000. All the other essentials such as office, furniture and equipment of the company was rented for the first year and the Company ABC provided tax based consultation services to its customers. The balance sheet of the company at the beginning and the end of the year is as under:-

Balance Sheet of ABC Company
Assets

Cash
Account Receivables

Total
Dec  31, 2007

$49,000
$36,000

$85,000
Jan 1, 2007

$ 0
$ 0

$ 0
Change
$49,000 Increase
$36,000 Increase
Liabilities and Equity

Accounts Payable
Common Stock
Retained Earnings

Total


$5000
$60,000
$20,000

$85,000


$ 0
$ 0
$ 0

$0


$ 5000 Increase
$ 60,000 Increase
$20,000 Increase

Income Statement of ABC Company
Revenue
$125,000
Operating Expense
$85,000
Income before taxes
$40,000
Income after taxes
$6,000
Net Income
$34,000
Conversion of the Net Income to the Net Cash Flow
Net Income
Net Income is adjusted to reconcile it into net cash by operating activities
Increase in account receivables
Increase in account payable

Net Cash provided by operating activates




$36,000
$5000
$34,000




$31,000

$3000

The above mentioned table shows that with the adjustments of accounts payable and accounts receivables the net income is transformed into the net cash.
Now the cash flow statement preparation by indirect method is as follows:-
Cash Flow Statement by Indirect Method
Cash Flows from operating activities

Net Income
Increase in account receivables
Increase in account payable

Net Cash by operating activities



$36,000
$5000


$34,000


$31,000

$3000
Cash Flow from Financing activities

Issuance of Common Stock
Payment of cash dividend

Net cash provided by Financing activities

Net Increase in Cash
January 1, 2007
December 31, 2007


$60,000
$14,000







$46,000
$49,000
$0
$49,000

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Preparation of the Cash Flow Statement through Direct Method with Example

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While preparing a cash flow statement with direct method a company uses gross cash receipts and gross cash payments as parameters. In the direct method the dividend received by the company can either be listed under the operating activities or under the investment activities. In this method the taxes paid are listed under operating activities if they are directly linked to the operating activities. However, if taxes are directly related to the investing or financing activities they are listed in the corresponding sections of the cash flow statement. The direct method of preparing cash flow statement is also called the income statement method of the cash flow statement preparation. In the direct method the operating cash disbursements are deducted from the net cash receipts of the operating activities. 

To understand the direct method of cash flow statement preparation let’s take an example of a company. Suppose the company ABC Limited has revenues of $125,000 for a specific part of the fiscal year 2010. The accounts receivable of the Company ABC Limited are $36,000 only. Now first we have to calculate the cash collected from the revenue. This can be calculated as under:-

Cash Collected from Revenue= Total Revenue – Account Receivable
Cash collected from revenues = $125,000 - $36,000
Cash Collected from revenues = $89,000

The operating expense of the company for that period of time were $85,000 and the account payable for the company at that interval of time increased at an amount of $5000. Now we have to calculate cash operating expense of the company. The cash operating expense can be calculated as:-

Cash payment for expense = Operating Expense – Accounts Payable
Cash payment for expense = $85,000 - $5000
Cash payment for expense = $80,000

Now the income tax expense of the ABC Limited for that year was $6000. For the above mentioned data we can easily prepare the cash flow statement with the help of direct method
Cash Collected from Revenues
$89,000
Cash Payment for Expense
$80,000
Income before paying income taxes
$9000
Cash payment of Income tax for the year
$6000
Net Cash provided by Operating activities
$3000

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