 Hello and welcome to this session. This is Professor Farhad in which we would look at adjustments to net income in the prior session We looked at how to prepare the statement of cash flows using the direct method as well as the indirect method and Under the indirect method if you remember we always start with net Income then what we do is we make certain adjustments to net income pluses and minuses now We learn about those adjustments, but there are special cases special circumstances or you would have few unusual Adjustments which they will need special attention. So the operating section using the indirect method starts with net income Then we make certain adjustments and I'm gonna list all the adjustments We're gonna be covering in this session and as if you know me once I have a list I'm gonna go over each item on this list separately starting with non-cash expenses Realized and unrealized holding gain and losses changes in deferred income taxes equity method of accounting stock options Unusual and unfrequent items account receivable net changes in short-term capital changes and Non-cash transaction once again, I'm gonna go over each item separately explaining how each item Effect somehow the adjustment to net income Starting with non-cash expenses non-cash expenses. We ignore them We don't take a look at them when we are dealing with the direct method because the direct method is converting something to a cash expense. Well, it's already non-cash expense You cannot convert it into a cash expense Therefore those non-cash expense items are ignored for the direct method For the indirect method non-cash expenses Non-cash expense expenses reduce net income. So what they do because remember under the Indirect method what we do is we start with net income So for the direct method, it's easy. We ignore them for the indirect method We start with net income and we go backward and we reconcile So what happened is this dose? Non-cash Expenses they were deducted to arrive to net income now. What do we need to do? Well, we if we're only looking for Income on a cash basis if we deduct them to get the net income We're gonna go back and add them back Therefore we add to net income and what are some examples of non-cash expenses? Well, the main one is depreciation Well depreciation think about it. We debit depreciation expense. We credit accumulated Depreciation so notice we did not credit cash. Therefore. This is a non-cash expense Amortization same concept but that expense and other non-cash expenses also. We need to be aware With discounts on bonds payable when we have discounts on bonds payable What's gonna happen is the the discount will increase the interest expense So whatever we discounted it increases interest expense. Well, it increases The expense so the expense was deducted and it increases well What do we have to do? We have to add back that increase because the discount was not really a cash outflow now The opposite is true for the premium If we have a premium on bonds and what that what did the premium do? Well, the premium involve expense expense reduces income, but the premium reduces the expense notice It reduces the expense well as a result because it reduces the expense without given us cash What do we need to do? We need to deduct as an adjustment So it's the opposite of a discount and hopefully this makes sense Because why because the expense went down, but we did not really save any cash Well, what happened is to adjust that premium that additional reduction in the expense that additional help we deducted back Now before we proceed any further and discuss other items I would like to remind you whether you are a student or a CPA candidate and most likely that's who you are if you are watching That's most likely who you are. That's a great. You have arrived go a step further Farhat lectures comm or I have additional resources Lectures multiple choice true false exercises that's gonna help you do better in your accounting course as well as the CPA exam I don't replace your CPA review course. I'm a useful addition I can help you understand the material better The fact that you are watching is you are looking for some help and you have arrived if you have not connected with me only then Please do so take a look at my LinkedIn recommendation like this recording share it with other Connect with me on Instagram Facebook Twitter and Reddit Let's talk about post retirement benefit cost simply put we are talking about pension expense Well, sometime pension expense might be higher or lower than the cash payment made to the trust So when the company sends this paycheck to the trust Well, the paycheck the cash payment might be different. Let me give you an example The company might debit bad that it might debit expense, which is specifically pension expense 100,000 might credit cash 70 and might credit pension obligation 70. So let's think about this so We have net income Before we arrive to net income we deducted 100,000 in pension expense This is how much we deducted to arrive to net income But in reality, we only send a check for 30,000. What does that mean? It means of the 100,000 30,000 was cash 70,000 was non-cash. So what do we have to do when we are making When we are making the adjustment Well, we have to add back 70,000 we have to add back 70,000 now. Let's assume another scenario. We debited Expense pension expense to be specific 150,000 so So now we are dealing with net income here and we deducted 150,000 in pension expense But we credited cash 200,000 we send a check for 200,000 and the difference either we owed the the Depension benefit or we added money to the trust either or it doesn't matter whether the debit is a to pension obligation Or to the asset to the asset of the fund the point is We Expensed 150 but we paid in cash 200,000 it means we have to deduct from a cash perspective in additional 50,000 little bit unusual Why because usually non-cash expenses are added now we are subtracting and the reason is because we expensed more than what we Paid so this is how we deal with those expenses and it doesn't have to be this expense All expenses that follow the same rules. They have to follow this basically the same Concept and we will see another example shortly. Let's take a look at the equity method of accounting Well, how does the equity method works? Well, let's review real quick Let's assume Adam owns 40% of Avi company. Well, Adam uses the equity method Avi reported 100,000 in net income and 30,000 in dividend Let's take a look at you at the journal entries that Adam would do Adam will debit investment in Avi 40,000 which is 100,000 times 40% would increase their investment and they will credit revenue from investment for 40,000 and remember the revenue from investment goes into net income So we have net income and what we did is we added 40,000 of revenue to come to come up to our net income Also for the dividend we debit cash 12,000 only which is 30,000 times 40% and we credit our investment in Avi 12,000 Now, let's take a look at what happened from a cash perspective from a cash perspective we added $40,000 which increased net income But how much of that 40,000 was only cash only 12,000 was cash the remaining was non cash non cash. So what do we have to do? We start with net income subtract 12,000 and add Subtract, I'm sorry 40 and at 12 so all in all will deduct 28,000 from net income from net income and To arrive to to arrive to the proper number and this is how we deal with the equity method Losses and gains are another major adjustment to net income now bear in mind for the direct method It's easy because they're already non cash. Therefore, we ignore them for the indirect method Losses add losses back because they are treated as non cash expenses. Why? Because we before we arrive to net income Losses were deducted. Okay, but losses are non Cash, so what do we do with losses if we deduct them then we add them back Now gains the same concept Gains are the same concept We gains are added to come up to net income, but they don't really increase cash There is no cash inflow. Therefore we deduct them Let's take a look at an example to just to illustrate this concept Land with the cost of 100,000 was sold for 110. Let's take a look at the journal entry. We debit cash 110,000 we credit the land and we credit gain on sale. So notice the gain on sale Was up here 10,000 which in turn increase net income However, the whole amount of cash is Counted in the investing section because we said the 110,000 selling the land is an investing activity therefore The additional that additional gain of 10,000 is already counted in the investing activity and it's considered a non cash inflow from operating perspective Therefore we deducted and we remove the land obviously this will be also an investing activity So the point to remember is the gain was already accounted for if you're if you're saying but I really had a ten thousand dollar Cash gain. Yes, that's fine The additional ten thousand was considered investing take it out of operating if not at least your double count in it If you don't you know, if you're not understanding how it's not a non cash revenue now the same concept would apply If you sold this land for 90,000 if you sold the land for 90,000 you would have a loss on sale of 10,000 Again, the loss would have deducted deducted your net income reduce your net income by 10,000 because it's deducted But it did not really lose 10,000 off cash Therefore you add back the loss and hopefully this will this this did it basically did it in a sense Clarified it and here we are talking about realized gains and losses. Let's talk about unrealized losses and gains unrealized holding losses and gains and what's the difference between unrealized and realized unrealized means You did not actually sell the investment. You did not sell the asset You did not sell the item you have it on the books and you're gonna mark to market Well, we have to be careful here because we could have three different scenarios for those unrealized holding gains and losses We could have trading debt securities trading debt investments Which they will incur unrealized holding gain loss Well unrealized holding gain and loss for those type of investments are listed on the income statement Well, if they are listed on the income statement, that's easy They follow the same rules as the previous regular regular means realized gains and losses because they affected their income and as a result loss is added and Gains are deducted. That's one category. The second category is that investments now. They are available for sale not trading Well, what do we have to know about this group? Well, this group any unrealized holding gain and loss is reported in Comprehensive income, which is part of the balance sheet. What does that mean? Well, good. That's easy No effect on income. Therefore, we ignore them. So you have to be very careful if you are dealing with that investment Available for sale and they're giving you unrealized holding gains or holding losses. Just simply from a cash flow perspective You don't have to worry about them. Whether the direct or the indirect because they did not affect net income Therefore from an operating perspective, you ignore them three unrealized gains and losses when you own less than 20% Well, what do you have to know about this group? This group goes into net income. So any unrealized Gain or loss goes into net income. Well, that's easy. If it goes into net income, we're back to one If we're back to one, it means we follow the same rules. We follow the regular gains and losses as we saw on the previous slide Stock options. What is stock options? Well stock options when the company grant options as a form of compensation to their employees What entry do we make when we grant stock options? We debit Compensation expense that's assumed 10,000 we credit paid in capital stock option 10,000. Well, I hope you already just know this real quick It's an expense and it's a non-cash expense Simply put non-cash expense. We ignore for the direct method for the indirect method We add back as a non-cash expense. So we'll take net income plus 10,000 for the non-cash expense Just like depreciation But that expense any non-cash expense But I just want you to pay attention to stock options because stock options could be buried could be part of your Compensations or salaries expense. Therefore, you might have to take it out Let's talk about the change in the third taxes. Let's assume we are Recording at the third taxed asset. Now, if you don't know what's the third taxed asset I can't explain it in this session the assumption is you know how this work You can go to far hat lectures. Otherwise, you will see the journal entry and hopefully it will make sense for now You will debit the third taxed asset 10,000 and you will credit the third when you record the third taxed asset It means you are saving on your income tax expense now So notice what happened your expenses your expenses went down So simply put if we're talking about net income what happened is you have an expense and that expense It's like a plus expense. What do I mean because usually expenses you get deducted to come up to net income Now It's adding to your net income. It's a plus in your net income. It's adding to your net income Why because your expenses are going down. It's like a plus. So think about it What happened is this you reduced your expenses by 10,000 which is but there was no cash inflow You did not really have an additional 10,000. No, what no one gave you 10,000 So you did deduct it since you since it reduces your expenses here You will need to deduct this from your net income So basically the opposite of non-cash expenses that we learn about because under non-cash expenses you deduct the expense That's non-cash then you add it now what you're doing is you're the opposite since it reduces your expenses without bringing your cash You will deduct it from operating. It's a little bit unusual. Yes, you just have to be careful Unusual and infrequent items they could be sometime investing or financing activities For example land condemnation by the government as a result you could have a gain or a loss you treated just like you would Read gains and losses a count receivable Well, you have to be careful with the count receivable because we are dealing in the allowance for bad that because what the count receivable comes allowance for bad that Remember allowance for bad that is a contra asset account. So any change Add back the increase in the change. Remember, it's kind of the opposite of receivable. Let's let's take a look at some numbers If we have in year x1, we have 90,000 in receivable in x2 a count receivable was 107 So notice a count receivable increased by 27 now, we know from a cash flow perspective. The adjustment is Negative to cash flow. Why? Because you sold more on account. It means you are not receiving the cash. Therefore, it's negative cash flow. That's fine Let's take a look at the related Allowance account well the related allowance account went from 10,000 to 15,000 That's also an increase of 5,000 also an increase But notice from a cash flow perspective Since the allowance is the opposite of a regular regular asset you add to cash flow So simply put what you do you net them out. Therefore the increase the The net is an increase 12,000 net increase and obviously that's overall a negative to cash flow Now bear in mind for the direct method you ignore the allowance because it's part of bad debt expense You would you you would use the gross receivable when you are analyzing your sales? Let's talk about working capital, which is Current assets minus current libraries That's what working capital is and sometime you might have changes in working capital that you need to be aware of it Unusual changes like what well it might affect cash, but not net income. Therefore, they are not part of your income Well, let's assume you purchase short-term securities, which is that's fine. If you purchase short-term securities, that's considered operating. That's fine However, if you issue short-term non-trade notes payable simply put you borrowed for short-term basis Well short-term is current liabilities. You would say well, this should affect my operating section It's not when you are borrowing money. It's financing be aware of this also When you declare dividend, you might have a dividend not you might you will have a dividend payable again dividend payable is a current liability You might be thinking well Let me let me compute the change in my dividend payable and included in operating not at all dividend payable is a financing activity Just be aware of those couple things now You might also have non-cash transaction that are significant. What do you need to do with those? You need to report them or disclose them like what? Exchange of non-monetary asset you exchange a truck for another truck building for another building. There's no cash exchange Exchange of long-term debt by another debt basically refinancing you took one debt You exchange it for another debt. You did not really receive any cash. All that happened is one debt to replace the other Non-cash transaction you purchased asset by issuing debt including capital leases again non-cash You purchased assets by issuing stocks equity non-cash. You converted that or preferred Stock into common stock again non-cash. You exchange equity for that You gave them some stocks inside of the debt non-cash transaction What do you need to do with all of those report or disclose? Make sure they are available so the users of the financial statement will make more sense of the numbers What should you do now go to far hat lectures and work MCQs through false questions? That's gonna help you understand this topic better. Don't short change yourself study hard. Good luck, and of course stay safe