Net cash flows from operating activities under the indirect method is determined by eliminating

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OPERATING ACTIVITIES

The inflows and outflows of cash that result from activities reported in the income statement are classified as cash flows from operating activitiesinflows and outflows of cash related to transactions entering into the determination of net income.. In other words, this classification of cash flows includes the elements of net income reported on a cash basis rather than an accrual basis.45

Operating activities are inflows and outflows of cash related to the transactions entering into the determination of net operating income.

Cash inflows include cash received from:

1. Customers from the sale of goods or services.
2. Interest and dividends from investments.

These amounts may differ from sales and investment income reported in the income statement. For example, sales revenue measured on the accrual basis reflects revenue earned during the period, not necessarily the cash actually collected. Revenue will not equal cash collected from customers if receivables from customers or unearned revenue changed during the period.

Cash outflows include cash paid for:

1. The purchase of inventory.
2. Salaries, wages, and other operating expenses.
3. Interest on debt.
4. Income taxes.

Likewise, these amounts may differ from the corresponding accrual expenses reported in the income statement. Expenses are reported when incurred, not necessarily when cash is actually paid for those expenses. Also, some revenues and expenses, like depreciation expense, don't affect cash at all and aren't reported in the statement of cash flows.

The difference between the inflows and outflows is called net cash flows from operating activities. This is equivalent to net income if the income statement had been prepared on a cash basis rather than an accrual basis.

Direct and Indirect Methods of Reporting. Two generally accepted formats can be used to report operating activities, the direct method and the indirect method. Under the direct method,the cash effect of each operating activity (i.e., income statement item) is reported directly on the statement of cash flows. the cash effect of each operating activity is reported directly in the statement. For example, cash received from customers is reported as the cash effect of sales activities. Income statement transactions that have no cash flow effect, such as depreciation, are simply not reported.

By the direct method, the cash effect of each operating activity is reported directly in the SCF.

By the indirect methodthe net cash increase or decrease from operating activities is derived indirectly by starting with reported net income and working backwards to convert that amount to a cash basis., on the other hand, we arrive at net cash flow from operating activities indirectly by starting with reported net income and working backwards to convert that amount to a cash basis. Two types of adjustments to net income are needed. First, components of net income that do not affect cash are reversed. That means that noncash revenues and gains are subtracted, while noncash expenses and losses are added. For example, depreciation expense does not reduce cash, but it is subtracted in the income statement. To reverse this, then, we add back depreciation expense to net income to get back to the amount that we would have had if depreciation had not been subtracted.

By the indirect method, cash flow from operating activities is derived indirectly by starting with reported net income and adding or subtracting items to convert that amount to a cash basis.

To contrast the direct and indirect methods further, consider the example in Illustration 4-10.

Direct Method. Let’s begin with the direct method of presentation. We illustrated this method previously in Chapter 2. In that chapter, specific cash transactions were provided and we simply included them in the appropriate cash flow category in the SCF. Here, we start with account balances, so the direct method requires a bit more reasoning.

From the income statement, we see that ALC’s net income has four components. Three of those—service revenue, administrative expenses, and income tax expense—affect cash flows, but not by the accrual amounts reported in the income statement. One component—depreciation—reduces net income but not cash; it’s simply an allocation over time of a prior year’s expenditure for a depreciable asset. So, to report these operating activities on a cash basis, rather than an accrual basis, we take the three items that affect cash and adjust the amounts to reflect cash inflow rather than revenue earned and cash outflows rather than expenses incurred. Let’s start with service revenue.

Net income is $35,000, but cash flow from these same activities is not necessarily the same amount.

Changes in assets and liabilities can indicate that cash inflows are different from revenues and cash outflows are different from expenses.

Service revenue is $90,000, but ALC did not collect that much cash from its customers. We know that because accounts receivable increased from $0 to $12,000, so ALC must have collected to date only $78,000 of the amount earned.

Similarly, administrative expenses of $32,000 were incurred, but $7,000 of that hasn’t yet been paid because accounts payable increased by $7,000. That means cash paid thus far for administrative expenses was only $25,000. The other expense, income tax, was $15,000, but that’s the amount by which income taxes payable increased so no cash has yet been paid for income taxes.

We can report ALC’s cash flows from operating activities using the direct method as shown Illustration 4-10A.

By the direct method, we report the components of net income on a cash basis.

Indirect Method. To report operating cash flows using the indirect method, we take a different approach. We start with ALC’s net income but realize that the $35,000 includes both cash and noncash components. We need to adjust net income, then, to eliminate the noncash effects so that we’re left with only the cash flows. We start by eliminating the only noncash component of net income in our illustration—depreciation expense. Depreciation of $8,000 was subtracted in the income statement, so we simply add it back in to eliminate it.

Depreciation expense does not reduce cash, but it is subtracted in the income statement. So, we add back depreciation expense to net income to eliminate it.

That leaves us with the three components that do affect cash but not by the amounts reported. For those, we need to make adjustments to net income to cause it to reflect cash flows rather than accrual amounts. For instance, we saw earlier that only $78,000 cash was received from customers even though $90,000 revenue is reflected in net income. That means we need to include an adjustment to reduce net income by $12,000, the increase in accounts receivable. In a similar manner, we include adjustments for the changes in accounts payable and income taxes payable to cause net income to reflect cash payments rather than expenses incurred. Because more was subtracted in the income statement for these two expenses than cash paid, we need to add back the differences--the increases in the liabilities for these expenses. Note that if these liabilities had decreased, we would have subtracted, rather than added, the changes.

We make adjustments for changes in assets and liabilities that indicate that components of net income are not the same as cash flows.

Cash flows from operating activities using the indirect method are shown in Illustration 4-10B.

By the indirect methods, we start with net income and work backwards to convert that amount to a cash basis.

Both the direct and the indirect methods produce the same net cash flows from operating activities; they are merely alternative approaches to reporting the cash flows. The FASB, in SFAS 95, stated its preference for the direct method. However, while both methods are used in practice, the indirect method is used much more frequently.

The choice of presentation method for cash flow from operating activities has no effect on how investing activities and financing activities are reported. We now look at how cash flows are classified into those two categories.

INVESTING ACTIVITIES

Cash flows from investing activitiesinvolve the acquisition and sale of long-term assets used in the business and non-operating investment assets. include inflows and outflows of cash related to the acquisition and disposition of long-term assets used in the operations of the business (such as property, plant, and equipment) and investment assets (except those classified as cash equivalents). The purchase and sale of inventories are not considered investing activities. Inventories are purchased for the purpose of being sold as part of the company’s operations, so their purchase and sale are included with operating activities rather than investing activities.

Investing activities involve the acquisition and sale of (1) long-term assets used in the business and (2) nonoperating investment assets.

Cash outflows from investing activities include cash paid for:

1. The purchase of long-term assets used in the business.
2. The purchase of investment securities like stocks and bonds of other entities (other than those classified as cash equivalents).
3. Loans to other entities.

Later, when the assets are disposed of, cash inflow from the sale of the assets (or collection of loans and notes) also is reported as cash flows from investing activities. As a result, cash inflows from these transactions are considered investing activities:

1. The sale of long-term assets used in the business.
2. The sale of investment securities (other than cash equivalents).
3. The collection of a nontrade receivable (excluding the collection of interest, which is an operating activity).

Net cash flows from investing activities represents the difference between the inflows and outflows. The only investing activity indicated in Illustration 4-10 is ALC’s investment of $40,000 cash for equipment.

FINANCING ACTIVITIES

Financing activitiesFinancing activities involve cash inflows and outflows from transactions with creditors (excluding trade creditors) and owners. relate to the external financing of the company. Cash inflows occur when cash is borrowed from creditors or invested by owners. Cash outflows occur when cash is paid back to creditors or distributed to owners. The payment of interest to a creditor, however, is classified as an operating activity.

Financing activities involve cash inflows and outflows from transactions with creditors (excluding trade creditors) and owners.

Cash inflows include cash received from:

1. Owners when shares are sold to them.
2. Creditors when cash is borrowed through notes, loans, mortgages, and bonds.

Cash outflows include cash paid to:

1. Owners in the form of dividends or other distributions.
2. Owners for the reacquisition of shares previously sold.
3. Creditors as repayment of the principal amounts of debt (excluding trade payables that relate to operating activities).

Net cash flows from financing activities is the difference between the inflows and outflows. The only financing activity indicated in Illustration 4-10 is ALC’s receipt of $50,000 cash from issuing common stock.

NONCASH INVESTING AND FINANCING ACTIVITIES

As we just discussed, the statement of cash flows provides useful information about the investing and financing activities in which a company is engaged. Even though these primarily result in cash inflows and cash outflows, there may be significant investing and financing activities occurring during the period that do not involve cash flows at all. In order to provide complete information about these activities, the SCF shows any significant noncash investing and financing activities (that is, noncash exchanges). An example is the acquisition of equipment (an investing activity) by issuing either a long-term note payable or equity securities (a financing activity). These noncash activities are reported either in a separate schedule or in a note.

Significant investing and financing transactions not involving cash also are reported.

An illustration of a statement of cash flows is provided in the following concept review exercise.

STATEMENT OF CASH FLOWS

Dublin Enterprises, Inc. (DEI) owns a chain of retail electronics stores located in shopping malls. The following are the company’s 2006 income statement and comparative balance sheets ($ in millions):

Required:

1. Prepare DEI’s 2006 statement of cash flows using the direct method.
2. Prepare the cash flows from operating activities section of DEl’s 2006 statement of cash flows using the indirect method.

SOLUTION

1. Prepare DEI’s 2006 statement of cash flows using the direct method.

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1Sales revenue of $2,100 million, plus $13 million decrease in accounts receivable (net). 2Cost of goods sold of $1,400 million, plus $40 million increase in inventory, less $15 million increase in accounts payable. 3Selling & administrative expenses of $355 million, plus $23 million decrease in payables for selling & administrative expenses. 4Income tax expense has not yet been accrued. The income tax rate is 40%. Determine the following: (a) operating income (loss), (b) income (loss) before any separately reported items, and (c) net income (loss).




2. Prepare the cash flows from operating activities section of DEI’s 2006 statement of cash flows using the indirect method.

   
   
   (K)

FINANCIAL REPORTING CASE SOLUTION How would you explain restructuring costs to Becky? Are they necessarily a negative? Restructuring costs include employee severance and termination benefits plus other costs associated with the shutdown or relocation of facilities or downsizing of operations. It’s not necessarily bad. In fact, the objective is to make operations more efficient. The costs are incurred now in hopes of better earnings later. Prior to 2003, when a company restructured its operations, it estimated the future costs associated with the restructuring and expensed the costs in the period in which the decision to restructure was made. An offsetting liability was recorded. Later expenditures were charged against this liability as they occurred. In addition to discontinued operations, what other events sometimes are reported separately in the income statement that you might tell Becky about? Why are these items reported separately? In addition to discontinued operations, extraordinary items also are reported separately in the income statement when they are present. The predictive ability of an income statement is significantly enhanced if normal and recurrent transactions are separated from unusual and nonrecurrent items. The income statement is a historical report, summarizing the most recent profit-generating activities of a company. The information in the statement is useful if it can help users predict the future. Toward this end, users should be made aware of events reported in the income statement that are not likely to occur again in the foreseeable future. Explain to Becky what is meant by discontinued operations and describe to her how one is reported in an income statement. A discontinued operation occurs when a company decides to discontinue a separate component. A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the entity. The net-of-tax effect of discontinued operations is separately reported below income from continuing operations. If the component has been disposed of by the end of the reporting period, the income effects include: (1) income or loss from operations of the discontinued component from the beginning of the reporting period through the disposal date and (2) gain or loss on disposal of the component’s assets. If the component has not been disposed of by the end of the reporting period, the income effects include: (1) income or loss from operations of the discontinued component from the beginning of the reporting period through the end of the reporting period, and (2) an impairment loss if the fair value minus cost to sell of the component’s assets is less than their carrying amount (book value).

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THE BOTTOM LINE

1. The FASB’s Concept Statement 6 defines the term comprehensive income as the change in equity from nonowner transactions. The calculation of net income, however, excludes certain transactions that are included in comprehensive income. To convey the relationship between the two measures, companies must report both net income and comprehensive income and reconcile the difference between the two. The presentation can be (a) included as an extension to the income statement, (b) reported (exactly the same way) as a separate statement of comprehensive income, or (c) included in the statement of changes in shareholders’ equity.
2. The components of income from continuing operations are revenues, expenses (including income taxes), gains, and losses, excluding those related to discontinued operations and extraordinary items. Companies often distinguish between operating and nonoperating income within continuing operations.
3. The term earnings quality refers to the ability of reported earnings (income) to predict a company’s future earnings. The relevance of any historical-based financial statement hinges on its predictive value. To enhance predictive value, analysts try to separate a company’s transitory earnings effects from its permanent earnings. Many believe that manipulating income reduces earnings quality because it can mask permanent earnings. Two major methods used by managers to manipulate earnings are (1) income shifting and (2) income statement classification.
4. Analysts begin their assessment of permanent earnings with income from continuing operations. It would be a mistake to assume income from continuing operations reflects permanent earnings entirely. In other words, there may be transitory earnings effects included in both operating and nonoperating income.
5. A discontinued operation refers to the disposal or a planned disposal of a component of the entity. A component of an entity comprises operations and cash flows that can be clearly distinguished, operationally and for financial reporting purposes, from the rest of the company. The net-of-tax effects of discontinued operations are separately reported below income from continuing operations.
6. Extraordinary items are material gains and losses that are both unusual in nature and infrequent in occurrence. The net-of-tax effects of extraordinary items are presented in the income statement below discontinued operations, if any.
7. Most voluntary changes in accounting principles are reported retrospectively. This means revising all previous periods’ financial statements to appear as if the newly adopted accounting method had been applied all along. Some changes are reported prospectively. These include: (a) changes in the method of depreciation, amortization, or depletion, (b) some changes in principle for which retrospective application is impracticable, and (c) a few changes for which an authoritative pronouncement requires prospective application.
8. A change in accounting estimate is treated currently and prospectively, rather than by recasting prior years’ financial statements to correct the estimate. In other words, the new estimate merely is used from that point on. Most errors are discovered in the same year that they are made. These errors are simple to correct. However, material errors discovered in a year subsequent to the year the error was made are considered prior period adjustments. The correction of the error is accounted for by restating prior years’ financial statements, causing an adjustment to beginning of period retained earnings.
9. Earnings per share (EPS) is the amount of income achieved during a period expressed per share of common stock outstanding. The EPS must be disclosed for income from continuing operations and for each item below continuing operations.
10. When a company provides a set of financial statements that reports both financial position and results of operations, a statement of cash flows is reported for each period for which results of operations are provided. The purpose of the statement is to provide information about the cash receipts and cash disbursements that occurred during the period.
11. To enhance the usefulness of the information, the statement of cash flows classifies all transactions affecting cash into one of three categories: (1) operating activities, (2) investing activities, or (3) financing activities.

What is the cash flow from operating activities using the indirect method?

What does the indirect method include to arrive at net cash flow from operating activities?

What is included in net cash flow from operating activities?

What does net income measure that the cash flow from operating activities does not?