The content is not intended as advice for a specific accounting situation or as a substitute for professional advice from a licensed CPA.
Notice that the bottom line is the same, it’s just the method of getting there that is different.The content provided on and accompanying courses is intended for educational and informational purposes only to help business owners understand general accounting issues. Now let’s compare it again to the direct method: Rumble Corp. Subcategory, Cash flows from operating activitiesĪdjustments to reconcile net income to net cash provided by operating activities: We can then create the operating section of the statement of cash flows: Rumble Corp. Income taxes payable increased by $18 (add back).Wages payable increase by $80 (add back).Accounts payable increased by $32 (add back).Gain on the sale of equipment $90 (subtract from accrual basis net income because it was a non-cash revenue and the actual proceeds will be reported in the investing section).Accounts receivable decreased by $15 (add back).Depreciation expense was $125 (add back to net income because it was a non-cash expense used to compute accrual basis net income).Here is the income statement for Rumble Corp.: RUMBLE CORPĪnd the comparative balance sheets: RUMBLE CORPĪnd here is the information we need to complete the cash flows from operations section of the statement of cash flows (all numbers represent millions of dollars): Net cash provided by Operating Activities – INCREASE in Current Assets (other than cash) + DECREASE in Current Assets (other than cash) + Amortization, depletion (from income statement) + Depreciation Expense (from income statement) (For example, a company not only paid for insurance expense but also paid cash to increase prepaid insurance.) The effect on cash flows is just the opposite for decreases in these other current assets. When a prepaid expense increases, the related operating expense on a cash basis increases. When inventory increases, cost of goods sold on a cash basis increases (increasing cash outflow). Thus, when accounts receivable increases, sales revenue on a cash basis decreases (some customers who bought merchandise have not yet paid for it).
Since the cash will be accounted for in later cash flow sections we want to remove the effect from net income so any accrual-basis losses will be added back to net income.Īs a general rule, an increase in a current asset (other than cash) decreases cash inflow or increases cash outflow. The same process would apply to losses on sales of long term assets or retirement of debt. Therefore, Rumble subtracts the gain from net income in converting net income to cash flows from operating activities. The difference between the book value of $60 and the cash received $150 is the gain of $90 which was reported on the income statement but is not a cash item. The cash would be reported in the investing section as proceeds from the sale of a long term asset. The equipment had a cost basis of $160 and had accumulated depreciation of $100. To illustrate the add back of losses from disposals of noncurrent assets, assume that Rumble Corp. The items added back include amounts of depletion that were expensed, amortization of intangible assets such as patents and goodwill, and losses from disposals of long term assets or retirement of debt. Positive cash flows from operating activitiesĬompanies may add other expenses and losses back to net income because they do not actually use company cash in addition to depreciation. Company B had a net loss for the year of $4,000 but after deducting $10,000 of depreciation, it had $6,000 of positive cash flows from operating activities, as shown here:Īdd depreciation expense (which did not require use of cash) Thus, Company A had $30,000 of positive cash flows from operating activities. Company A had net income for the year of $20,000 after deducting depreciation of $10,000, yielding $30,000 of positive cash flows. Under the indirect method, since net income is a starting point in measuring cash flows from operating activities, depreciation expense must be added back to net income.Ĭonsider the following example. Because accountants deduct depreciation in computing net income, net income understates cash from operations. This transaction has no effect on cash and, therefore, should not be included when measuring cash from operations. The journal entry to record depreciation debits an expense account and credits an accumulated depreciation account. The most common example of an operating expense that does not affect cash is depreciation expense.
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