indirect cash flow method, why do we have to subtract increases and add decreases in current assets

Avatar 37a3bd7bc7328f0ead2c0f6f635dddf60615e676e6b4ddf964144012e529de45 rohith asked over 3 years ago

In the indirect cash flow method, why do we have to subtract increases and add decreases in current assets and do the opposite for current liabilities?

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Avatar 37a3bd7bc7328f0ead2c0f6f635dddf60615e676e6b4ddf964144012e529de45 narahari answered almost 3 years ago

It is because 'included' in your net income are expenses that you never paid cash for (e.g. depreciation expense). Now, let's apply that same concept to an invoice we just received. Let's journalize it. DR Expense CR Accounts payable

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Open uri20170510 32134 1ue0f38?1494421710 rohit agarwal answered over 3 years ago

Hi, As far as your question is concerned that in the indirect cash flow method, why do we have to subtract increases and add decreases in current assets and do the opposite for current liabilities? To get an answer for this, You'll have to think conceptually to better understand the reasons. Let's start with the basic formula for the first section of a cash flow statement: 1) Net income 2) add non cash items (depreciation/amortization, share-based comp, etc.) 3) add increases in current liabilities 4) (subtract) decreases in current liabilities 5) add decreases in current assets 6) (subtract) increases in current assets 7) equals cash generated from/(used in) operations Why do we add back non-cash items to income (#2, above)? Let's think about that for a moment. It is because 'included' in your net income are expenses that you never paid cash for (e.g. depreciation expense). Now, let's apply that same concept to an invoice we just received. Let's journalize it. DR Expense CR Accounts payable What just happened? Well, we increased expense which lowered net income. We, also increased current liabilities (#3, above). Conceptually, this is exactly the same as our #2 above, adding back non-cash items. This expense represents a transaction that is decreasing income without cash (since the other side of the entry is accounts payable). This is the reason why, in this case, the cash flow statement requires you to 'add back' the increase to your current liabilities. With me so far? Let's move onto what happens afterwards, perhaps in the next accounting period. Well, eventually, we will want to pay that invoice we recorded last month. What will happen? DR Accounts payable CR Cash This transaction has nothing to with the computation of net income during this accounting period. However, we have now 'used' cash (to pay the invoice). Hence, from our original equation above (numbers 1 through 7), we will have to record how cash was 'used'. Well, we know that accounts payable 'decreased' when we paid this liability. Therefore, on the statement of cash flow, we will 'subtract' the decrease in our current liabilities (i.e. accounts payable). If you think about it, this transaction is simply the opposite, in terms of cash flow, of the first transaction I described (i.e. DR expense, CR A/P) and the reasons the signs are simply opposite: 'add' increases and 'subtract' decreases to current liabilities. Once you have a firm understanding of these concepts, you'll understand the concepts for how this applies to current assets. Hope this helped and wasn't too confusing. Regards

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Avatar 37a3bd7bc7328f0ead2c0f6f635dddf60615e676e6b4ddf964144012e529de45 Vinita Khemani answered over 3 years ago

HI Answer is As because they are already added in our cash flow we are going in reverse way so increase in assets already considered so we give reverse affect to arrive at cashflow. For example if any Expenditure is disallowed in Income tax so we add it back to profit which is reduced from profit earlier to arrive at taxable profit

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