![]() It is an allocation of a historical cost to expense over an asset’s useful life. It is omitted because depreciation is neither a source nor use of cash. This expense appears on virtually all income statements but has no purpose when cash flows are being determined. By far the most obvious example is depreciation. Although such balances are important in arriving at net income, they are not relevant to the cash generated and spent in connection with operations. The first step is the complete elimination of any income statement account that does not involve cash. To transform a company’s income statement into its cash flows from operating activities, three distinct steps must be taken. However, the amount of cash generated by the company’s operating activities might be considerably more or much less than that income figure. The $100,000 net income figure reported here by Liberto is based on the application of U.S. ![]() For example, income tax expense has been omitted.įigure 17.4 Liberto Company Income Statement Year Ended December 31, Year One This statement has been kept rather simple so that the conversion to cash flows from operating activities is not unnecessarily complex. “Sales,” for example, is turned into “cash collected from customers.” “Salary expense” and “rent expense” are recomputed as “cash paid to employees” and “cash paid to rent facilities.”įor illustration purposes, assume that that Liberto Company prepared the following income statement for the year ended December 31, Year One. Then, each of the separate figures is converted into the amount of cash received or spent in carrying on operating activities. How is information presented when the direct method is selected to disclose a company’s cash flows from operating activities?Īnswer: The direct method starts with the income statement for the period. The direct method seems a bit easier to explain and will be discussed first. In contrast, reporting companies (by an extremely wide margin) have continued to use the more traditional indirect method. The informational value to decision makers, though, is potentially affected by the approach selected.įASB has indicated a preference for the direct method. The increase or decrease in cash is a fact that will not vary based on the manner of presentation. The numerical amount of the change in cash resulting from the company’s daily operations is not impacted by this reporting choice. According to FASB, that information can be presented within the statement of cash flows by either of two approaches: the direct method or the indirect method. Question: The net cash inflow or outflow generated by operating activities is especially significant information to any person looking at an organization’s financial health and future prospects. Compute the cash inflows and outflows from common revenues and expenses such as sales, cost of goods sold, rent expense, salary expense, and the like.Identify common “connector accounts” that are used to convert accrual accounting figures to the change taking place in the cash balance as a result of these transactions.List the income statement accounts that are removed entirely in computing cash flows from operating activities and explain that procedure when the direct method is applied. ![]()
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