Example Exercise 2 Two Methods Cash Flows from Operating Activities Direct Method Indirect Method A company can choose from two alternative methods for reporting cash flows from operating activities [CLICK] The direct method or [CLICK] the indirect method. The direct method reports operating cash inflows and outflows [CLICK] as shown while the indirect method starts with net income and [CLICK] adjusts it for revenues and expenses that do not involve the payment or receipt of cash.

Example Exercise 2 The Indirect Method It is important to know whether a company uses the direct or indirect method of determining their net cash flow from operating activities…

Example Exercise 2 The Indirect Method …the results will be the same. However, as you can see, the way they report the cash flows are different.

Example Exercise 2 The Indirect Method An income statement for Rundell Inc. is shown. Notice that net income is $108,000 [CLICK]. Recall that we mentioned earlier that cash flows from operating activities are cash flows that affect the net income of a company.

Example Exercise 2 The Indirect Method Now, let’s look at the partial statement of cash flows for Rundell Inc. as shown. Notice that net cash flow from operating activities is $100,500 [CLICK] which is different than the net income shown on the income statement of $108,000. The reason for the difference is that the income statement is prepared on an accrual basis. In order to determine net cash flow, we need to convert net income to a cash basis. We do this by making adjustments to net income.

Example Exercise 2 The Indirect Method Let’s look at some of the detailed steps involved in converting net income to a cash basis using the indirect method.

Example Exercise 1 The Indirect Method The first step includes adding expenses that do not affect cash. These expenses decrease net income but do not involve cash payments. Examples of these types of expenses include depreciation of fixed assets and amortization of intangible assets.

Example Exercise 2 The Indirect Method The second step involves losses and gains on disposal of assets. Since the disposal of noncurrent assets is an investing activity rather than an operating activity, we need to eliminate these amounts from cash flow from operating activities. Gains on disposal of assets increase net income; therefore, we need to subtract gains. Losses on disposal of assets have the opposite effect, they decrease net income. Therefore, we need to add losses back to net income.

Example Exercise 2 The Indirect Method We’ll look at step 3, changes in current operating assets and liabilities in the next example exercise.

Example Exercise 2 For now we’ll just focus on steps one and two in this example exercise. Let’s assume that the only adjustments that affect net cash flows from operating activities for Omni Corporation are for depreciation [click], amortization, [click] and a gain on the sale of land [click]. We need to start with net income of $50,000 [CLICK].

Example Exercise 2 Accumulated depreciation increased by $12,000. Depreciation expense is an increases to accumulated depreciation so we know that depreciation expense is $12,000. Because it is a deduction from net income but doesn’t involve a cash payment, we need to add $12,000 to net income [CLICK] to calculate net cash flow from operating activities.

Example Exercise 2 Similar to depreciation, amortization of patents of $3,400 is added back [CLICK]] since it is a deduction from net income but doesn’t involve a cash payment.

Example Exercise 2 The gain on sale of land is deducted [CLICK] from net income since it represents an investing activity and isn’t included in calculating net cash from operating activities[click] of $61,300.

Example Exercise 2  For Practice: PE 2A, PE 2B Refer to Practice Exercises PE 2A and PE 2B to practice making adjustments to net income using the indirect method.  For Practice: PE 2A, PE 2B