When using the indirect method of preparing the statement of cash flows?

Question: 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. Home Store, Inc., had net income of $124,000 in 2012. 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?

Answer: 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 12.4 "Operating Activities Format and Adjustments", which also displays the format used for the operating activities section of the statement of cash flows. Examine this figure carefully.

Adjustment Three: Adding and Subtracting Changes in Current Assets and Current Liabilities

Question: What is the third type of adjustment necessary to convert net income to a cash basis?

Answer: 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 12.3 "Balance Sheet and Income Statement for Home Store, Inc.". Two important rules must be followed to determine how the change is reflected as an adjustment to net income. Study these two rules carefully:

1. Current assets. Increases in current assets are deducted from net income; decreases in current assets are added to net income. (There is an inverse relationship between the change in a current asset account and how it is shown as an adjustment.)
2. Current liabilities. 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.)

Now let’s work through each current asset and current liability line item shown in the balance sheet (Figure 12.3 "Balance Sheet and Income Statement for Home Store, Inc.") and use these rules to determine how each item fits into the operating activities section as an adjustment to net income.

The first current asset line item, cash, shows the change in cash from the beginning of the year to the end of year. Cash decreased by $98,000. The goal of the statement of cash flows is to show what caused this $98,000 decrease. 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.

Accounts receivable (current asset) increased by $60,000. The current asset rule states that increases in current assets are deducted from net income. Thus $60,000 is deducted from net income in the operating activities section of the statement of cash flows. Here’s why.

Assume all Home Store’s sales shown on the income statement are credit sales (each sale required a debit to accounts receivable and a credit to sales). The beginning accounts receivable balance of $25,000 is increased by $900,000 for credit sales made during the year, resulting in $925,000 in total receivables to be collected. Since $85,000 in accounts receivable remains at the end of the year, $840,000 in cash was collected (= $925,000 − $85,000). On a cash basis, Home Store, Inc., should show $840,000 in revenue rather than $900,000. Thus net income must be reduced by $60,000 (= $900,000 revenue using accrual basis − $840,000 revenue using cash basis). The accounts receivable T-account shown in the following provides further clarification.

Here’s how the accounts receivable adjustment to net income appears in the operating activities section of the statement of cash flows for Home Store, Inc.:

We will continue analyzing each current asset and current liability item in the balance sheet shown in Figure 12.3 "Balance Sheet and Income Statement for Home Store, Inc." and present the resulting adjustments and completed operating activities section at the end of our analysis in Figure 12.5 "Operating Activities Section of Statement of Cash Flows (Home Store, Inc.)".

Merchandise inventory (current asset) increased by $66,000. Because the current asset rule states that increases in current assets are deducted from net income, $66,000 is deducted from net income in the operating activities section of the statement of cash flows. To explain why, let’s assume Home Store, Inc., pays cash for all purchases of merchandise inventory. If the merchandise inventory account increases over time, more goods are purchased than are sold. Because merchandise inventory at Home Store, Inc., increased $66,000 and cost of goods sold totaled $546,000 (as shown in Figure 12.3 "Balance Sheet and Income Statement for Home Store, Inc."), the company must have purchased inventory with a cost of $612,000 during the period (= $66,000 + $546,000). Thus more cash was paid for merchandise ($612,000) than was reflected on the income statement as cost of goods sold ($546,000). If expenses are higher using a cash basis, the adjustment must decrease net income. Therefore $66,000 is deducted from net income in the operating activities section of the statement of cash flows. This information is summarized in the merchandise inventory T-account in the following.

Prepaid expenses (current asset) decreased by $2,000. Because the current asset rule states that decreases in current assets are added to net income, $2,000 is added to net income in the operating activities section of the statement of cash flows. This is because cash paid for these expenses was lower than the expenses recognized on the income statement using the accrual basis. Since expenses are $2,000 lower using the cash basis, net income must be increased by $2,000.

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.

Question: 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?

Answer: The current liability rule is a bit different than the current asset rule as described next.

Accounts payable (current liability) increased by $1,000. Because the current liability rule states that increases in current liabilities are added to net income, $1,000 is added to net income in the operating activities section of the statement of cash flows. An increase in accounts payable signifies that Home Store, Inc., recorded more as an expense on the income statement (accrual basis) than the company paid in cash (cash basis). Since expenses are lower using the cash basis, net income must be increased by $1,000.

Income tax payable (current liability) decreased by $9,000. Because the current liability rule states that decreases in current liabilities are deducted from net income, $9,000 is deducted from net income in the operating activities section of the statement of cash flows. A decrease in income tax payable signifies that Home Store, Inc., paid more for income taxes (cash basis) than the company recorded as an expense on the income statement (accrual basis). Since expenses are higher using the cash basis, net income must be decreased by $9,000.

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.

Question: What does the operating activities section of the statement of cash flows look like for Home Store, Inc.?

Answer: Figure 12.5 "Operating Activities Section of Statement of Cash Flows (Home Store, Inc.)" shows the completed operating activities section of the statement of cash flows for Home Store. Inc. The most important line is at the bottom, which shows cash of $22,000 was generated during the year from daily operations of the business. Notice this amount is significantly lower than the net income amount of $124,000 reported on the income statement. Study Figure 12.5 "Operating Activities Section of Statement of Cash Flows (Home Store, Inc.)" carefully noting the three types of adjustments made to net income.

Figure 12.5 Operating Activities Section of Statement of Cash Flows (Home Store, Inc.)

Review Problem 12.4

Note 12.21 "Review Problem 12.4" through Note 12.25 "Review Problem 12.7" will use the data presented as follows for Phantom Books. 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. Phantom’s most recent balance sheet, income statement, and other important information for 2012 are presented in the following.

Additional data for 2012 include the following:

• Sold equipment with a book value of $8,000 (= $30,000 cost − $22,000 accumulated depreciation) for $12,000 cash
• Purchased equipment for $27,000 cash
• Sold long-term investments with an original cost of $11,000 for $3,000 cash
• Purchased long-term investments for $25,000 cash
• Signed a note with the bank for $5,000 cash. No principal amounts were paid during the year
• Repurchased common stock (treasury stock) for $16,000 cash. No new common stock was issued
• Declared and paid $13,000 in cash dividends

Solution to Review Problem 12.4

1. 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.

   

2. Cash totaling $82,000 was generated from the company’s operating activities during the year.

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.

When using the indirect method to prepare the operating activities section of the statement of cash flows The first amount listed is?

When preparing a statement of cash flows using the indirect method which of the following should not be classified as an operating cash flow?

When using the indirect method to prepare the statement of cash flows the impairment of goodwill should be presented as a n?

When cash flow statement is prepared by using indirect method which part of it is different from the direct method?