Net income is computed using accrual accounting, which
recognizes revenues when earned and expenses when incurred. Revenues and
expenses do not necessarily reflect the receipt and payment of cash.
The indirect method of computing and reporting net cash flows from
operating activities involves adjusting the net income figure to obtain
the net cash provided or used by operating activities. This includes
subtracting noncash increases (credits) from net income and adding
noncash charges (debits) back to net income.
Point: Noncash credits refer to revenue amounts reported on the income statement that are not collected in cash this period. Noncash charges refer to expense amounts reported on the income statement that are not paid this period.
To
illustrate, the indirect method begins with Genesis’s net income of
$38,000 and adjusts it to obtain net cash provided by operating
activities of $20,000. Exhibit 16.11
shows the results of the indirect method of reporting operating cash
flows, which adjusts net income for three types of adjustments. There
are adjustments to ① reflect changes in noncash current assets and
current liabilities related to operating activities, ② to income
statement items involving operating activities that do not affect cash
inflows or outflows, and ③ to eliminate gains and losses resulting from
investing and financing activities (not part of operating activities).
This section describes each of these adjustments.
| EXHIBIT 16.11 | Statement of Cash Flows— Indirect Method |
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① Adjustments for Changes in Current Assets and Current Liabilities This section describes adjustments for changes in noncash current assets and current liabilities.
Adjustments for changes in noncash current assets. Changes
in noncash current assets normally result from operating activities.
Examples are sales affecting accounts receivable and building usage
affecting prepaid rent. Decreases in noncash current assets yield the
following adjustment:
Decreases in noncash current assets are added to net income.
To
see the logic for this adjustment, consider that a decrease in a
noncash current asset such as accounts receivable suggests more
available cash at the end of the period compared to the beginning. This
is so because a decrease in accounts receivable implies higher cash
receipts than reflected in sales. We add these higher cash receipts
(from decreases in noncash current assets) to net income when computing
cash flow from operations.
Point:
Operating activities are typically those that determine income, which
are often reflected in changes in current assets and current
liabilities.
In contrast, an increase in noncash
current assets such as accounts receivable implies less cash receipts
than reflected in sales. As another example, an increase in prepaid rent
indicates that more cash is paid for rent than is deducted as rent
expense. Increases in noncash current assets yield the following
adjustment:
Increases in noncash current assets are subtracted from net income.
To illustrate, these adjustments are applied to the noncash current assets in Exhibit 16.10.
Accounts receivable. Accounts receivable
increase
$20,000, from a beginning balance of $40,000 to an ending balance of
$60,000. This increase implies that Genesis collects less cash than is
reported in sales. That is, some of these sales were in the form of
accounts receivable and that amount increased during the period. To see
this it is helpful to use
account analysis. This usually involves
setting up a T-account and reconstructing its major entries to compute
cash receipts or payments. The following reconstructed Accounts
Receivable T-account reveals that cash receipts are less than sales:
We
see that sales are $20,000 greater than cash receipts. This $20,000—as
reflected in the $20,000 increase in Accounts Receivable—is subtracted
from net income when computing cash provided by operating activities
(see Exhibit 16.11).
Merchandise inventory. Merchandise inventory
increases
by $14,000, from a $70,000 beginning balance to an $84,000 ending
balance. This increase implies that Genesis had greater cash purchases
than cost of goods sold. This larger amount of cash purchases is in the
form of inventory, as reflected in the following account analysis:
Point: Refer to Exhibit 16.10 and identify the $5,000 change in cash. This change is what the statement of cash flows explains; it serves as a check.
The amount by which purchases exceed cost of
goods sold—as reflected in the $14,000 increase in inventory—is
subtracted from net income when computing cash provided by operating
activities (see Exhibit 16.11).
Prepaid expenses. Prepaid Expenses
increase
$2,000, from a $4,000 beginning balance to a $6,000 ending balance,
implying that Genesis’s cash payments exceed its recorded prepaid
expenses. These higher cash payments increase the amount of Prepaid
Expenses, as reflected in its reconstructed T-account:
The
amount by which cash payments exceed the recorded operating expenses—as
reflected in the $2,000 increase in Prepaid Expenses—is subtracted from
net income when computing cash provided by operating activities (see Exhibit 16.11).
Adjustments for changes in current liabilities. Changes
in current liabilities normally result from operating activities. An
example is a purchase that affects accounts payable. Increases in
current liabilities yield the following adjustment to net income when
computing operating cash flows:
Increases in current liabilities are added to net income.
To
see the logic for this adjustment, consider that an increase in the
Accounts Payable account suggests that cash payments are less than the
related (cost of goods sold) expense. As another example, an increase in
wages payable implies that cash paid for wages is less than the
recorded wages expense. Since the recorded expense is greater than the
cash paid, we add the increase in wages payable to net income to compute
net cash flow from operations.
Conversely, when current liabilities decrease, the following adjustment is required:
Decreases in current liabilities are subtracted from net income.
To illustrate, these adjustments are applied to the current liabilities in Exhibit 16.10.
Accounts payable. Accounts payable
decrease
$5,000, from a beginning balance of $40,000 to an ending balance of
$35,000. This decrease implies that cash payments to suppliers exceed
purchases by $5,000 for the period, which is reflected in the
reconstructed Accounts Payable T-account:
The
amount by which cash payments exceed purchases—as reflected in the
$5,000 decrease in Accounts Payable—is subtracted from net income when
computing cash provided by operating activities (see Exhibit 16.11).
Interest payable. Interest payable
decreases
$1,000, from a $4,000 beginning balance to a $3,000 ending balance.
This decrease indicates that cash paid for interest exceeds interest
expense by $1,000, which is reflected in the Interest Payable T-account:
The
amount by which cash paid exceeds recorded expense—as reflected in the
$1,000 decrease in Interest Payable—is subtracted from net income (see Exhibit 16.11).
Income taxes payable. Income taxes payable
increase
$10,000, from a $12,000 beginning balance to a $22,000 ending balance.
This increase implies that reported income taxes exceed the cash paid
for taxes, which is reflected in the Income Taxes Payable T-account:
The
amount by which cash paid falls short of the reported taxes expense—as
reflected in the $10,000 increase in Income Taxes Payable—is added to
net income when computing cash provided by operating activities (see Exhibit 16.11).
② Adjustments for Operating Items Not Providing or Using Cash The
income statement usually includes some expenses that do not reflect
cash outflows in the period. Examples are depreciation, amortization,
depletion, and bad debts expense. The indirect method for reporting
operating cash flows requires that
Expenses with no cash outflows are added back to net income.
To
see the logic of this adjustment, recall that items such as
depreciation, amortization, depletion, and bad debts originate from
debits to expense accounts and credits to noncash accounts. These
entries have
no cash effect, and we add them back to net income
when computing net cash flows from operations. Adding them back cancels
their deductions.
Similarly, when net income includes
revenues that do not reflect cash inflows in the period, the indirect
method for reporting operating cash flows requires that
Revenues with no cash inflows are subtracted from net income.
We apply these adjustments to the Genesis operating items that do not provide or use cash.
Depreciation. Depreciation
expense is the only Genesis operating item that has no effect on cash
flows in the period. We must add back the $24,000 depreciation expense
to net income when computing cash provided by operating activities. (We
later explain that any cash outflow to acquire a plant asset is reported
as an investing activity.)
③ Adjustments for Nonoperating Items Net
income often includes losses that are not part of operating activities
but are part of either investing or financing activities. Examples are a
loss from the sale of a plant asset and a loss from retirement of notes
payable. The indirect method for reporting operating cash flows
requires that
Nonoperating losses are added back to net income.
To
see the logic, consider that items such as a plant asset sale and a
notes retirement are normally recorded by recognizing the cash, removing
all plant asset or notes accounts, and recognizing any loss or gain.
The cash received or paid is not part of operating activities but is
part of either investing or financing activities.
No operating
cash flow effect occurs. However, because the nonoperating loss is a
deduction in computing net income, we need to add it back to net income
when computing cash flow from operations. Adding it back cancels the
deduction.
Point: An income
statement reports revenues, gains, expenses, and losses on an accrual
basis. The statement of cash flows reports cash received and cash paid
for operating, financing, and investing activities.
Similarly,
when net income includes gains not part of operating activities, the
indirect method for reporting operating cash flows requires that
Nonoperating gains are subtracted from net income.
To illustrate these adjustments, we consider the nonoperating items of Genesis.
Loss on sale of plant assets. Genesis
reports a $6,000 loss on sale of plant assets as part of net income.
This loss is a proper deduction in computing income, but it is
not part of op-erating activities.
Instead, a sale of plant assets is part of investing activities. Thus,
the $6,000 nonoperating loss is added back to net income (see Exhibit 16.11). Adding it back cancels the loss. We later explain how to report the cash inflow from the asset sale in investing activities.
Gain on retirement of debt. A $16,000 gain on retirement of debt is properly included in net income, but it is
not part of operating activities.
This means the $16,000 nonoperating gain must be subtracted from net
income to obtain net cash provided by operating activities (see Exhibit 16.11). Subtracting it cancels the recorded gain. We later describe how to report the cash outflow to retire debt.
Summary of Adjustments for Indirect Method
Exhibit 16.12
summarizes the most common adjustments to net income when computing net
cash provided or used by operating activities under the indirect
method.
| EXHIBIT 16.12 | Summary of Selected Adjustments for Indirect Method |
* Excludes current portion of long-term debt and any (nonsales-related) short-term notes payable—both are financing activities. |
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The
computations in determining cash provided or used by operating
activities are different for the indirect and direct methods, but the
result is identical. Both methods yield the same $20,000 figure for cash
from operating activities for Genesis; see Exhibits 16.7 and 16.11.
compute the net increase or decrease in cash; 
compute and report the net cash provided or used by operating
activities (using either the direct or indirect method; both are
explained); 
compute and report the net cash provided or used by investing activities; 
compute and report the net cash provided or used by financing activities; and 
compute the net cash flow by combining net cash provided or used by operating, investing, and financing activities and then prove it by adding it to the beginning cash balance to show that it equals the ending cash balance.
