Accounting: The Language of Business - Vol. 1 (Part 96)

I've met them down in the Cost and Accounting Department, clean-shaven and in white collars. They can't see a damn thing ridiculous about themselves... only about you.

Jean Shepherd

Statement of Cash Flows (Part B)

by

Charles Lamson

Statement of Cash Flows the Indirect Method

The indirect method of reporting cash flows from operating activities is normally less costly and more efficient than the direct method. In addition, when the direct method is used, the indirect method must also be used in preparing a supplemental reconciliation of net income with cash flows from operations. Most companies use the indirect method. For these reasons, we will discuss first the indirect method of preparing the statement of cash flows.

To collect the data for the statement of cash flows, all the cash receipts and cash payments for a period could be analyzed. However, this procedure is expensive and time-consuming. A more efficient approach is to analyze the changes in the noncash balance sheet accounts. The logic of this approach is that a change in any balance sheet account (including cash) can be analyzed in terms of changes and the other balance sheet accounts. To illustrate, the accounting equation is rewritten below to focus on the cash account:

Any change in the cash account results in a change in one or more noncash balance sheet accounts. That is, if the cash account changes, then a liability, stockholders' equity, or noncash asset account must also change.

Additional data are also obtained by analyzing the income statement accounts and supporting records. For example, since the net income or net loss for the period is closed to retained earnings a change in the retained earnings account can be partially explained by the net income or net loss reported on the income sheet statement.

There is no order in which the noncash balance sheet accounts must be analyzed. However, it is usually more efficient to analyze the accounts in the reverse order in which they appear on the balance sheet. Thus, the analysis of retained earnings provides the starting point for determining the cash flows from operating activities, which is the first section of the statement of cash flows.

The comparative balance sheet for Rundell Inc. on December 31, 2023 and 2022, is used to illustrate the indirect method. This balance sheet is shown in Exhibit 3.

Retained Earnings

The comparative balance sheet for Rundell Inc. shows that retained earnings increased $80,000 during the year. Analyzing the entries posted to the retained earnings account indicate how this change occurred. The retained earnings account for Rundell Inc. is shown below.

The retained earnings account must be carefully analyzed because some of the entries to retained earnings may not affect cash. For example, a decrease in retained earnings resulting from issuing a stock dividend does not affect cash. Such transactions are not reported on the statement of cash flows.

For Rundell Inc., the retained earnings account indicates that the $80,000 change resulted from net income of $108,000 and cash dividends declared of $28,000. The effect of each of these items on cash flows is discussed in the following sections.

Cash Flows from Operating Activities

The net income of $108,000 reported by Rundell Inc. normally is not equal to the amount of cash generated from operations during the period. This is because net income is determined using the accrual method of accounting.

Under the accrual method of accounting, revenues and expenses are recorded at different times from when cash is received or paid. For example, merchandise may be sold on account and the cash received at a later date.

Likewise, insurance expense represents the amount of insurance expired during the period. The premiums for the insurance may have been paid in a prior period. Thus, the net income reported on the income statement must be adjusted in determining cash flows from operating activities. The typical adjustments to net income are summarized in Exhibit 4.

EXHIBIT 4 Adjustments to Net Income---Indirect Method

Some of the adjustment items in Exhibit 4 are for expenses that affect noncurrent accounts but not cash. For example, depreciation of fixed assets and amortization of intangible assets are deducted from revenue but do not affect cash.

Some of the adjustment items in Exhibit 4 are for revenues and expenses that affect current assets and current liabilities but not cash flows. For example, a sale of $10,000 on account increases accounts receivable by $10,000. However, cash is not affected. Thus, the increase in accounts receivable of $10,000 between two balance sheet dates is deducted from net income in arriving at cash flows from operating activities.

Cash flows from operating activities should not include investing or financing transactions. For example, assume that land costing $50,000 was sold for $90,000 (a gain of $40,000). The sale should be reported as an investing activity: "Cash receipts from the sale of land, $90,000." However, the $40,000 gain on the sale of the land is included in net income on the income statement. Plus, the $40,000 gain is deducted from net income in determining cash flows from operations in order to avoid "double-counting" the cash flow from the gain. Likewise, losses from the sale of fixed assets are added to net income in determining cash flows from operations.

The effect of dividends payable on cash flows from operating activities is omitted from Exhibit 4. Dividends payable is omitted because dividends do not affect net income. Later, we will discuss how dividends are reported in the statement of cash flows. In the remainder of this post and in the next post, we will discuss each of the adjustments that change Rundell Inc.'s net income to "Cash flows from operating activities."

Depreciation

The comparative balance sheet in Exhibit 3 indicates that Accumulated Depreciation---Building increased by $7,000. As shown below, this account indicates that the depreciation for the year was $7,000 for the building.

The $7,000 of depreciation expense reduced net income but did not require an outflow of cash. Thus the $7,000 is added to net income in determining cash flows from operating activities, as follows: 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 645-648*

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