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Scarbdr-

I understand your confusion. I think it is stemming from the use of net income in the cash flow statement. Now, stick with me, this may get a little long winded.

The purpose of the cash flow statement is not to show how earnings were spent, but how cash was spent. Lets say you own an engineering firm in your house. All you have is some cash (and your house to use as an office). Before you have any income, you can still spend the cash you had on hand to begin with. It is the same for a big corporation. Some of the cash spent during the period is not generated during the period, but was on hand at the beginning.

Now, there are two ways to prepare the cash flow statement, the direct method and the indirect method. Under the direct method, a company keeps track of every dollar in cash it takes in and sends out. AS you may imagine, this would require and extraordinary amount of excess bookkeeping. So, most organizations use the indirect method, which converts accrual basis earnings (net income on the income statement) to cash basis in or outflow (cash flow from operations). Basically, we're just using net income to figure out how much cash we generated. We are not saying how much of those earnings were spent.

As for retained earnings, let's go back to the engineering firm example. We'll say in the first year, you make $100,000 net income. You give yourself $50,000 of it to live on, but now what to do with the rest? That extra $50,000 goes nowhere, it is retained (not distributed) by the firm. However, as owner, you are still entitled to that amount, so it is reported in the equity section. This would be reported as retained earnings.

Also, the cash flow statement is not used to develop an ending cash balance for the balance sheet. The cash balances on the balance sheet are generated from actual cash balances per bank statements and such. The cash flow statement just shows what the organization has done with its cash which caused the balance to change.

Hope I have helped a little more.

RG
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