Cash flow from operating activities under indirect method: Cash flows from operations are generated from the organization’s normal activities. These cash flows are generally routine and recurring. They are particularly important because most organizations must be capable of generating positive cash flows from operations over the long run to remain viable. It deals with the cash generated or used by the entity’s primary activities. The cash flow statement reports past cash flows, but the same or similar activities and cash flows can be expected to occur in the future. In this section under indirect method company start with accrual-basis net income and adjust that figure to obtain the cash ...view middle of the document...
The depreciation expense recognized during a period is not a cash expense; it does not result in a decrease in the cash balance. Cash was reduced initially when the asset was first acquired. The expense is simply an accountant’s allocation of a cost incurred previously. Therefore, while income for the period is decreased by the amount of the depreciation expense, cash is not. The difference in timing between the cash outflow for the purchase of a fixed asset and the related income effects can be shown as follows:
Noncash effect on income
Passage of time
Purchase of Asset End of asset life
Cash outflow for
Purchase of equipment
If we are interested in the amount of cash generated by a company’s operations, then we need to add back the amount of depreciation expense to the company’s net income. In other words, if all other revenues and expenses were cash items, net income would understate cash generated by the amount of the depreciation expense.
Amortization of debt discount:
When interest expense has been increased by the amortization of bond discount, an amount must be added to net income in the cash flow statement to determine the amount of cash generated from operations. The reason is that a portion of the discount is charged to interest expense each period under accrual accounting. However, the amount of discount expensed each period represents a noncash charge against income.
Gains and losses:
Companies often include in their income statements gains and losses that are not directly related to their regular operations. For example, companies often report gains and losses from disposing of investments or fixed assets, and from retiring debt. Because these gains and losses are not related to regular operations, they must be eliminated from the operating section of the cash flow statement. Gains must be deducted from net income in the operating section of the cash flow statement to arrive at cash generated from operations, and losses must be added back. The cash effects of the transactions giving rise to the gains and losses are reported in the investing or financing sections of the cash flow...