Lesson 64: Preparing a Cash Flow Statement Using the Indirect Method Part 1
In this lesson, we will learn to
prepare the cash flow statement. We will start by showing where net income or
loss is recorded, learn about the concept of accrual accounting and cover the
three sections of the cash flow statement.
The cash flow statement will be the last concept that we discuss in
this introductory accounting course. The cash flow statement offers information
to both internal and external users about the company's payments and receipts
to give insight as to the future income needs.
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This financial statement can often be the most complex,
so we will break each topic down to
minimize the chance for errors when you are
preparing cash flow statements on your own.
Using the accrual basis of accounting means that
revenues are reported on the income statement when they are earned, even if the
cash has not been received yet. Accruals also apply to expenses, as they are
reported when they are incurred, not necessarily when the company pays for the
expenses.
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After the expenses are deducted from the revenues,
we are left with the net income figure. It is important to know that
accrual accounting is not the same as cash accounting.
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Let's start by looking at an income statement and where net loss is recorded.
Above is an example of a consolidated statement of income for the Barrick Gold
Corporation.
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Let's take note of the net loss figure that will be recorded in
the cash flow statement.
The cash flow statement lists the amount of net loss in millions at the top as
you can see in the example above.
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If you look at the bottom of the cash flow statement,
you can see that
the cash and equivalents at the beginning of the year was roughly 2.1 billion.
The cash at the end of the year was actually higher at 2.4 million. The cash
flow statement reflected an increase of $327 million in cash while there was a
net loss of 10 billion.
What is important to know here is that net income does not mean that
the cash flow is going up. This always applies in the reverse as the net loss
doesn't necessarily mean the cash is going down. As you can in see in this
example, there was a net loss and the amount of cash increased.
The reason net income is not directly correlated with cash flow increasing or
decreasing is because it is based on accrual accounting, meaning it compounds
over the given time period.
In order to use the indirect approach to create the cash flow statement,
we must start with the net income or net loss figure from
the income statement. We then adjust it based on the accrual journal entries to
come up with the cash basis section of net income.
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The company ultimately wants to
know how much cash has changed for the year when looking at the operating
activities section of the cash flow statement. This section is one of three
parts of the business activities sections including operating, investing and
financing activities.
The investing and
financing sections will remain the same whether the indirect or direct method
is used. The only section that changes based on the indirect approach is the
operating section that shows all of the cash flow items for operations.
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In order to prepare this section,
we will be learning how to
convert the net income figure into a cash basis figure in the next several
lessons.