I'm Larry Walther.
This is principlesofaccounting.com Chapter 16 on the Statement of Cash Flows.
And this segment's going to look at the indirect approach to preparing
the Statement of Cash Flows.
A previous module looked at the direct approach.
And these methods are very close, but there are important differences.
To begin with, the operating cash flows, the calculation of cash flows from
operating activities with the indirect approach is based upon essentially,
the reconciliation format that was supplemental to the direct approach.
So rather than presenting in the statement itself, rather than presenting cash
received from customers, cash paid to suppliers, cash paid to wages and so on.
We'll start with the income of the business.
Here I chose to start with net income.
We might start with a different measure of income in some cases but for
illustration, we'll start with net income in this case.
And you can see, we have various adjustments.
Adds and subtracts they come up with $800,000 cash from operating activities.
This is exactly the same amount that we came up with under the direct approach but
calculated in a different fashion.
And so let's consider why we would be adding and
subtracting things to come up with operating cashflows.
If we look at depreciation expense of $120,000 here,
recognize that that is a non-cash expense.
Depreciation is a calculated amount.
>From a journal entry point of view,
we debit depreciation expense and credit accumulated depreciation.
There's no cash moving in that case, but it reduces net income.
So in that sense, depreciation reduces income, but it doesn't use up any cash.
Hence, we would need to add it back as one specific example.
So, I say the depreciation added back to net income.
It reduced income, but did not consume any cash.
If we look at the gain on sale of land that I'm included, it's being subtracted.
And that may seem odd.
You may say well wait a minute, why are you subtracting a gain?
Well for one thing, the gain increased income but it's not related to operations.
This is an operating activity section, and so
the only thing in net income related to the sale transaction is
the gain in this case or it could have been a reduction for a loss.
But we're trying essentially purge it from the operating activity section so
we would subtract the gain, add back the loss.
That devoids the operating activity section of
any measures related to this transaction.
However, the furtherance of this transaction is to consider that
the total amount of cash that was received from the sale was reported
as an investing activity.
A cash flow from an investing activity.
We discussed this in the last module, but I'll restate it here.
Consider this, if you sold your car for $10,000 and
let's say your car had a cost of $7000.
You would have had $3000 gain on that car, but
it would have generated $10000 of cash.
All you want to measure in the cash flow stipend is a total of $10000.
That would be reported in the cash flows from investing activities section of
the $10000 inflow.
We would not also want to include the gain in the operating activity section,
because we would be in essence double counting part of the transaction.
Let's think about increases in accounts receivable.
There was one of those in a particular problem, and we subtracted it.
Why would we subtract an increase in accounts receivable?
Very simply, it represents sales on accounts that have not been collected.
Sales drive up income, but until we collect the receivable, we have no cash.
So we'll need to subtract an increase of accounts receivable.
Conversely, we would add back a decrease supposing that those receivables are being
collected in the subsequent period without any further effects on income.
Other adjustments, we have a decrease in inventory that's added.
It's a bit more complex but we can state it very simply.
It represents costs of sales that are generated from existing inventories
not through the new purchase of additional inventory.
Increase in accounts payable are added.
These are essentially expenses that we're not paying yet.
decreases in wage payable was subtracted.
These are essentially cash outflows to pay wages that were expensed or
accrued in a previous accounting period.
And so, there are many other scenarios I could cite where we
could have potential adjustments, adds and subtracts, but
this grid might prove helpful in having you think about this.
For our current assets that increase, we'll generally subtract those.
That would be for example, if we had an increase in accounts receivabl.
It represents again sales we have not collected so
we'll subtract it in reconciling income to cash from operating activities.
Conversely, current assets that decrease we add.
And when we go the other side to the balance sheet, current liabilities that
increase are added and current liabilities that decrease are subtracted.
So as you dig your homework and examination questions,
if you can reconstruct one or two and build your grid up and
then you use that to kinda help you remember how it flows.
It's always a converse effect, whether it's increase or
decrease or current asset or current liabilities.
A very helpful little helpful little tool to get you through the problems with all
the right adds and subtracts.
Now let me speak about the Indirect Approach.
We've seen the reconciliation of income to cash from operating activities.
The statement of cash flows can be prepared under a direct approach
which is the recommended and preferred approach under the accounting standards.
Or an alternative indirect approach which at this time,
more companies still use an indirect approach by a considerable margin.
Some companies don't have the information systems to allow them to accurately get
to that direct Cash flow statement.
Other companies argue that the direct cash flows can be misleading.
If you're a financial institution with a lot of cash in flow and
out flow, it may not be reflective of the earning process, so
much as an indirect approach might be a better presentation or viewed as a better
presentation of the information that describes the cash flows of the entity.
Anyway, when the Indirect Approach is used under the Indirect Approach,
the operating cash flows are presented as a reconciliation of the income
to cash from operating activities.
And here's a statement of cash flows.
Here is the fist section, the cash from operating activities.
We have the net income plus and minus the various adjustments.
This is what we saw in the earlier slide.
The $800,000 net cash provided by operating activities.
The cash flow from investing activities is identical to what it was
with the direct approach from the previous module
as there is the cash flows from financing activities.
Lastly, though when you present an indirect approach there's one
additional disclosure requirement in the United States.
You have to supplement your indirect approach with cash paid for interest, and
cash paid for taxes.
Essentially, those are direct approach presentations of the amounts paid for
interest and taxes,
supplemental to the primary cash flow information under the direct approach.