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The indirect operating activities section always starts out with the net income for the period followed by non-cash expenses, gains, and losses that need to be added back to or subtracted from net income. These non-cash activities typically include:
Depreciation expense
Amortization expense
Depletion expense
Gains or Losses from sale of assets
Losses from accounts receivable
The non-cash expenses and losses must be added back in and the gains must be subtracted.
The next section of the operating activities adjusts net income for the changes in asset accounts that affected cash. These accounts typically include:
Accounts receivable
Inventory
Prepaid expenses
Receivables from employees and owners
This is where preparing the indirect method can get a little confusing. You need to think about how changes in these accounts affect cash in order to identify what way income needs to be adjusted. When an asset increases during the year, cash must have been used to purchase the new asset. Thus, a net increase in an asset account actually decreased cash, so we need to subtract this increase from the net income. The opposite is true about decreases. If an asset account decreases, we will need to add this amount back into the income. Here's a general rule of thumb when preparing an indirect cash flow statement:
Asset account increases: subtract amount from income
Asset account decreases: add amount to
income
The last section of the operating activities adjusts net income for changes in liability accounts affected by cash during the year. Here are some of the accounts that usually are used:
Accounts payable
Accrued expenses
Get ready. If you weren't confused by the assets part, you might be for the liabilities section. Since liabilities have a credit balance instead of a debit balance like asset accounts, the liabilities section works the opposite of the assets section. In other words, an increase in a liability needs to be added back into income. This makes sense. Take accounts payable for example. If accounts payable increased during the year, it means we purchased something without using cash. Thus, this amount should be added back. Here's a basic tip that you can use for all liability accounts:
Liability account increases: add amount from income
Liability account decreases: subtract amount to income
All of these adjustments are totaled to adjust the net income for the period to match the cash provided by operating activities.
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