Exhibit 22.

Relation between income flows and cash flows

Data refer to Solinger Electric Company for Year 4.
Sales revenue in the income statement $125,000
Cash collected from sales during the year 90,000
Cost of Goods Sold in the income statement 60,000
Cash paid to suppliers during the year 50,000
Salaries in the income statement 20,000
Salaries paid to employees during the year 19,000
Depreciation expense for the year (this is not a cash outflow) 10,000
Interest expense and paid interest 4,000
Other expenses in the income statement 11,000
Other expenses paid during the year 9,000
Purchase of new equipment during the year (paid) 125,000
Dividend paid during the year 8,000
Cash collected from issuing new long-term bonds 100,000

The first illustration shows the Income statement and in the right-hand portion the Statement of
Cash Flows using the direct method (Exhibit 22/a).
Most firms use the indirect method of computing cash flow from operations. For this calculation
we need the balance sheet of the company (Exhibit 22/b).
The Cash Flow Statement is shown in Exhibit 22/c. Here we calculated the cash flow from
operations under the indirect method.
Depreciation does not provide cash.
Because the indirect method adds depreciation expense to net income to calculate cash provided
by operations, readers of financial statements might incorrectly conclude that depreciation
expense provides cash. If a firm makes no sales, there will be no cash provided by operations
regardless how large the depreciation charge may be.
Ignore income taxes for a moment. Suppose that depreciation for Year 4 instead of $10,000 had
been $25,000. Exhibit 22/d shows in the first part the condensed original income statement, and
in the second part the income statement with $25,000 depreciation charge.
Note that the total cash flow from operations, which is the difference between receipts from
revenues and all expenses that used cash, remains $8,000.
When the firm considers income taxes, depreciation does affect cash flow. Depreciation affects
the calculation of net income reported in the income statement, and as a deduction, it also
reduces taxable income. The larger the amount of depreciation, the smaller is the taxable income
and the smaller the current payment for income taxes.
To overcome some of these interpretative problems of the indirect method, the FASB permits
firms to use the direct method in reporting cash flow from operations in the statement of cash
flows, but a note to the financial statements must reconcile net income with cash flow from
operations using the indirect method.

12/6
Exhibit 22/a SOLINGER ELECTRIC CORPORATION
Income Statement and Statement of Cash Receipts and Disbursements, Year 4
Income Cash Receipts Notes to Cash Receipts
Statement and Payments to Payments
Sales Revenue $125,000 $90,000 Collections from Customers
Less: Expenses:
Cost of Goods Sold $ 60,000 $ 50,000 Payment to Suppliers
Salaries 20,000 19,000 Payment to Employees
Depreciation 10,000 - -
Interest 4,000 4,000 Interest paid on Loan
Other Expenses 11,000 9,000 Payment to other Suppliers
Total Expenses $105,000 $ 82,000 Total expenses paid
Net Income $ 20,000
Cash Received and Paid (90,000 – 82,000) $ 8,000 Cash Flow from Operations
Purchase of Equipment $(125,000) Cash Flow from Investing
Dividend declaration and Payment $ (8,000) Dividend Payment
Issue of Long-term Bonds 100,000 Receipts from Bonds issue
$ 92,000 Cash Flow from Financing
Total Cash Flow (8,000 – 125,000 + 92,000) $ (25,000) Net Change in Cash

Reconciliation: Balance Sheet figure $ 30,000 Cash Balance Jan 1, Year 4

Balance Sheet figure (5,000) Cash Balance Dec 31, Year 4
$ (25,000) Net Change in Cash

Exhibit 22/b Comparative Balance Sheet for December 31, Year 3 and Year 4
Year 3 Year 4
Assets
Current Assets: Cash $ 30,000 $ 5,000
Accounts Receivable 20,000 55,000
Merchandise Inventory 40,000 50,000
Total Current Assets $ 90,000 $110,000
Non-current Assets:
Building and Equipment (cost) $100,000 $225,000
Accumulated Depreciation (30,000) (40,000)
Total Non-current Assets $ 70,000 $185,000
Total Assets $160,000 $295,000

Liabilities and Shareholders’ Equity

Current Liabilities:
Accounts Payable – Merchandise Suppliers $ 30,000 $ 50,000
Accounts Payable – Other Suppliers 10,000 12,000
Salaries Payable 5,000 6,000
Total Current Liabilities $ 45,000 $ 68,000

Non-current Liabilities: Bond Payable $ 0 $100,000

Shareholders’ Equity: Common Stock $100,000 $100,000

Retained Earnings 15,000 27,000
Total Shareholders’ Equity $115,000 $127,000
Total Liabilities and Shareholders’ Equity $160,000 $295,000

12/7
Exhibit 22/c Statement of Cash Flows for Year 4

Operations:
Net Income ............................................................................. $ 20,000
Add Depreciation Expense Not Using Cash ........................... 10,000
Increased Accounts Receivable …………………………….. (35,000)
Increased Merchandise Inventory …………………………… (10,000)
Increased Accounts Payable: To Suppliers Merchandise …… 20,000
To Other Suppliers ………….. 2,000
Increased Salaries Payable ………………………………….. 1,000
Cash Flow from Operations .................................................. $ 8,000

Investing:
Acquisition of Buildings and Equipment ..............................$(125,000)
Cash Flow from Investing ..................................................... $(125,000)

Financing:
Dividends Paid ...................................................................... $ (8,000)
Proceeds from Long-term Bonds Issued ............................... 100,000
Cash Flow from Financing .................................................. $ 92,000
NET CHANGE IN CASH FOR THE YEAR .......................... $(25,000)

Exhibit 22/d
Year 4 Depreciation $10,000
Income Statement Cash Flow from Operations
Revenues $125,000 Net Income $ 20,000
Expenses except Depreciation (95,000) Additions:
$ 30,000 Depreciation 10,000
Depreciation Expense (10,000) Other 23,000
Subtractions (45,000)
Net Income $ 20,000 Cash Flow from Operations $ 8,000

If the depreciation policy was changed from $10,000 to $25,000 the tables are the
following:

Year 4 Depreciation $25,000

Income Statement Cash Flow from Operations
Revenues $125,000 Net Income $ 5,000
Expenses except Depreciation (95,000) Additions:
$ 30,000 Depreciation 25,000
Depreciation Expense (25,000) Other 23,000
Subtractions (45,000)
Net Income $ 5,000 Cash Flow from Operations $ 8,000

Depreciation expense do not affect the ‘Cash flow from operations’ because
it changes the net income but the added-back depreciation will cause no difference in
the Cash flow statement.

12/8