Under both International Financial Reporting Standards (IFRS) and U.S. Generally Accepted Accounting Principles, when a statement of cash flows is prepared using the indirect method of cash flows, the net income from either the income statement or the statement of other comprehensive income is the starting point in the preparation. Adjustments are then made to the net income figure to arrive at the balance of cash and equivalents at the end of the financial reporting period.
Adjustments for Non-Cash Transactions
The first adjustments made to the net income balance involve non-cash transactions that have increased or decreased the amount of net income or loss reported by the entity during the financial reporting period. The most common non-cash transaction to be adjusted involves depreciation expense or amortization. Depreciation or amortization expense occurs when the value of an owned asset is reduced to reflect a write-down in the remaining useful life of that asset. Since no cash has been actually exchanged, the amount of depreciation or amortization expense must be added back to the amount of net income or loss reported by the entity. A similar adjustment is made for unrealized foreign translation gains or losses. Again, since no cash has actually been exchanged, the amount of any loss is added back to the net income or loss reported by the entity while the amount of any gain is subtracted from the amount of net income or loss.
Operating Activity Adjustments
Next, adjustments are made to reflect the increase or decrease in net cash from the change in the value of the operating assets or liabilities of the reporting entity during the financial reporting period. A decrease in operating assets results in an add-back to the net income or loss of the entity while a decrease in operating liabilities results in a deduction to the net income or loss of the entity. For example, if an entity's accounts receivable (an operating assets) fell from $100 to $50 during the financial reporting period, $50 is added to net income.
Investing Activity Adjustments
After all operating activity adjustments have been made, adjustments are next made to reflect the increase or decrease in net cash resulting from the change in the value of the investing assets or liabilities of the entity during the financial reporting period. A common investing asset is machinery or equipment. If an entity purchases $500 of equipment during a financial reporting period, $500 must be subtracted from the amount of net income or loss. Relatedly, if the entity sold $100 of old equipment to no longer necessary because of the new equipment, then, in a separate line item on the statement of cash flows, $100 is added to the amount of net income or loss.
Financing Activity Adjustments
The final category of adjustments to net income or loss are adjustments made to reflect the increase or decrease in net cash resulting from the change in the value of the financing assets or liabilities of the entity during the financial reporting period. A common financing activity is a bank loan. If an entity borrowing $100,000 from a bank during the financial reporting period, $100,000 must be added to the amount of net income or loss. If the entity subsequently pays down $5,000 of the principal (not interest) of the bank loan, then, in a separate line item on the statement of cash flows, $5,000 is subtracted from the amount of net income or loss.
