BUS103: Introduction to Financial Accounting

Cash flows from operating activities show the net amount of cash received or disbursed during a given period for items that normally appear on the income statement. You can calculate these cash flows using either the direct or indirect method. The direct method deducts from cash sales only those operating expenses that consumed cash. This method converts each item on the income statement directly to a cash basis. Alternatively, the indirect (addback) method starts with accrual basis net income and indirectly adjusts net income for items that affected reported net income but did not involve cash.

The Statement of Financial Accounting Standards No. 95 encourages use of the direct method but permits use of the indirect method. Whenever given a choice between the indirect and direct methods in similar situations, accountants choose the indirect method almost exclusively. The American Institute of Certified Public Accountants reports that approximately 98 percent of all companies choose the indirect method of cash flows.

The direct method converts each item on the income statement to a cash basis. For instance, assume that sales are stated at USD 100,000 on an accrual basis. If accounts receivable increased by USD 5,000, cash collections from customers would be USD 95,000, calculated as USD 100,000 - USD 5,000. The direct method also converts all remaining items on the income statement to a cash basis, as we will illustrate later.

The indirect method adjusts net income (rather than adjusting individual items in the income statement) for (1) changes in current assets (other than cash) and current liabilities, and (2) items that were included in net income but did not affect cash.

The most common example of an operating expense that does not affect cash is depreciation expense. The journal entry to record depreciation debits an expense account and credits an accumulated depreciation account. This transaction has no effect on cash and, therefore, should not be included when measuring cash from operations. Because accountants deduct depreciation in computing net income, net income understates cash from operations. 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.

Consider the following example. Company A had net income for the year of USD 20,000 after deducting depreciation of USD 10,000, yielding USD 30,000 of positive cash flows. Thus, Company A had USD 30,000 of positive cash flows from operating activities. Company B had a net loss for the year of USD 4,000 after deducting USD 10,000 of depreciation. Although Company B experienced a loss, it had USD 6,000 of positive cash flows from operating activities, as shown here:

Company B's loss would have had to exceed USD 10,000 to generate negative cash flows from operating activities.

Companies add other expenses and losses back to net income because they do not actually use company cash; they call these addbacks noncash charges or expenses. Besides depreciation, the items added back include amounts of depletion that were expensed, amortization of intangible assets such as patents and goodwill, amortization of discount on bonds payable, and losses from disposals of noncurrent assets.

An accounting perspective:
Business insight

Certain revenues and gains included in arriving at net income do not provide cash; these items are noncash credits or revenues. Quick should deduct these revenues and gains from net income to compute cash flows from operating activities. Such items include gains from disposals of noncurrent assets, income from investments carried under the equity method, and amortization of premiums on bonds payable.

To illustrate why we deduct the gain on the disposal of a noncurrent asset from net income, assume that Quick sold the equipment just mentioned for USD 9,000. The journal entry to record the sale is:

Quick shows the USD 9,000 inflow from the sale of the equipment on its statement of cash flows as a cash inflow from investing activities. Thus, it has already recognized the total USD 9,000 effect on cash (including the USD 2,000 gain) as resulting from an investing activity. Since the USD 2,000 gain is also included in calculating net income, Quick must deduct the gain in converting net income to cash flows from operating activities to avoid double-counting the gain.