Whether you are an investor, a manager, or a taxpayer, you need to understand the difference between cash flows and the accrual basis of accounting.
Accrual-based information is used in determining the profitability and the financial position of a business-especially a business of considerable financial strength. But in evaluating such factors as solvency, type prospects for short-term survival, and the ability of a business to seize investment opportunities, cash flows may be more relevant than accrual-based measurements .Concluding Comments In summary, we urge managers and investors alike to look beyond changes in earnings and cash flows from one period to the next. Consider the factors that cause these changes and how they may affect future operations.
There is more to financial statement analysis than looking at current numbers and short-term trends. The informed decision maker must understand the company ‘s business activities and anticipate the long-term’ effects of its business strategies
THE INDIRECT METHOD
•In a statement of cash flows,:the net cash flows from ,operating activities may be determined by,either the direct method or the indirect method. We previously illustrated both methods using data in our Allison Corporation example. For your convenience, these illustrations are repeated below. (Accrual-based data appear in blue; cash flows are shown in red.)
Comparison of the Direct and Indirect Methods
The two methods of computing net cash flows from operating activities are more similar than they appear at first glance. Both methods are based on the same accounting data and both result in the same net cash flow. Also, the computations underlying both methods are quite’ similar. Both methods convert accrual-based income statement amounts into cash flows by adjusting for changes in related balance sheet accounts. ,
To illustrate the similarity in the computations, look briefly at the formulas for computing the cash inflows and outflows shown under the direct method (pages 562-564). Each formula begins with an income statement amount and then adds -or subtracts the change during the period in related balance sheet accounts. Now look at our illustration of the indirect method.
Notice that this computation also focuses on the net changes during the period in balance sheet accounts. The difference between the two methods lies only in format. However, the two formats provide readers of the statement of cash flows with different types of information That method informs these readers of the nature and dollar amounts of the specific cash ‘inflows and outflows comprising the operating activities of the business,
The indirect method, in contrast, explains why the net cash flows from operating activitifer from other measurement’ofperformance=-net income. ‘Differences Be(Ween Net Income and Net Cash Flows from Operating Activities As previously stated, net cash flows from operating activities differ from net income for’ three major reasons. (Note: In the following discussions we, will assume that both. Income. and net cash flows are positive amounts.)1., Noncash expenses. Some expenses, such as depreciation expense, reduce net income but do not require any.cash outlay during the current period.
2. Timing differences. Revenue and expenses are measured using the concepts of accrual . accounting. Net cash flows, on t~e other hand, reflect the effects of cash transactions. Thus revenue and expenses may be recognized ina different accounting periodfrom .
. the related cash flows.
3. Nonoperating ,~ains andlosses. By definition, net cash flows from operating activities show only the effects of those cash transactions classified us operating activities . . Net income, on the other hand, may include gains and losses relating to investing and financing activities
Reoncillng Net Income with Net Cash Flows
To-acquaint you with the indirect method, we will now discuss some common types of ‘adjustments needed to reconcilenet income with net cash flows from operating activities. The nature and dollar amounts of these adjustments are determined by an accountant using a’ worksheet or a computer program;
they are, not entered in the company’s accounting records. “I. Adjustment for Noncash Expenses Depreciation ‘is an ‘example of a noncash expense-that is, depreciation expense re- ‘duces net income but does not require any cash outlay during the period. (The cash outflow related to depreciation resulted when the asset”was purchased-before any depreciation was ever recognized.)
Thus expenses on the accrual basis exceed cash payments, and net income for the period is less than net cash flows.
To reconcile net income with net cash flows, we. add back to net income the amount of. depreciation and any other noncash expenses. (Othernoncash expenses included unfunded pension expense, amortization of intangible assets, depletion of natured resources, ‘and amortization of bond discount.)
2. Adjust for Timing Differences TIming differences between elements of net income and net cash flows arise whenever revenue or expenses are recognized by debiting or crediting an account other than cash. Changes over the period in the balances of these asset and liability accounts represent differences between the amount of revenue or expenses recognized in the income statement and the net cash flows from operating activities.
The balance sheet accounts that give rise to these timing differences include Accounts Receivable, Inventories, Prepaid Expenses, Accounts Payable, and Accrued Expenses Payable. Let us look separately at the effects of changes in each type of account. Changes in Accounts Receivable Receivables increase as revenue is earned and decrease as cash is collected from customers.
A net increase in Accounts Receivable over the. period indicates that the revenue from credit sales exceeds collections from customers. Part of the revenue recognized increased receivables rather than cash. in our reconciliation of these two amounts, the net increase in Accounts Receivable is deducted from net income to determine cash provided by,revenue transactions.