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Welcome back. Last time, you reconciled beginning and ending equity, distinguishing income, share transactions, and dividends. This lesson reconciles a different balance-sheet account: cash. You’ll prepare a statement of cash flows using the indirect method, a core skill for USA CMA financial reporting. Allow about 40 minutes to watch, read, and follow the worked statement.
The central question is not simply whether a company earned income. It is why its cash balance changed. A profitable company might collect sales later, buy equipment now, or raise cash by borrowing. The statement separates those effects so they can be understood rather than buried in one net figure.
Start with the cash change you must explain
To prepare the statement, gather the period’s income statement, balance sheets for the beginning and end of the period, and details of significant asset, debt, and equity transactions. The balance sheets provide a check: ending cash less beginning cash must equal the net cash change explained by the completed statement.
Cash flows are grouped by activity:
- Operating: cash effects of the company’s ordinary revenue and expense activities.
- Investing: cash paid to acquire, or received from disposing of, long-term assets and investments.
- Financing: cash raised from or returned to lenders and owners.
Watch The Cash Flow Statement for Beginners from Accounting Stuff. Its complete example shows how the three sections fit together. The indirect method changes how the operating section is prepared; investing and financing still report their cash receipts and payments.
The CASH FLOW STATEMENT for BEGINNERS
Watch the explanation of the statement’s purpose, then the indirect-method overview and worked example. Focus on where each figure comes from: the income statement, comparative balance sheets, or additional transaction details.
Begin with three categories, where the video sets up the cash reconciliation. Watch the indirect method, then the worked demonstration. In the demonstration, notice why the loss on a furniture sale is added back in operating activities while the cash received from the sale appears in investing activities.
OpenStax’s Principles of Accounting Section 16.3 provides a useful preparation sequence and explains the operating adjustments you’ll apply below.
16.3 Prepare the Statement of Cash Flows Using the ...
Read OpenStax’s preparation steps and its explanation of how accrual-based net income becomes operating cash flow.
In Section 16.3, read the five steps, from the opening sentence through Step 5. Then, under “Prepare the Operating Activities Section of the Statement of Cash Flows Using the Indirect Method,” read the subsections “Start with Net Income,” “Add Back Noncash Expenses,” “Reverse the Effect of Gains and/or Losses,” and “Adjust for Changes in Current Assets and Liabilities.” Continue through “Current Operating Liability Decrease”: operating adjustments. Concentrate on why each adjustment has its sign.
Convert net income into operating cash flow
Net income uses accrual accounting: revenue can be earned before customers pay, and expenses can be recognized before or after cash is paid. The indirect method begins with net income and removes those differences to arrive at net cash from operating activities.
First, add back expenses included in net income that did not use cash during the period, such as depreciation. Buying equipment may have used cash, but that purchase belongs in investing activities; recording depreciation later does not represent a second cash payment.
Next, reverse gains or losses on the sale of long-term assets. A gain increased net income, so subtract it from operating cash flow; a loss reduced net income, so add it back. Report the full cash proceeds from the sale in investing activities. The gain or loss is not the cash received.
Finally, adjust for changes in operating current assets and liabilities. Compare each ending balance with its beginning balance:
| Operating balance changes | Adjustment to net income | Reason |
|---|---|---|
| Noncash current asset increases | Subtract | For example, sales in receivables have not yet been collected. |
| Noncash current asset decreases | Add | For example, collection of earlier receivables brings in cash. |
| Operating current liability increases | Add | For example, an accrued expense has not yet been paid. |
| Operating current liability decreases | Subtract | For example, cash has been used to pay down an obligation. |
Think of these as reconciliation adjustments, not a list of separate cash transactions. An increase in inventory may be offset by an increase in accounts payable if the inventory was bought on credit. Both changes are needed to derive the net operating cash effect. Do not apply the operating-liability rule indiscriminately to loans or dividends payable: borrowing and cash dividends belong with financing.
We can now build a full statement for Propensity Company. Its net income is $4,340. It recorded $14,400 of depreciation and a $4,800 gain on a land sale. Its accounts receivable decreased $4,500; prepaid insurance increased $700; inventory increased $2,500; accounts payable decreased $1,800; and salaries payable increased $400.
The operating calculation is:
Notice the two different reasons for an addition. Depreciation is added back because it reduced income without using cash now. The decrease in receivables is added because cash collections exceeded the revenue reflected in current-period income, assuming the change arose from ordinary customer transactions.
Identify investing, financing, and noncash transactions
For the remaining sections, inspect the underlying transactions, not just the change in a balance-sheet total. Equipment’s ending carrying amount, for example, can reflect purchases, disposals, and depreciation. It is not automatically the cash spent on equipment.
Read OpenStax’s treatment of the transactions behind Propensity’s investing and financing sections. Pay particular attention to the distinction between sale proceeds and gain, and between a transaction’s value and its cash effect.
16.3 Prepare the Statement of Cash Flows Using the ...
Continue in OpenStax Section 16.3 for the cash transactions and the separate noncash disclosure.
Under “Prepare the Investing and Financing Activities Sections of the Statement of Cash Flows,” read “Investing Activities Leading to an Increase in Cash” through “Investing Activities Leading to a Decrease in Cash”: asset sales and purchases. Then read “Financing Activities Leading to an Increase in Cash” and “Financing Activities Leading to a Decrease in Cash”: financing cash flows. Finally, in “Noncash Investing and Financing Activities,” read the disclosure explanation, ending with Propensity’s land-for-note exchange. Use the stated cash transactions, rather than changes in account balances alone, to determine the section totals.
Propensity received $14,800 for land whose carrying amount was $10,000. Their difference is the $4,800 gain already removed from operating cash flow. Investing activities report the $14,800 received, along with $60,000 paid for new equipment:
In financing activities, Propensity received $10,000 from issuing notes and $45,000 from issuing common stock. It paid $440 in dividends. Recall the distinction from the previous lesson: a dividend declaration changes equity, whereas a dividend payment uses cash. Thus:
Propensity also acquired $20,000 of land by issuing a note directly to the seller. That transaction affects both a long-term asset and debt, but no cash changes hands. Disclose it separately; do not insert a $20,000 investing outflow and a matching financing inflow into the cash-flow sections.
Assemble and check the statement
Put the three sections together, then reconcile them to the balance-sheet cash amounts. Parentheses below indicate a negative adjustment or cash outflow.
Propensity Company
Statement of Cash Flows—Indirect Method
For the Year Ended December 31, 2018
| Amount | |
|---|---|
| Cash flows from operating activities | |
| Net income | $4,340 |
| Add: depreciation | 14,400 |
| Less: gain on land sale | (4,800) |
| Add: decrease in accounts receivable | 4,500 |
| Less: increase in prepaid insurance | (700) |
| Less: increase in inventory | (2,500) |
| Less: decrease in accounts payable | (1,800) |
| Add: increase in salaries payable | 400 |
| Net cash from operating activities | 13,840 |
| Cash flows from investing activities | |
| Proceeds from land sale | 14,800 |
| Equipment purchased for cash | (60,000) |
| Net cash used in investing activities | (45,200) |
| Cash flows from financing activities | |
| Cash from issuing notes | 10,000 |
| Cash from issuing common stock | 45,000 |
| Dividends paid | (440) |
| Net cash from financing activities | 54,560 |
| Net increase in cash | 23,200 |
| Cash, beginning of year | 24,300 |
| Cash, end of year | $47,500 |
Noncash investing and financing activity: Land worth $20,000 acquired in exchange for a note payable.
The final check has two parts:
The result agrees with ending cash on the balance sheet. Compare your finished layout with OpenStax’s illustration of Propensity’s statement:
A balanced reconciliation is essential, but it is not the only check. Also ask whether each item represents cash this period and whether it appears in the right section. Otherwise, two classification mistakes could offset each other while ending cash still agrees.
Key takeaways
To prepare an indirect-method statement, start with net income, add back noncash expenses, reverse gains or losses on long-term asset disposals, and adjust for changes in operating assets and liabilities. Report actual cash paid or received for investing and financing transactions, disclose significant noncash investing and financing transactions separately, and verify that the three section totals explain the change from beginning to ending cash.
This completes the module’s sequence of financial-statement preparation. The next lesson turns to correcting accounting errors: you’ll determine which statements and balances change when a previously recorded amount is wrong.