Notice that $5,000 in cash was received, not $2,000. It is essentially there to balance the transaction. The gain or loss on the transaction is considered to be a noncash part of the transaction. While some cash may change hands when an asset is sold, the amount of cash received relates to the removal of the asset. Other noncash items include amortization, gains and losses. Adding it back removes it from net income, helping us get closer to the change in cash. Since the depreciation was subtracted on the income statement, we need to add it back to net income on the statement of cash flow. This leads to one of the differences between net income and change in cash. On the income statement, the expense lowers net income but there is no corresponding decrease in cash. The entry creates an expense, which appears on the income statement but no cash changes hands. Think about the entry recorded for depreciation. The most common noncash item is depreciation. Noncash operating activities relate to items that appear on the income statement, yet cash was not affected by that item. There are two main types of operating activities: noncash and those related to current assets and current liabilities. In other words, these are items related to income and expenses. These are activities related to operations or the income statement. The statement ends with the amount that cash has increased or decreased over the course of the period and the ending balance in cash.Įvery source or use of cash can fit into one of three categories: operating activities, investing activities or financing activities. Each line on the statement explains where cash is coming from, called a source of cash, or where cash is going, called a use of cash. If there was a $500,000 profit, the statement of cash flow explains why the increase in cash is not also $500,000. The purpose of the statement of cash flow is to explain the difference net income and the change in cash over the same period. It could have even decreased! When that money is not there, the person may believe there is a problem with the income statement. Individuals think in terms of cash so when an individual sees a company with a profit of $500,000, he or she may think that there is an additional $500,000 worth of cash sitting in the bank at the end of the year. This causes a problem for many people looking at the financial statements. In business, we are frequently recording income and expenses when no money has changed hands. These businesses recognize expenses when the cost is incurred, regardless of payment status. Most businesses recognize income when the work is done, whether or not the job has been paid for. It is important to remember that most businesses do not operate that way. We recognize expenses when they are paid. As individuals, we do not consider income when it is earned. I believe this is because most people live in a cash basis world. Most people have a difficult time understanding the concept of accrual accounting. Once you understand the purpose of the statement, wrapping your brain around how to complete it is much easier. Understanding the purpose of the statement of cash flow is the key. It could be argued that the statement of cash flow is the most important of all the financial statements.
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