Question

How to and an example: 1. Prepare Operating activities for the statement of cash flow using indirect method

Answer 1

Statement of Cash Flows From Operating Activities - Indirect Method

Statement of cash flows in a very important part of the financial statements prepared by a business organisation which will details how the cash has come in and the various ways in which the cash has been utilised.

For preparing the cash flow from operating activities, the starting point is the net income of the organization for the period under consideration. The net income needs to be adjusted for any non-cash incomes and expenses accounted during the year. The most important non-cash items in an income statement are the Depreciation/Amortization expense, and gain/loss from sale of fixed assets .

Since there is no cash flow due to depreciation/amortization (this being only a adjustment entry), this needs to be added back to arrive at the actual cash flow.

Similarly, gain/loss does not represent the actual cash flow. This needs to be adjusted for the book value of the assets to arrive at the actual cash flow. Further this cash flow is not due to the regular operations of the business. Hence the gain/loss as adjusted above shall be reflected under cash flow from Investing activities (because this is due to sale of the assets in which the organisation has invested it’s funds).

After adjusting the two non cash items, the next step is to make adjustments for any increase/decrease in the balances of the current assets and liabilities, as these arise due to the normal operations of the organization.

The following examples will clarify the issue.

Example 1.Let us consider the following figures.

Sales                           $100,000

  Cost of goods sold     $40,000

Expenses                     $30,000 (including depreciation od $10,000)

Net income    $30,000

Beginning balance of accounts receivable     $10,000

Ending balance of accounts receivable           $15,000

The actual cash receipts from sale will be   : Beginning A/R + Sales – Ending A/R

                                                                                10,000 + 100,000 – 15,000 = 95,000

The increase in A/R has resulted in the actual cash flow from sales being less than the actual sales.

Therefore we can say that increase in A/R will reduce the cash flow .

Therefore this adjustment needs to be made to the net income to arrive at the actual cash flow.

Similarly regarding the expenses , we can prove that any increase assets is reducing the cash inflow and any increase in current liabilities increases the cash flows.

The actual cash flow from operations is arrived at after making the adjustments as mentioned above.

A sample statement of cash flow from operations is given below for understanding the preparation of the statement.

Cash flow from operating activities
Net income		312000
Adjustment for items not affecting cash
Depreciation for the year *	25000
Amortization of patents	4000
Gain on sale of investments	-6000
Gain on sale of equipment	-4000
Adjustment for changes in working capital
Increase in accounts receivable	-32000
Increase in inventory	-14000
Decrease in prepaid expense	8000
Decrease in accounts payable	-13000
Decrease in accrued liabilities	-14000
Increase in taxes payable	14000	-32000
Net cash flow from operating activities		280000