Each Tuesday we present basic, and sometimes 'not so basic', principles and tips on accounting. From the concepts of 'debits and credits' for start-up businesses, to the complexities of GAAP-based financial statements, we cover a wide range and depth of accounting theory and practical application.
A couple of weeks ago, our contributing author, Rob Shaff wrote an article on the need to use proper nomenclature when preparing financial statements. In response to that article, we not only received some excellent comments, but a few questions. One of those questions really sparked Rob's interest, and he penned a response that I felt warranted publication as an article, not simply as a reply commentary.
So this week's feature is that reply which, as you will read, covers accounting concepts that even some of the most skilled professionals sometimes have difficulties tracking through.
Can someone explain the process of reconciliation between net income and cash flow from operations?
Your question involves two of the four primary financial statements - the income statement (“IS”) and statement of cash flows (“CF”). Generally, the income statement is fairly straight forward in its preparation and readability, while the statement of cash flows can flummox even the most experienced. The reason is simple: unless you’re preparing/reading GAAP-based financials daily, most business owners (or clients, if you’re an independent accountant) rarely want to see the CF because they don’t understand it.
It is important to note that the CF has three primary classifications through which cash flow is tracked – operating, investing, and financing. For your question, we’ll only deal with the first category, cash flows from operating activities, but I will provide you with examples of items fitting in the other two categories. Very quickly, one caveat: there are two methods of preparing the CF, the direct and indirect methods. I’m not going to go into the explanation of both here because it is not germane to your question, but just know that the explanation and example provided herein utilizes the indirect method. The reason? Because the indirect method actually uses net income as its starting point, which, for your question, will provide the best proof of reconciliation.
Cash flow from operating activities identifies the movement of the primary revenue-generating activities for the reporting period. That is, to complete the reconciliation of the operating activities, identify the income and expense components of the core operations, and exclude or remove everything else. Adjustments to consider within your reconciliation are:
• Elimination of expenses classified under the financing or investing categories (for instance, interest expense would be eliminated and reported under the financing category);
• Elimination of income classified under the financing or investing categories (for instance, interest income would be eliminated and reported under the investing category);
• Elimination of non-cash income and/or expense items (for instance, depreciation reducing net income is added back); and
• Changes in working capital line items (increases/decreases in accounts receivable, inventory, accounts payable, etc.).
The list below provides some basic examples of a few of the items that might be found in the Investing and Financing categories, thus being eliminated from operating activities:
• Loan proceeds, a cash inflow (financing),
• Principal payments on debt, a cash outflow (financing),
• Sale of fixed assets, a cash inflow (investing),
• Purchase of fixed assets, a cash outflow (investing), and
• Purchase of investments, public or private, a cash outflow (investing).
Since these items are not part of the core revenue-generating activities, they are excluded from the operating activities classification.
Construction of the Reconciliation (Operating Activities Section of the CF)
The reconciliation you seek is synonymous with the preparation of the operating activities section of the CF. As a result, I think the easiest path to providing the reconciliation process is to provide the construction of the operating activities section. The example I have used is fairly basic to mitigate confusion, but once you begin doing these reconciliations, like anything else, it will begin to come to you quite easily.
In the example, ABC Company is a small plumbing contractor utilizing the accrual method of accounting. ABC is relatively profitable year-over-year, but they require bank financing occasionally to supplement fixed asset purchases. ABC’s cash account at the beginning of the year totaled $75,000, while at the end of the year, it totaled $538,000. During the year in question, ABC had the following cumulative transactions affecting its financial statements:
In addition, the following balance sheet accounts affecting working capital experienced increases or decreases:
I have presented the entire cash flow statement just so you can see the flow and how each component plays into the preparation of the statement. I have highlighted (in yellow) below, the operating activities section so you can see how the items above affect cash flow from operations.
Hopefully this not only clarifies the question of our reader, but all of you out there when it comes to the issue of the Statement of Cash Flows, especially as they regard cash flows from operating activities.