Accounting: The Language of Business - Vol. 2 (Intermediate: Part 72)

The SEC does way more good than harm - the last thing I would do is get rid of the SEC...if accounting were thoroughly fixed, a lot of other sins would go away. We're paying a huge price for deterioration of accounting.

                                                                        Charlie Munger

Statements of Financial Position and Cash Flows and the Annual Report (Part J)

by

Charles Lamson

Format For Cash Flows from Operating Activities 

There are two acceptable formats for cash flows from operating activities:

• The indirect method (or the reconciliation format)

• The direct method (or the income statement format)

The only difference between the statement of cash flows under the direct and indirect methods is reporting cash flows from operating activities. The investing and financing sections of the direct and indirect reporting formats are the same. The Financial Accounting Standards Board (FASB) prefers the direct method, but it is the least popular in practice---it is used by only 1% of U.S. companies [AICPA, Accounting Trends and Techniques - 2012 (New York, NY: AICPA, 2012)].

We begin our discussion by presenting operating activities under the indirect method.

The Indirect Method of Reporting Cash Flows from Operating Activities. The indirect method (also referred to as the reconciliation format) begins with net income from the income statement [For more info about the income statement, see "Accounting: The Language of Business (Part 8)]" and then reconciles the net income to net cash generated from operating activities. Reconciling items are separated into two groups:

• Adjustments for non-cash items

• Changes and operating assets and liabilities

Exhibit 6.9 lists a few of the common adjustments or reconciling items. 

EXHIBIT 6.9 Reconciling Items for the Indirect Method

Exhibit 6.10 provides the operating activities section of Johnson & Johnson's statement of cash flows using the indirect method. Note that the first line in the operating section is net income, followed by the adjustments for noncash items such as depreciation and bad debt expense (referred to in the exhibit as "accounts receivable allowances"). Although depreciation expense and bad debt expense are deducted on the income statement, they are not cash outflows. Thus, Johnson & Johnson must add them back to net income to arrive at net operating cash flows.

EXHIBIT 6.10 Statement of Cash Flows, Operating Activities, Johnson & Johnson, Financial Statements, for the Year ended January 1, 2017 

Click to enlarge.

Source: https://www.investor.jnj.com/annual-meeting-materials/2016-annual-report

Next, Johnson & Johnson adjusts for changes in operating assets and liabilities such as accounts receivable and accounts payable. Other common operating asset and liability adjustments are for inventory, prepaid expenses, and accrued liabilities.

To illustrate changes in operating assets and liabilities, consider accounts receivable. Assume that NRR Company reported accounts receivable of $10,000 and $12,000 at the beginning and end of the year, respectively. The company also reported $55,000 in sales revenue. The increase in accounts receivable indicates that $2,000 of this year's sales were not collected. As a result, NRR collected $53,000 from customers ($55,000 - $2,000). Therefore, NRR subtracts the increase in accounts receivable ($2,000) from net income to arrive at net cash provided by operations. 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 249-251*

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