The Statement of Cash Flows is prepared using an activity format where items are classified as operating, investing, or financing activities.
Operating activities are normal daily operating activities of running a business. The indirect method of preparing the Statement of Cash Flows adjusts the net income figure to remove noncash revenues and expenses. Also removed are items like gains and losses that are not attributable to the operating activities of the business. In considering changes in current assets and liabilities, it should be remembered that changes in notes receivable and notes payable are not shown as operating section adjustments. Changes in notes receivable is shown in the investing section, while changes in notes payable is shown in the financing section.
The general reconciliation format for the operating section is as follows:
Net Income + Depreciation expense + Losses - Gains - Increases in current assets + Decreases in current assets + Increases in current liabilities - Decreases in current liabilities ----------------------------------- = Cash flows from operating activties =================================== Notes: Rather than memorizing the above format, a few simple examples can help in understanding the logic: 1. Depreciation is a non-cash expense that reduces net income. Therefore, it is added back to put net income on a cash basis. 2. The total cash proceeds from the sale of assets is reported in the investing section of the statement. The effect of gains and losses is removed from net income. Gains are subtractions because they increased net income. Losses are additions because they decreased net income. 3. Consider accounts receivable in regard to current assets. An increase in accounts receivable increases net income because of the associated revenue. However, since no cash is provided, the increase in this current asset is shown as a reduction to put net income on a cash basis. The reverse is true for a decrease in accounts receivable. A collection of accounts receivable provides cash but does not affect net income. Therefore, the decrease in this current asset is an addition to put net income on a cash basis. 4. Consider accounts payable in regard to current liabilities. An increase in accounts payable decreases net income because of the associated expense. However, since no cash is yet paid, the increase in this current liability is shown as an addition to put net income on a cash basis. The reverse is true for a decrease in accounts payable. A payment of accounts payable uses cash but does not affect net income. Therefore, the decrease in this current liability is a subtraction to put net income on a cash basis. Example: Changes in various accounts and gains and losses on the sale of assets during the year for Johnson Company are given below: Item Amount Add Deduct ---------------------------- --------------- ----- ----- Accounts receivable 20,000 decrease X Accrued interest receivable 5,000 increase X Inventory 95,000 increase X Prepaid expenses 2,500 decrease X Accounts payable 30,000 decrease X Accrued liabilities 5,000 increase X Deferred income taxes 15,000 increase X Sale of equipment 9,000 gain X Sale of long-term investments 10,000 loss X
Buying and selling property, plant, and equipment items are classified as investing activities. Also, all investments, (current and long-term) are classified as investing activities whether buying or selling the investment.
Financing activities include transactions affecting long-term liabilities and stockholders' equity accounts, including the payment of cash dividends. Short-term borrowing and repaying of loans is also a financing activity. However, note that payment of interest expense is considered part of operating actitivities. Since net income is already reduced for interest expense, the only adjustment that might be required in the operating section is for changes in interest payable.
Some transactions occur that do not impact cash. These transactions are simply disclosed at the bottom of the Statement of Cash Flows as a disclosure entitled "Significant Noncash Investing and Financing Activities". An example would be the purchase of land by issuing stock.