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I suppose I'm getting stuck when it comes to understanding why, for instance, a decrease in Accounts Receivable is an addition to Net Income? Why a loss on a sale of a long term asset is an addition to Net Income? Why a gain on a sale of a long term asset is a deduction from Net Income? Why a decease in Accounts Payable is a deduction from Net Income? (Why, why, WHY?!?!) Everything seems to be the opposite of what I immediately think - and I can't quite get myself acclimated to the whole concept.

I agree with the book recommendation (The Accounting Game : Basic Accounting Fresh from the Lemonade Stand by Darrell Mullis and Judith Handler Orloff), but I will try to help you out. My heart goes out to you, because the statement of cash flows is one of the most challenging feats in accounting.

I hope I don't make your head spin. Just take your time and think through it.


It helps to think of assets (other than cash) as using up cash and liabilities as providing cash. This makes sense in a way. You spend cash to purchase assets, and liabilities are like loans that provide additional cash.

An increase in an asset will reduce cash flow (as if we made a cash purchase).
A decrease in an asset will increase cash flow (as if we sold it for cash).
An increase in a liability will increase cash flow (as if we borrowed cash).
A decrease in a liability will decrease cash flow (as if we paid off a loan with cash).

Alternatively, you can think of the cash flow impact as if the company sold their beginning asset balances, receiving cash for this amount, and purchased their ending asset balances, paying cash for this amount. The net impact will be the difference between the two.

For liabilities, you can think of the cash flow impact as if the company paid off their beginning liability balances, paying cash for this amount, and borrowed their ending liability balances, receiving cash for this amount. The net impact will be the difference between the two.


Assets and liabilities will generally be classified in three ways that correspond with the three sections of the cash flow statement:
1) Operating assets and liabilities (generally current assets and current liabilities)
2) Capital assets (generally fixed assets and other investments, such as investments in subsidiaries or marketable securities)
3) Financing (generally long-term debt)


Another concept to understand is that the indirect method basically tries to reconcile from net income to cash flow. Net income is affected by many items of non-cash revenue, expenses, gains, and losses, so we have to adjust net income for these items to reconcile to cash flow. In effect, each item on the income statement has to be adjusted to match actual cash flows (as you will see, in practice this is done -- strangely enough -- by looking at the balance sheet).

Revenue, for example, is either from cash sales or credit sales. The cash sales portion is just fine the way it is because cash sales affect net income and cash flow identically. Credit sales, however, are non-cash sales, so the cash flow from credit sales doesn't depend on the level of credit sales, but rather on the collections of the related Accounts Receivable (A/R), which is where the adjustment for the change in A/R comes in.

Here is an example. Assume the following data:

Beginning A/R $ 30,000
Credit Sales 100,000
Collections 120,000
Ending A/R 10,000

It should be fairly obvious that the only cash flow impact of credit sales is Collections, which equals $120,000. So we need to adjust to this number. If we are starting with net income, then our starting point is Credit Sales of $100,000 (which is buried in the net income number, whatever it is), which we need to adjust upward by $20,000 in order to get it to $120,000.


Credit Sales $100,000
Reconciling Adjustment 20,000
Cash flow (Collections) $120,000

Our adjustment was equal to Collections – Credit Sales. In this case, Collections > Credit Sales, so the adjustment was positive. If Collections < Credit Sales, the adjustment would have been negative.

Luckily, we don't actually need to know Credit Sales or Collections to make our adjustment. You will notice that our adjustment happens to equal our decrease in A/R.

The change in any account balance is reflected in the general formula:
Beginning Balance + Additions – Deductions = Ending Balance

If you think about what increases or decreases A/R, the equation would be:
Beginning A/R + Credit Sales – Collections = Ending A/R

Or rearranging:
Collections – Credit Sales = Beginning A/R – Ending A/R

Therefore, we can figure out the necessary adjustment by looking at what happened to A/R. If A/R declined, then Beginning A/R > Ending A/R and our adjustment will be positive. If A/R increased, then Beginning A/R < Ending A/R and our adjustment will be negative.

This matches what I was saying earlier about an increase in assets being like a purchase of assets for cash and a decrease in assets being like a sale of assets for cash. You can use this line of thinking for all of your operating assets and liabilities.

It's a little different for capital assets and long-term debt, as you'll see below.


When I am preparing a statement of cash flows, I of course start with net income. Then I go to the balance sheet and look at each asset, liability, and equity account in order to determine the impact on cash flow (this is easier than thinking through each item of income or expense, and it achieves the same result, as we saw above).

I go through my current assets (except cash) and make adjustments to operating cash flow. Then I continue on to fixed assets and other investments, which will be reflected in the investing cash flows section of the cash flow statement. Because this section uses the direct method (i.e. it shows cash flows directly), it is a little different from the operating cash flow section. It separates cash outflows for asset purchases from cash inflows from asset sales, so it requires knowing cash received or spent for these items (rather than the net change in the account balance).

Applying our equation from before to fixed assets:
Beginning Fixed Assets + Purchases – Sales = Ending Fixed Assets

The difference is that Purchases and Sales need to be separately stated rather than showing just a net adjustment (as in the indirect method).

The thing to remember about these assets is that you have to go back and adjust net income for any non-cash income, expenses, gains, or losses. This typically includes depreciation and any gain/loss on disposal of capital assets (whether they were sold, traded, or junked). Because depreciation was a non-cash expense that reduced net income, we need to add it back. Even though depreciation is related to a capital asset, we add it back to the operating cash flow section because this is the only section that uses the indirect method (i.e. reconciles from net income to cash flow). Depreciation was deducted from net income, but since it didn't decrease operating cash flow, and since we didn't already make an adjustment for it like we did with the operating assets and liabilities, we need to add it back.

The same goes for gains or losses on disposal of assets. A gain on disposal of assets increases net income but is a noncash gain. Therefore, we need to deduct it to arrive at operating cash flow. (Cash might have been received if we sold the assets, but this cash inflow would already be reflected in the investing cash flows section). A loss on disposal of assets decreases net income but is a noncash loss. Therefore, we need to add it back to arrive at operating cash flow.

Once I complete my analysis of fixed assets and other investments, I move on to current liabilities, which will be handled like operating assets. Then I move on to long-term liabilities, which is handled like the capital assets except that the cash flows would go in the financing section. Cash inflows from new borrowings is stated separately from cash outflows from repayments (i.e. we are once again using the direct method).

Lastly, I look at changes to equity to see if any equity transactions took place (like liabilities, equity can be thought of as providing cash). Examples would include the sale or repurchase of stock. These cash inflows and outflows would be reflected in the financing section using the direct method.


An important key to completing a statement of cash flows is to methodically proceed through your balance sheet and determine the impact on cash flow. Whenever I am having a problem reconciling from my beginning cash balance to my ending cash balance, I go through my balance sheet once more to make sure that everything associated with each asset, liability, and equity account has been properly reflected in the statement of cash flows. This will require keeping in mind any income, expense, gain or loss associated with the balance sheet item in question, as we saw in the case of fixed assets and depreciation.


Hopefully, I have provided a basic framework. Good luck, and let me know if you have any questions.
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