I'd really like to offer you the opportunity to gain a conceptual understanding of the statement of cash flow, rather than just preparing one very routinely. I'd like you to understand conceptually what goes on there, so that if you encounter transactions that you haven't seen before, you would know what to do to work them in to the statement of cash flow. So let's start here by looking at the statement of cash flow. We're talking about preparing at using the indirect method. And recall that the statement of cash flow that's prepared using the indirect method starts with net income. Now, recall that the income statement, another financial statement, ends with net income. So I'm going to suggest that we keep in the back of our minds, An imaginary income statement that sits above that statement of cash flow, because the income statement's ending in the exact same number that the statement of a cash flow is beginning with. And if we can keep that in the back of our minds, then what we'll start to notice is that these adjustments that we're making under the indirect method to the net income number that we start the statement of cash flow with will be adjustments to capture the difference in the timing of the accrual based accounting entries that result in each of these income statement numbers. And the cash receipts and outlays that are associated with each of those line items. Let's do some examples and I think you'll see what I mean. Let's start with the example where revenue is recognized on the income statement for the period in a total amount of $200,000. And all of them were cash sales, so company doesn't do any sales on account. So all of these are going to be cash sales. Let's look at the journal entry to record those revenues. We have a left side or debit to cash, cash goes up by 200,000. And then the right side or credit, is to retained earnings that I'm abbreviating with RE, which is a owner's equity account. I'll put a note that these are revenues for 200,000. Now, it's apparent, I think from looking at the journal entry, that the cash receipts, From customers, Are $200,000. It's pretty straightforward. Now, let's go back to our statement of cash flow. If we're looking at a statement of cash flow using the direct method, which I have here on our left, we would just directly list cash receipts from customers, In the amount of 200,000, okay? But now, let's move over to the right. Here, where we've got the indirect method. And let's remember that our income statement would include those $200,000 of revenues. And so, that means that net income was increased by the $200,000 of revenues. And how much cash receipts from customers do we need to have show up on the indirect method, statement of cash flow, $200,000. So we start with a number that includes the exact cash receipts from customers in it. So we need to make no adjustment on the statement of cash flow under the indirect method. Now, let's turn to a slightly modified example, okay? Here, we have the same revenue for $200,000. But this time, we're talking about a company that does make some of its sales on account. Let's say, 60% of those sales are on account. In addition to what happened with revenue this period, collections from customers on account totaled $98,000. Let's look at the journal entries to record those revenues and collections. To record the revenues, We're going to have a left side entry to cash or debit for $80,000, 40% of the $200,000 revenues. And then we're going to also have a left side entry to accounts receivable, For 120,000, that's 60% of the revenues that we're on account. And then the right side or the credit side of the entry, of course, is to retained earnings with a note that we're looking at revenues. And that's increasing by $200,000. So that's the entry we'd see for the revenues. Now, what about the cash collections of $98,000? Well, cash is going up for those. And the accounts receivable account would decrease because we're collecting from customer's own account, okay? Now, from these two entries, it becomes apparent that the cash receipts from customers, or cash collections from customers. Are equal to the 80,000 here, plus the 98,000 here, so a total of 178,000, okay? Now, if we were using the direct method of the statement of cash flow, then we would just directly list that as cash receipts from customers of $178,000. But if we're using the indirect method, we're going to need to make some adjustments. The revenues on the income statement are $200,000, so there's 200,000 effect on that income, right? What we'll need to do is make this adjustments. We've got 120,000 of our revenues were not cash revenues. So those need to be taken out of the $200,000. And then we have 98,000 collections of cash from customers that were not included revenue's line on the income statement. So these adjustments are going to need to be made, and that's negative 22,000. The net is a negative 22,000. Well, let's think about where that information shows up, that we can get to it conveniently. Let's look at our accounts receivable, T-account. We know by now that we have a beginning balance in this account and an ending balance in this account. In this situation, we don't know what those balances are, but that's not important for us at the moment. But what we do know here is that, The sales on account increased that account by 120, that's from here. And the collections from customers on account, Was 98, that's from here, okay? So the two adjustments that we need to make actually show up in the accounts receivable account. And they net to, The negative $22,000. And so what we find is that the change in the accounts receivable balance, we turn because of these two things, is the negative $22,000. So we can just take that number and make the adjustment on the statement of cash flow. So let's go back to the statement of cash flow and do that. We will adjust net income for the change in the accounts receivable balance, okay? And in this case, accounts receivable went up, so we have a negative adjustment. So, what we're doing is we're making an adjustment to the amount that showed up under accrual accounting to recognize that, that's all not a cash inflow. And that adjustments can't prove by the change in the accounts receivable account. Now notice, the net effect here is we've got the 200,000 in revenues, and then the adjustment of negative 22,000 that gets us to the 178 cash collections from customers, That we see on the direct method statement, okay? So we get to the same point, but we just have to go a little bit more round about way with the indirect method. And this increase in the accounts receivable account is just capturing the difference at which customers buy things from the company and then pay there bills, so they do those at different rates.
