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Where do we start in preparing Home Store, Inc.

Operating Activities Cashflow Indirect Method | Formula | Example

As stated earlier, the information needed to prepare the statement of cash flows includes the balance sheet, income statement, and other selected data. This information is presented in Figure Other pertinent data for are as follows:.

With these data and the information provided in Figure It is important to note that all positive amounts shown in the statement of cash flows denote an increase in cash, and all negative amounts denote a decrease in cash. We will be using the indirect method to prepare the operating activities section. The direct method is covered in the appendix. The starting point using the indirect method is net income.

Cash Flow Computations - Indirect Method

This amount comes from the income statement, which was prepared using the accrual basis of accounting. How do we convert this amount to a cash basis? Several adjustments are necessary to convert this amount to a cash basis and to provide an amount related only to daily operating activities of the business.

If the resulting adjusted amount is a cash inflow, it is called cash provided by operating activities ; if it is a cash outflow, it is called cash used by operating activities. Three general types of adjustments are necessary to convert net income to cash provided by operating activities. These three types of adjustments are shown in Figure Examine this figure carefully.

What is the first type of adjustment necessary to convert net income to a cash basis? The first adjustment to net income involves adding back expenses that do not affect cash often called noncash expenses. For example, the accrual basis of accounting deducts depreciation expense in calculating net income, even though depreciation expense does not involve cash.

Recall the financial accounting entry to record depreciation expense: Notice cash is not involved. Thus to convert net income to a cash basis, depreciation expense is added back to net income.

In effect, we are reversing depreciation expense because it is not an expense using the cash basis of accounting. The end result is as though depreciation expense was never deducted as an expense. Next, we show how the first adjustment to net income appears in the operating activities section of the statement of cash flows for Home Store, Inc.

The income statement for Home Store, Inc. What is the second type of adjustment necessary to convert net income to a cash basis?

The second adjustment to net income involves adding back losses and deducting gains related to investing activities. For example, Home Store, Inc. This loss is shown on the income statement as a deduction in calculating net income see Figure However, this loss is not related to the daily operations of the business.

That is, Home Store, Inc. Remember, we are trying to find the cash provided by operating activities in this section of the statement of cash flows. Since equipment is a noncurrent asset, cash activity related to the disposal of equipment should be included in the investment activities section of the statement of cash flows.

What is the third type of adjustment necessary to convert net income to a cash basis? The third type of adjustment to net income involves analyzing the changes in all current assets except cash and current liabilities from the beginning of the period to the end of the period. These changes are already shown in the far right column of the balance sheet portion of Figure Two important rules must be followed to determine how the change is reflected as an adjustment to net income.

Study these two rules carefully:. The first current asset line item, cash, shows the change in cash from the beginning of the year to the end of year.

Statement of Cash Flows (Indirect Method)

This amount will appear in step 4 when we reconcile the beginning cash balance to the ending cash balance. The next line item is accounts receivable. The current asset rule states that increases in current assets are deducted from net income. On a cash basis, Home Store, Inc.

The accounts receivable T-account shown in the following provides further clarification. We will continue analyzing each current asset and current liability item in the balance sheet shown in Figure If the merchandise inventory account increases over time, more goods are purchased than are sold.

Because merchandise inventory at Home Store, Inc. If expenses are higher using a cash basis, the adjustment must decrease net income. This information is summarized in the merchandise inventory T-account in the following.

This is because cash paid for these expenses was lower than the expenses recognized on the income statement using the accrual basis. When preparing the operating activities section of the statement of cash flows, increases in current assets are deducted from net income; decreases in current assets are added to net income.

Now that we know how to handle the change in current assets when preparing the operating activities section of the statement of cash flows, what do we do with current liabilities? The current liability rule is a bit different than the current asset rule as described next.

An increase in accounts payable signifies that Home Store, Inc. A decrease in income tax payable signifies that Home Store, Inc. When preparing the operating activities section of the statement of cash flows, increases in current liabilities are added to net income; decreases in current liabilities are deducted from net income.

What does the operating activities section of the statement of cash flows look like for Home Store, Inc.? Each review problem corresponds to the four steps required to prepare a statement of cash flows.

Phantom Books is a retail store that sells new and used books. Additional data for include the following:.

Preparation of the Statement of Cash Flows: Indirect Method

Start with net income from the income statement; make the appropriate adjustments for 1 noncash expenses, such as depreciation and amortization; 2 gains and losses related to investing activities; and 3 changes in current assets other than cash and current liabilities. The operating activities section of the statement of cash flows for Phantom Books appears as follows.

Before moving on to step 2, note that investing and financing activities sections always use the same format whether the operating activities section is presented using the direct method or indirect method.

Now that we have completed the operating activities section for Home Store, Inc. What information is used for this section, and how is it prepared? The investing activities section of the statement of cash flows focuses on cash activities related to noncurrent assets. Review the noncurrent asset section of Home Store, Inc. Three noncurrent asset line items must be analyzed to determine how to present cash flow information in the investing activities section.

The additional information provided for indicates two types of transactions caused this increase. Notice the two entries to property, plant, and equipment shown previously.

This is summarized in the following T-account:. How is this property, plant, and equipment information used in the investing activities section of the statement of cash flows for Home Store, Inc.?

Instead, Home Store, Inc. The formal presentation of this information in the investing activities section is shown later in Figure This contra asset account is not typical of the other asset accounts shown on Home Store, Inc. Thus as this accumulated depreciation account increases, it further reduces overall assets. Terminology can get confusing, so here is a simple way to look at it.

The higher the account goes; the more it reduces assets. This is why the change column shows this account as decreasing assets. Two items caused the change in the accumulated depreciation account. This information is summarized in the following T-account:.

How is accumulated depreciation information used in the statement of cash flows for Home Store, Inc.? This information is already reflected in two places the work has already been done! First, depreciation expense is a noncash expense and is added back to net income in the operating activities section of the statement of cash flows see Figure The additional information provided for indicates there were no sales of long-term investments during the year.

Using the information presented in Note Start by analyzing changes in noncurrent assets on the balance sheet. Then prepare the investing activities section of the statement of cash flows. The cash flows related to each noncurrent asset account are underlined as follows. Additional data provided indicate 2 items caused this change: Two items caused this change: Neither of these entries to accumulated depreciation impacts the investing activities section. The investing activities section of the statement of cash flows for Phantom Books is shown as follows:.

Now that we have completed the operating and investing activities sections for Home Store, Inc. The formal presentation of this information in the financing activities section is shown later in Figure The additional information provided for indicates Home Store, Inc. Two items caused this increase: How is this information used in the statement of cash flows? Net income is already included at the top of the operating activities section as shown in Figure Photo courtesy of Rob Enslin, http: Dividend Payments at Microsoft Corporation.

After reviewing its options, the company chose to give much of this cash back to shareholders in the form of cash dividends. Do these types of transactions appear in the statement of cash flows? These exchanges do not involve cash and thus do not appear directly on the statement of cash flows.

However, if the amount is significant, this type of exchange must be disclosed as a separate note below the statement of cash flows or in the notes to the financial statements. Then prepare the financing activities section of the statement of cash flows. Net income is already included at the top of the operating activities section as shown in the solution to Note The financing activities section of the statement of cash flows for Phantom Books is shown as follows:.

What is the fourth and final step needed to complete the statement of cash flows? The final step is to show that the change in cash on the statement of cash flows agrees with the change in cash on the balance sheet. As shown at the bottom of the completed statement of cash flows for Home Store, Inc. Follow the format presented in Figure Recall the dialogue at Home Store, Inc. He asked Linda to investigate and wanted to know how much cash was generated from daily operations during the year.

The group reconvened the following week. As you read the dialogue that follows, refer to Figure As you can see from this dialogue, the statement of cash flows is not only a reporting requirement for most companies, it is also a useful tool for analytical and planning purposes.

Next, we will discuss how to use cash flow information to assess performance and help in planning for the future. Creative Commons supports free culture from music to education.

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Help a Public School. Prepare the Operating Activities Section Question: Adding Back Noncash Expenses Question: Adding Back Losses and Deducting Gains Related to Investing Activities Question: Adding and Subtracting Changes in Current Assets and Current Liabilities Question: Study these two rules carefully: Increases in current assets are deducted from net income; decreases in current assets are added to net income.

Cash Flow Computations - Direct Method

There is an inverse relationship between the change in a current asset account and how it is shown as an adjustment. Increases in current liabilities are added to net income; decreases in current liabilities are deducted from net income. There is a direct relationship between the change in a current liability account and how it is shown as an adjustment.

Key Point Important Current Asset Rule When preparing the operating activities section of the statement of cash flows, increases in current assets are deducted from net income; decreases in current assets are added to net income. Key Point Important Current Liability Rule When preparing the operating activities section of the statement of cash flows, increases in current liabilities are added to net income; decreases in current liabilities are deducted from net income.

Prepare the Investing Activities Section Question: Prepare the investing activities section of the statement of cash flows for Phantom Books. How much cash did Phantom Books use for investing activities during the year? Solution to Review Problem The investing activities section of the statement of cash flows for Phantom Books is shown as follows: Prepare the Financing Activities Section Question: Business in Action Significant Noncash Investing and Financing Activities Question: Prepare the financing activities section of the statement of cash flows for Phantom Books.

How much cash did Phantom Books use for financing activities during the year? The financing activities section of the statement of cash flows for Phantom Books is shown as follows: Reconcile the Change in Cash Question: How much cash did we generate from ongoing operations for the year? That does seem like a huge disparity. Linda, are you sure this is correct? The reason cash from operating activities is so much lower than net income is that accounts receivable and merchandise inventory increased significantly from the beginning of the year to the end of the year.

In fact, both accounts more than doubled. The cash tied up in these two areas is definitely hurting our cash flow. We really struggled to meet our cash budgets for accounts receivable collections and inventory purchases. Operating activities produced positive cash flow in spite of these receivables and inventory issues. Yes, I recall purchasing a new forklift—the old one was a safety hazard—and purchasing long-term investments at the beginning of the year when our cash balance was on the high side.

Looking back, we probably should have financed the equipment rather than having paid for it all at once. What else can you tell us, Linda? I realize the board felt cash levels were high enough during to warrant a large dividend payment in , but we need to cut way back on these dividends in the future. This provides the information we need to improve cash flow going forward.

Key Takeaway The statement of cash flows is prepared using the four steps described in the previous segment. In step 1, the indirect method starts with net income in the operating activities section and makes three types of adjustments to convert net income to a cash basis. The first adjustment is adding back expenses that do not affect cash, such as depreciation. The second adjustment is adding back losses and deducting gains related to investing activities. The third adjustment is adding and subtracting changes in current assets except cash and current liabilities using the adjustment rules.

Step 4 shows that the change in cash on the statement of cash flows agrees with the change in cash on the balance sheet.