Study Guide in Financial Analysis and Reporting FM-AA-CIA-15 Rev.

0 03-June-2020

FM 101: Financial Analysis and Reporting Module 4: Equity Changes and Cash Flow Reporting

STUDY GUIDE 4

Equity Changes and Cash Flow Reporting

MODULE OVERVIEW

This module discusses presentation of equity changes, cash flow reporting, classification of cash,
and treatments of interest, dividends, and taxes.

LEARNING OBJECTIVES

After studying and completing this module, you should be able to

- Define a declaration of equitable changes;
- Identify the elements on the face of the statement of changes in equity.
- Explain the line items in the shareholders' equity section
- Define a cash flow statement
- Differentiate between cash flows attributed to operating, financing, and investment
operations.
- Discuss the preferred and alternative treatment of interest, dividends, and income taxes.
- Differentiate the cash flows from operational operations using both direct and indirect
techniques.

LEARNING CONTENTS

STATEMENT OF CHANGES IN EQUITY

The Statement of Changes in Equity (SoCE) is a statement dated “for the year ended”. The report
shows a reconciliation of the beginning and ending balances of the equity account. It summarizes
the equity transactions with the owners of the business that occurred during the year.

Objective of Statement of Changes in Equity

The business organization determines the presentation of the SoCE.

There are three basic forms of business organization, namely: (1) sole proprietorship, (2)
partnership, and (3) corporation. They differ in terms of number of owners, legal personality of
the business, and ease of transferability of ownership.

a. Sole Proprietorship is the simplest form of a business organization. There is only one
owner referred to as sole proprietor. Oftentimes, the owner is also the manager. The
business has no legal personality separate from its owner. In the eyes of the law, the
business and the owner is one entity. For example, the business and the owner are taxed
as one. Also, the claim of the creditors of the business extends to the personal assets of
the owner. As a result, raising capital for the business is constrained to the owner’s
resources and credit standing.

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FM 101: Financial Analysis and Reporting Module 4: Equity Changes and Cash Flow Reporting

b. Partnership is a business owned by two or more owners called partners. They pool their
resources together such as money property and industry, to operate a business and divide
the profit among themselves. Partners re generally involved in the management of the
business. The agreement of the partners is stated in the contract of partnership specifically,
the partner’s profit and loss sharing arrangements.

A partnership has a legal personality separate from its owners’. It is taxed separately from
the partners except for those formed for the practice of the profession of the partners (i.e.
lawyers, accountants, etc.) However, the claims of the partnership creditors may extend to
the partners personal assets.

c. Corporation is the most complex form of business organization. A corporations is owned

by many owners called stockholders or shareholders. Ownership is divided into common
stocks or share of stocks. One shareholder can own many stocks. Shareholders are not
normally involved in the day to day operations of the corporation. Rather, owners set up
policies for the management of the corporation. In policy setting, each stock is normally
entitled to one vote. A stockholder that owns 1,000 stocks has 1,000 votes. Therefore, the
stockholder that owns 50% +1 of the total stock outstanding can control the corporation.
Rules that govern the management of the corporation are written in the Articles of
Incorporation and By-Laws.

The Corporation Code governs all corporations in the Philippines. Corporations are
registered with the Securities and Exchange Commission (SEC). Some corporations are
listed in the Philippine Stock Exchange (PSE). This means PSE provides a platform where
investors can buy and sell stocks of listed corporations.

One of the characteristics of a corporation is the separation of ownership and management.

Shareholders invest their funds and the corporation only have claims to the corporation’s
asset. A corporation is a legal entity separate from its owners.

PRESENTATION OF STATEMENT OF CHANGES IN EQUITY

Statement of Changes in Equity - Sole Proprietorship

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FM 101: Financial Analysis and Reporting Module 4: Equity Changes and Cash Flow Reporting

Statement of Changes in Equity - Partnership

Statement of Changes in Equity - Corporation

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FM 101: Financial Analysis and Reporting Module 4: Equity Changes and Cash Flow Reporting

STATEMENT OF CASH FLOWS

A statement of cash flows is a component of financial statements summarizing the operating,

investing and financing activities of an entity.

CLASSIFICATION OF CASH

• Operating Activities

Operating activities are the cash flows derived primarily from the principal revenue producing
activities of the entity.

Examples of cash flows from operating activities are:

a. Cash receipts (increase cash) from sale of goods and rendering of services
b. Cash receipts from royalties, rental, fees, commissions and other revenue
c. Cash payments to suppliers for goods and services
d. Cash payments (decrease your cash) for selling, administrative and other expenses
e. Cash receipts and cash payments of an insurance enterprise for premiums and claims,
annuities and other policy benefits
f. Cash payments or refund of income taxes unless they can be specifically identified with
financing and investing activities
g. Cash receipts and payments for securities held for dealing or trading purposes

• Investing Activities

Investing activities are the cash flows derived from the acquisition and disposal of long-term
assets and other investments not included in cash equivalent.

As a simple guide, investing activities include cash flows from transactions involving
nonoperating assets.

Examples of cash flows from investing activities are:

a. Cash payments to acquire property, plant and equipment, intangibles and other long-
term assets
b. Cash receipts from sales of property, plant and equipment, intangibles and other long-
term assets
c. Cash payments to acquire equity or debt instruments of other entities and interests in
joint ventures (current and long-term investments)
d. Cash receipts from sales of equity or debt instruments of other entities and interests in
joint venture
e. Cash advances and loans to other parties (other than advances and loans made by
financial institution)
f. Cash receipts from repayment of advances and loans made to other parties
g. Cash payments for future contract, forward contract, option contract and swap contract
h. Cash receipts from future contract, forward contract, option contract and swap contract

• Financing Activities

Financing activities are the cash flows derived from the equity capital and borrowings of the
entity.
In other words, financing activities are the cash flows that result from transactions:
a. Between the entity and the owners – equity financing

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FM 101: Financial Analysis and Reporting Module 4: Equity Changes and Cash Flow Reporting

b. Between the entity and the creditors – debt financing

As a simple guide, financing activities include the cash flows from transactions involving
nontrade liabilities and equity of an entity.

Examples of cash flows from financing activities are:

a. Cash receipts from issuing shares or other equity instruments, for example, issuance of
ordinary and preference shares
b. Cash payments to owners to acquire or redeem the enterprise’s shares, for example,
payment for treasury shares
c. Cash receipts from issuing debentures, loans, notes, bonds, mortgages, and other short
or long-term borrowings
d. Cash payment for amounts borrowed
e. Cash payments by a lessee for the reduction of the outstanding principal lease liability
Cash payments to settle obligations such as trade accounts and notes payable, income tax
payable, accrued expenses and similar items are operating activities, not financing activities.

TREATMENT OF DIVIDENDS, INTEREST AND INCOME TAXES

Interest
• Interest paid and interest received shall be classified as operating cash flows because they
enter into the determination of net income or loss.
• Alternatively, interest paid may be classified as financing cash flow because it is a cost of
obtaining financial resources.
• Alternatively, interest received may be classified as investing cash flows because it is a
return on investment.
• For a financial institution, interest paid and interest received are usually classified as
operating cash flows.

Dividends
• Dividend received shall be classified as operating cash flow because it enters into the
determination of net income.
• Alternatively, dividend received may be classified as investing cash flow because it is a
return on investment.
• Dividend paid shall be classified as financing cash flow because it is a cost of obtaining
financial resources.
• Dividend paid may be classified as operating cash flow in order to assist users to determine
the ability of the entity to pay dividends out of operating cash flows.

Income taxes
• Cash flows arising from income taxes shall be separately disclosed as cash flows from
operating activities unless they can be specifically identified with investing and financing
activities.
• Tax cash flows are often difficult to match to the originating underlying transaction, so most
of the time all tax cash flows are classified as arising from operating activities.

PREPARATION OF STATEMENT OF CASH FLOWS

Direct Method

PAS 7, paragraph 18, provides that an entity shall report cash flows from operating activities using

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FM 101: Financial Analysis and Reporting Module 4: Equity Changes and Cash Flow Reporting

either the direct method or indirect method.

The direct method shows in detail or itemizes the major classes of gross cash receipts and gross
cash payments.

The cash receipts are listed one by one, the cash payments are listed one by one, and the difference
represents the net cash flows from operating activities.

In essence, the direct method is the “cash basis” income statement.

1. Accounts receivable – 2018 350,000

Sales 6,500,000
Total 6,850,000
Accounts receivable – 2019 (940,000)
Collections from customers 5,910,000

2. Rent income 80,000

Unearned rent income – 2019 10,000
Total 90,000
Unearned rent income – 2018 (40,000)
Rent received 50,000

3. Accounts payable – 2018 150,000

Purchases 3,200,000
Total 3,350,000
Accounts payable – 2019 (170,000)
Payments to merchandise creditors 3,180,000

4. Salaries 950,000
Accrued salaries payable – 2018 10,000
Total 960,000
Accrued salaries payable – 2019 (25,000)
Salaries paid 935,000

5. Insurance 40,000
Prepaid insurance – 2019 15,000
Total 55,000
Prepaid insurance – 2018 (20,000)
Payment for insurance 35,000

6. Other expenses paid 500,000

7. Interest expense 55,000

Accrued interest payable – 2018 15,000
Total 70,000
Accrued interest payable – 2019 (10,000)
Interest paid 60,000

8. Income tax 350,000

Income tax payable – 2018 250,000
Total 600,000
Income tax payable – 2019 (350,000)
Payment for income tax 250,000

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FM 101: Financial Analysis and Reporting Module 4: Equity Changes and Cash Flow Reporting

Direct Method – Operating Activities

Cash received from customers 5,910,000

Rent received 50,000
Cash payments to merchandise creditors (3,180,000)
Salaries paid (935,000)
Insurance paid (35,000)
Other expenses paid (500,000)
Cash generated from operations 1,310,000
Interest paid (60,000)
Income tax paid (250,000)
Net cash provided by operating activities 1,000,000

PAS 7, paragraph 32, provides that interest paid is disclosed separately whether it has been
recognized in profit or loss or capitalized.

Paragraph 35 provides that income tax paid is also disclosed or presented separately.

Observe that the depreciation of P50,000 and amortization of P10,000 do not appear in the
statement of cash flows using the direct method.

The reason is that these are noncash expenses or expenses not requiring use of cash.
PAS 7, paragraph 19, provides that entities are encouraged to report cash flows from operating
activities using the direct method.

Indirect Method

The indirect method means that the net income or loss is adjusted for the effects of transactions of
a noncash nature, any deferrals or accruals of past or future operating cash receipts and payments,
and items of income or expense associated with investing and financing activities.

The indirect method of presenting the cash flow from operations begins with the accrual basis net
income and applies a series of adjustments to convert the income to a cash basis.

The following general guidelines are offered for the adjustments of net income to cash basis:
1. All increases in trade noncash current assets are deducted from the net income.
2. All decreases in trade noncash current assets are added to net income.
3. All increases in trade current liabilities are added to net income.
4. All decreases in trade current liabilities are deducted from net income.
5. Depreciation, amortization and other noncash expenses are added back to net income to
eliminate the effect they had on net income.
6. Any gain on disposal of property or gain on early retirement of nontrade liabilities is included
in net income but it is a nonoperating item. Thus, this is deducted from net income.
7. Any loss on disposal of property or loss on early retirement of nontrade liabilities is deducted
from net income but thus is a nonoperating item Thus, this is added back to net income.
8. Other noncash income or gain is deducted from net income and other noncash expense or
loss is added to net income to eliminate the effect on net income.
Continuing the Illustration, the changes in current assets and current liabilities are summarized as
follows:

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FM 101: Financial Analysis and Reporting Module 4: Equity Changes and Cash Flow Reporting

2019 2018 Increase (Decrease)

Accounts receivable 940,000 350,000 590,000
Inventory 175,000 100,000 75,000
Prepaid insurance 1 5,000 20,000 (5,000)
Accounts payable 170,000 150,000 20,000
Accrued salaries payable 25,000 10,000 15,000
Accrued interest payable 10,000 15,000 (5,000)
Income tax payable 350,000 250,000 100,000
Unearned rent income 10,000 40,000 (30,000)

Indirect Method – Operating Activities

Net income 1,500,000

Increase in accounts receivable (590,000)
Increase in inventory (75,000)
Decrease in prepaid insurance 5,000
Increase in accounts payable 20,000
Increase in accrued salaries payable 15,000
Decrease in accrued interest payable (5,000)
Increase in income tax payable 100,000
Decrease in unearned rent income (30,000)
Depreciation 50,000
Amortization of patent 10,000
Net cash provided by operating activities 1,000,000

Comprehensive Illustration

Illustrar Company provided the following statement of financial position at year-end and other
financial data relating to activities during the current year:

2019 2018
Cash and cash equivalent 600,000 200,000
Accounts receivable, net of allowance 1,100,000 1,040,000
Notes receivable – trade 150,000 200,000
Inventory 1,200,000 1,360,000
Prepaid expenses 110,000 120,000
Investment in equity securities, at cost 300,000 500,000
Property, plant and equipment 3,400,000 2,000,000
Accumulated depreciation (900,000) (600,000)
5,960,000 4,900,000

Accounts payable 880,000 840,000

Notes payable – trade 60,000 240,000
Accrued expenses 100,000 330,000
Note payable – bank (short term debt) 400,000 --
Share capital, P100 par 3,000,000 2,400,000
Share premium 530,000 400,000
Retained earnings 990,000 790,000
Treasury shares, at cost -- (100,000)
5,960,000 4,900,000

The statement of retained earnings for the year ended December 31, 2019 showed the following:

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FM 101: Financial Analysis and Reporting Module 4: Equity Changes and Cash Flow Reporting

Retained earnings – January 1 790,000

Net income for 2019 1,000,000
Total 1,790,000
Cash dividend paid (800,000)
Retained earnings – December 31 990,000

Additional Information
• The entity sold an investment in equity securities for P240,000 cash. There were no other
transactions affecting the investment in equity securities.
• Land was purchased in the current year for P1,200,000, paying P1,000,000 cash and
issuing P200,000 share capital at par value.
• Equipment costing P200,000 and having a carrying amount of P80,000 was sold for
P60,000 cash.
• Equipment of P400,000 was purchased for cash.
• The entity borrowed P400,000 from a bank to be paid June 30, 2020.
• Share capital with par value of P400,000 was issued for cash at a premium of P100,000.
• The treasury shares were reissued for P130,000 cash.
• The patent was fully amortized.
Basic Guidelines
a. Operating activities include the cash effects of transactions that enter into the
determination of net income.
b. Investing activities include the cash effects of transactions involving nonoperating assets.
c. Financing activities include the cash effects of transactions involving nontrade liabilities
and equity.
The cash effect of the properly numbered original entries is summarized as follows:

Operating Investing Financing

1. Net income 1,000,000
2. Payment of cash dividend (800,000)
3. Increase in accounts receivable (60,000)
4. Decrease in notes receivable 50,000
5. Decrease in inventory 160,000
6. Decrease in prepaid expenses 10,000
7. Sale of investment 240,000
Gain on sale of investment (40,000)
8. Payment for land (1,000,000)
9. Purchase of equipment (400,000)
10. Sale of equipment 60,000
Loss on sale of equipment 20,000
11. Depreciation 420,000
12. Amortization of patent 80,000
13. Increase in accounts payable 40,000
14. Decrease in notes payable (180,000)
15. Decrease in accrued expenses (230,000)
16. Proceeds from bank notes payable 400,000
17. Issuance of share capital 500,000
18. Reissuance of treasury shares ________ _________ 130,000
Net cash provided (used) 1,270,000 (1,100,000) 230,000

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FM 101: Financial Analysis and Reporting Module 4: Equity Changes and Cash Flow Reporting

Preparation of Statement of Cash Flows

The formal statement of cash flows can now be prepared from the preceding summary of operating,
investing and financing activities.

Illustrar Company
Statement of Cash Flows
Year ended December 31, 2019

Cash flows from operating activities:

Net income 1,000,000
Increase in accounts receivable (60,000)
Decrease in notes receivable 50,000
Decrease in inventory 160,000
Decrease in prepaid expenses 10,000
Gain on sale of investment (40,000)
Loss on sale of equipment 20,000
Depreciation 420,000
Amortization of patent 80,000
Increase in accounts payable 40,000
Decrease in notes payable (180,000)
Decrease in accrued expenses (230,000)
Net cash provided by operating activities 1,270,000

Cash flows from investing activities:

Sale of investment 240,000
Sale of equipment 60,000
Purchase of land (1,000,000)
Purchase of equipment 400,000
Net cash used in investing activities (1,100,000)

Cash flows from financing activities:

Cash received from bank loan 400,000
Issuance of share capital 500,000
Reissuance of treasury shares 130,000
Payment of cash dividend (800,000)
Net cash provided by financing activities 230,000

Increase in cash and cash equivalents 400,000

Add: Cash and cash equivalents – January 1 200,000

Cash and cash equivalents – December 31 600,000

REFERENCES

Financial Accounting and Reporting; Nick L. Aduana

The Intermediate Accounting Series Vol 3 Robles, N. Belview 2019

Intermediate Accounting 2019 Volume 3 Robles, N. & Empleo, P. Belview 2019

Financial Accounting and Reporting "Fundamentals" (2019-2020 Edition) Cabrera, E.B., Cabrera,
G.A Belview 2019

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FM 101: Financial Analysis and Reporting Module 4: Equity Changes and Cash Flow Reporting

Management Services Comprehensive Guide, Agamata; 2019

Financial Management Comprehensive Volume (2019-2020); Cabrera E.B.; 2019-2020

Financial Management for Decision Makers 9th edition ePub; Atrill, Peter Dr, 2020

Contemporary Financial Management; Moyer/McGuigan/Rao; 2018

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