The balance in the Inventory account-increases as merchandise
is purchased and decreases as goods are sold.
A net increase in the Inventory account during the period indicates that purchases during the period exceed the cost of goods sold Reconciliation net income with net cash flows, we deduct from net-income the amount of these additional purchases (the net increase in the balance of the Inventory account).
A-net decrease in the balance of the Inventory account over the period indicates that the cost of goods sold (reported in the income statement) exceeds purchases made during the period.
To the extent that the cost of goods sold’ consists ‘of a decrease in Inventory, no cash payment is required in the current period. Therefore, we .add :to net income the amount of a ‘net decrease in Inventory.
Changes In Prepaid Expenses Prepaid Expenses appear in Ute financial statements as assets, Increases in these assets result from cash payments, ‘and decreases result from ‘” expiring amounts being recognized as expenses of the’ period.
A,net increase over the ,period in the amount of Prepaid Expenses indicates that cash payments made for these items .exceeded the amounts recognized as expense. In determining net cash flows from operating activities, we deduct from net income the net increase in a company’s. Prepaid, Expenses.
A net decrease in Prepaid Expenses indicates that shoutlays during the period were ,less than the amounts deducted as expense in the computation of net income. A net decrease in Prepaid Expenses is added back to net income amanuenses Accounts Payable Accounts Payable are reached by purchases on account arid are reduced by cash payments to suppliers.
A net increase in Accounts Payable indicates that the-accrual-based figure for purchases, which is included in.the cost of goods sold, is greater than the cash payments made to suppliers. Therefore, in converting net income to cash flows, we add back the amount of merchandise purchases financed by a ‘net increase’ in Accounts Payable.
A netdecrease in Accounts Payable indicates that cash, payments to suppliers exceed , the Plrhases madeduring the period. Thus a net decrease in Accounts’ Payable.is subtracted from net income in the computation of, net cssh flows. Changes In Accrued Expenses Payable The liability for;Accrued Expenses Payable in creases with the recognition of expenses that ‘Will be paid in the future anddecreasesas cash payments are made.
A net increasein Accrued Expenses Payable indicates that expenses in the period exceed the related cash payments:’ Thus net income is’less than het cash flows, and the increase in the Accrued Expenses Payable account should be added ,’ to net income. A net decrease in Accrued Expenses Payable indicates that cash payments exceed the related amounts of expense, This decrease, therefore.Js subtracted from net income. ,
The liability Deferred Income Taxes may be viewed as a long-term accrued expense , payable; However, in the reconciliation of net income with net cash flows-from operating activities, the change in the liability Deferred Income Taxes is shown separately from the net.change in other accrued expenses payable.
A net increase in this liability is added to-net income; a net decrease is subtracted. A Helpful, Hint Based,on Oeblts and Credits In preceding discussion, we explained, why increases and decreases in a number of asset and liability accounts represent differences between the net income and net cash flows ‘for the period.
We, do not expect you to memorize the effects of all of these changes. Rather, we hope that you will, identify the types of transactions that cause a given account balance to increase or decrease and will then evaluate the effects of these transactions on net income and net cash flows.This type of analysis will enhance your understanding of the relationships between accrual accounting and cash transactions .
However, let us offer you a quick hint. Double-entry accounting provides a simple rule that will let you check your analysis, For those asset and liability accounts that explain timing differences between net income and net cash flows, a net credit change in the account’s balance« is always added to net income,’ a net debit change is always subtracted.
(For practice, test this rule on the adjustments in the summary of the indirect method nonappearance,.It applies to every adjustment that describes an increase or decrease in a balance sheet account.)3. Adjusting for Non operating Gains and Losses Non-operating gains and losses include gains and losses from sales of investments, ,plant assets, and discontinued operations (which relate to investing activities); and gains ,and losses on early retirement of-debt (which relate to financing activities) In a statement of cash flows, cash flows are classified as operating activities, investing activities, financing activities. Nonoperating gains and losses, by definition, do not affect operating activities. However, these gains and losses do enter into the determination of net income.
Therefore, in converting net in come to net cash flows from operating. activities, we add back any non operating losses and deduct any non operating gains included in net income. The full cash effect of the transaction is then presented as aD investing activity (for example, sale of a building) or as a financing activity (for example, retirement of debt) in the statement of cash flows.
The Indirect Method: A Summary
The adjustrrients to net income explained in our p~ng discussion are summarized as follows: I~dlrect Method May Be Required In a Supplem’entary Schedule The FASB recommends use of the direct method in presenting net cash flows from operating activities. The vast majority of companies. however, elect to use the indirect method.
One reason is that the FASB requires companies opting for the direct method to meet an additional reporting requirement. Companies using the direct method are required to provide a supplementary schedule illustrating the computation of net cash flows from operating activities by the indirect method.
However, no supplementary computations are required of companies that present the indirect method computations in their cash flow statements. In the opinion of theauthors, this reporting requirement severely undermines the FASB’s efforts to encourage use of the direct method