Now, let's apply what we've learned to the Garden Spot year two case. Recall that Mary Jo has just completed her second year of operations. Several things happened during the year. We, together, have done quite a bit of work on this case. We've recorded the transactions for the second year. We've prepared an income statement for the second year of operations. We've prepared a balance sheet as of the end of the second year. And now we need to prepare a statement of cash flows for the second year. I'm going to start with a completed statement of cash flows for year two and walk through it. Notice that I have this imaginary income statement, Sitting at the top of the statement of cash flow because the statement of cash flows starts with net income, which, remember, is exactly where the income statement ends. And I also have here the beginning and ending balance sheet for the Garden Spot for year two. I'm going to start with the operating activities section. And then I'll move to the investing activities section and, finally, the financing activities section. And when I have included the entire change in any balance sheet account on the face of this statement of cash flows, I will check off that account on the balance sheet. And, remember, once I have checked off all of the accounts on the balance sheet, I should be done with the statement of cash flows. First, I'm going to start by including net income at the top of the statement of cash flow, which was 29.325 in year two. What balance sheet account does that help us explain the change in? Yes, the retained earnings account. Look at the balance sheet, and we see that the retained earnings account increased from 5,610 to 26,935 in year two. I'm going to draw a T account for retained earnings so we can understand what caused that change. I'm going to put the beginning balance and the ending balance in that T account. Recall that there are two things we know about that affect retained earnings. Net income, Which was 29,325. And dividends. However, despite the fact that I've put net income at the top of the statement of cash flow, I have not put dividends on the statement of cash flow yet. So I haven't included on the statement of cash flow the entire change in the retained earnings T account. So I'm not going to check that account off on the balance sheet just yet. Okay, second, I need to adjust net income for those current asset and current liability accounts that help us understand the difference in the timing in accrual accounting-based entries and cash outlays for each line item on the income statement. Now, we have a few more of those in year two than we did in year one. Let's look at the balance sheet. We have accounts receivable and inventory, which we had in year one. But we have a new current asset account, prepaid advertising, which is an operating asset account. I need to make an adjustment to net income for the change in each of these accounts. Now let's move to the current liability section. We have accounts payable, wages payable, taxes payable, and deferred revenue that are all operating liabilities. And we also interest payable. Recall that US GAAP requires us to include that in the operating activities section. So now I need to make an adjustment to net income for the change in each of these accounts. I'm going to skip dividends payable for now and come back to that. Dividends payable is not an operating liability, and so it's not one for which we need to make for adjustment in the operating activities section. And there's nothing related to dividends that shows up on the income statement, so there's nothing we need to make an adjustment for. Now notice that the balance in each of these current asset accounts increased. So they act as cash outflows. And we put those changes here on the statement of cash flow in parentheses as a result. Notice also that the balance in accounts payable, Taxes payable, interest payable, and deferred revenue increased. They are all liability accounts. So the increases act like cash inflows, and we include them as positive numbers on the statement of cash flows. And the balance in the wages payable account decreased, Which acts like a cash outflow, so we include that adjustment here in parentheses. So those are all of the current asset and current liability accounts for which we need to make an adjustment for in the Operating Activities section of the statement of cash flows. I'm going to check those accounts off on the balance sheet now because I have included the change in those account balances on the statement of cash flow. Next, I need to make an adjustment for depreciation expense. Now, remember, we have this imaginary income statement that starts with revenues. And ends with net income. And it has a depreciation expense on it. A depreciation expense is a noncash expense, so I have to add it back to net income, which is the adjustment I'm making here. And then there's a new adjustment that we haven't seen before. Recall that the company sold some equipment. It received $600 in cash, but it took $800 off the books because the net book value of what was sold was $800. And as a result, it reported a loss of $200. That $200 loss was included on the income statement, so net income was reduced by that $200. Now, importantly, the cash that was received was $600. And it is that $600 that should show up in the investing section. Because that section includes all cash inflows and outflows from selling and buying equipment. Now if we think about the statement of cash flow as being a continuation of an income statement that already includes a negative $200 related to this sale, then we have a net of $400 being included in our changing cash related to that sale of the equipment. We have the negative 200 and the positive 600.. But that's puzzling because we didn't get $400 when we sold the equipment, we got $600. And that entire $600 should show up in the investing section. Therefore, we need to add back $200 to net income in the operating activities section. So then we have a negative 200 and a positive 200, which cancel each other out in the operating section. So there's no effect of the sale on cash flow from operations. And we're left with the positive 600 in the investing section, which is exactly the cash we got from the sale of the equipment. So the bigger picture here, or the bottom line, is that we have to add back any losses and subtract any gains from the sale of long lived assets when we're doing the operating activities of the statement of cash flows. I'm going to go back the the balance sheet now, and I'm going to construct a T account for property, plant and equipment. I'm going to put the beginning balance and the ending balance in that account. Now, we know that there are several things that affect property, plant and equipment. We know that purchases of PP&E increase the account balance. We know that depreciation decreases the account balance. And we know that the sale of PP&E also decreases the account balance. We just included 4,200, that's kind of hard to see, In depreciation on the face of the statement of cash flow. And we've included, $800 related to the sale on the face of the statement of cash flow. But we haven't included everything that affects the property, plant and equipment account because we haven't included purchases. So I cannot check that account off yet. I will come back to that one later. Now, if I total the net income and all the adjustments in the operating activity section, I see that cash flow from operations is $7,000. Now we've completed our work on the operating activities section.
