Most companies use the accrual method of accounting for their business. In other words, revenues and expense are reported in the period in which they occurred, not when cash is received or paid out.
For example, an expense of $5,000 is recorded for advertising in month one, but not paid in month one. The expense is posted as a debit to advertising expense and a credit to a liability payable account. The effect of this is that net income for month one is reduced by $5,000, but no cash is spent, therefore the cash balance remains unaffected from this transaction in month one.
Adjustments to Net Income
With the indirect method, these differences are used to reconcile net income to cash flows from operating activities. The adjustments to net income begin with expenses that do not affect cash. These include depreciation expense and amortization of intangible assets. These amounts are added back to net income because they represent a decrease to net income, but not a cash outlay. Depreciation and amortization are accounting entries that are recorded in order to recognize the cost of the asset over a period of time. The original cash outlay occurred when the asset was purchased.
The next adjustments are for gains and losses from disposal of assets. This step is necessary because cash flows from operating activities should not include investing or financing activities. For example, if land was sold for $65,000 that had an original cost of $40,000, the total sale of $65,000 is reported under investing activities on the cash flow statement. However, the gain of $25,000 is already included in net income; therefore the $25,000 should be deducted from net income to determine cash flows from operations.
After that, changes in current operating assets and liabilities accounts must be calculated and recorded on the cash flows from operating activities. These accounts include accounts receivables, inventory, and prepaid expenses, accounts payable and accrued liabilities. Knowing whether to add or subtract these changes to net income can be a little tricky. A chart can illustrate the proper method.
Subtract
- Increases in accounts receivable
- Increases in inventory
- Increases in prepaid expenses
- Decreases in accounts payable
- Decreases in accrued liabilities
Add
- Decreases in accounts receivable
- Decreases in inventory
- Decreases in prepaid expenses
- Increases in accounts payable
- Increases in accrued liabilities
As an example, if inventory at the end of year one was $145,000 and $120,000 at the end of year two, the change in the account is a decrease of $25,000. The decrease indicates that the merchandise sold exceeds the cost of the merchandise purchased by $25,000. The cost of merchandise sold expense reported on the income statement for the year included $25,000 that did not require a cash outlay during the year. Therefore, the $25,000 is added to net income on the cash flows from operating activities.
Cash Flows from Operating Activities
To reconcile net income to net cash flow from operating activities, simply begin with net income, and add or subtract the adjustments to arrive at a net cash flow from operating activities. A negative net cash flow from operating activities is an indication that the company may have difficulty in meeting its financial obligations, and could be a sign of future problems. A positive net cash flow from operations is an indication that the company is generating cash from operations.
A statement of cash flows from operating activities is an important tool in assessing the financial health of any business. Understanding how it is prepared can greatly enhance its value to users of the financial reports.
Diane White - Diane White is the founder and owner of Expert Bookeeping & Tax Service, LLC. She developed her accounting expertise during the ...
