Companies that use accrual basis accounting can assemble their statement of cash flows in one of two ways, using either the direct method or the indirect method. The more commonly used indirect method shows the company's net income, and adjusts it with reconciling entries, to arrive at the company's operating cash flow.
The Indirect Method
The less common direct method requires building a cash flow statement from the ground up, using data from potentially thousands of individual transactions, although it's often difficult to gather data in this manner. Conversely, the indirect method uses information from the company's income statement and balance sheet, making the cash flow statement preparation a simple exercise.
For the indirect method, start your reconciliation with your company's net income, or profit, for the desired time period. You'll find this figure at the bottom of the company's income statement. Unlike the cumulative nature of the income statement numbers, the balance sheet works like a snapshot, showing data at a certain point in time. For this reason, you'll need two balance sheets, such as two consecutive monthly versions, because it is the changes in the balance sheet accounts that represent the amounts that have been adjusted.
Making the Adjustments
You'll need to make three types of adjustments to reach operating cash flow. The first, noncash items, includes items that don't reduce cash, but they still get recorded as an income statement expense that reduces net income. The second category, timing differences, involves changes in assets and liabilities on the balance sheet. These adjusting entries compensate for the way companies recognize revenue and expenses under accrual accounting rules. The third category covers non-operating gains or losses, which means income or losses generated by activities other than the core functions of the company.
Add or Subtract Noncash Items
In accrual accounting, some items change profits, but don't have any effect on cash flow. Reconciling net income to operating cash flow involves adding or subtracting these noncash items. To get started, enter all of the noncash expenses shown on the income statement during the given reporting period into your cash flow adjustment calculation. Depreciation and amortization are the most common examples, and these income statement expenses reduce net income but have no effect on cash flow, so they must be added back.
Factor in Current Assets
Opposite of the noncash items, certain current assets affect your company's actual cash flow but don't affect your income statement profit. They include inventory, accounts receivable and prepaid expenses. When a current asset increases, it reduces your operating cash flow in relation to net income. For example, if you have an item in inventory, that means you've laid out cash for it. But because of accrual accounting rules, if you haven't sold it yet, you can't report its cost as an expense, and therefore, its cost hasn't yet reduced net income.
This represents an accounting timing difference and needs to be factored into your reconciliation. For each category of current assets except cash, take the account balance from the balance sheet at the beginning of your given period and the same figure from the balance sheet at the end period. Subtract the beginning figure from the ending figure to get the period change for that particular current asset. Do this for all categories of current assets, and record these differences in your reconciliation calculation.
Calculate Current Liabilities
Current liabilities on the balance sheet include accounts payable and accrued expenses such as wages and rent. These accrued expenses have been incurred and reported, but the company has not yet paid out any cash. Current liabilities have the opposite effect on cash flow as that of current assets. When a current liability increases, such as accruing another week of wages owed, cash flow goes up, relative to net income.
For example, as workers earn wages, you report what they earn as an income statement expense, which reduces net income. But until you actually issue paychecks, their wages won't yet reduce cash flow. Calculate the period change in each category of current liabilities the same way you did for current assets, and add these results to your reconciliation.
The Final Reconciliation
If your company has any gains or losses coming from non-operating activities, you'll need to also factor these into your reconciliation. Look for gain or loss items on the income statement. Examples include charges related to discontinued operations, and any profit over book value from sales of non-inventory items, such as old equipment or office furniture. Take the appropriate figures from the income statement and add them to your reconciliation.
Start your reconciliation with net income at the top. Add back the total value of noncash expenses to your operating cash flow. Next, subtract the period change for each category of current assets. Then, add the period change in each category of current liabilities. Some of these period changes might be negative. Finally, add back any expenses related to non-operating activities, and subtract any income from non-operating activities.
Removing a negative charge increases your operating cash flow; adding a negative charge decreases your operating cash flow. Do the math to get to your reconciled cash flow from operations. If you add the two other sections of the cash flow statement, net cash flow from investment activities and net cash flow from financing activities, you'll have produced a complete cash flow statement.
