 This audio lecture is brought to you by the YouTube channel Farhat Accounting Lectures. On my YouTube channel you can find over 1500 free accounting, auditing and tax lectures to prepare for your CPA exam. Those audio lectures are designed for people on the go, for busy people, people who are commuting on the plane, on the train or if you are spending some time in the gym or walking in the park or even trying to go to sleep. So they are designed to review the material for the exam. If you really want to learn the material in depth, please visit my YouTube channel. And if you happen to visit my YouTube channel, please consider making a donation to support the channel. I'm here to help you. Let's get started. This audio file can be downloaded from my website, farhatlectures.com. In this audio we will discuss the operating section of the cash flow statement. When you think of the operating section, think of net income. Why? The operating section of the cash flow statement is taken net income that's prepared on an accrual accounting basis and converting that net income into cash basis. So that's why I want you to think about net income. Now what goes into net income? What goes into net income is revenues and expenses. If you want simply put, if you want to compute your net income, you take your revenues minus your expenses. Remember we are dealing with revenues that is accrual in basis and expenses that's accrual in basis. That means in addition to the revenues and the expenses that you see on the income statement, you will need some additional information. What do you need? You need information about the changes in your account receivable and in your inventory, in your supplies, in your prepaid, in your account spable. Simply put, you need more information about the changes in current assets and current liabilities. Therefore, when you are preparing a statement of cash flow, you need a current statement of net income, of the income statement to get net income. You need two years worth of balance sheet, the current year and the prior year and you might need additional information as needed for that particular company. So those are the information that you will need. So to prepare the operating section of the cash flow statement, you will start with net income. And the purpose of this section is to take net income and convert net income into cash net income by going through a reconciliation process. So to go through over this reconciliation process, I'm going to summarize it into four steps that you can always take to the bank and it will always work for you. So let's start with step one. Step one is starting with net income. Guess what? That step could be very easy if the income statement is given or if net income is giving. If net income is giving, that's your first piece of the operating section of the cash flow statement, net income. Now you might be saying, what happened if it's not giving? If it's not giving, then you must be giving some information about retained earnings. Okay? So you should be giving the beginning retained earnings and the ending retained earnings. What does that mean? It means you have to look at your balance sheet information and analyze retained earnings. Let's assume retained earnings started at 10 and ended up this year at 15. It means there was an increase of $5 in retained earnings. But you have to be careful. You have to see if there is any dividend, any changes in retained earnings. Let's assume they told you the company declared and paid $2 of dividend. That means you started at 10, you should have went down by 2, but you end up an increase of 15. That means your net income is $7. Remember, beginning retained earnings plus net income minus dividend equal to ending retained earnings. You must be giving beginning retained earnings, ending retained earnings and dividend. Again, beginning retained earnings plus net income minus dividend equal to your ending retained earnings. So we are done with step one. Just hope net income will be given to you. Okay? Let's discuss step two. Step two is add any non-cash expenses. So you need to know what are the non-cash expenses? It means expenses that you had to book on the income statement, but those expenses did not consume cash. What does that mean? It means when you book them, when you debited your expense, you credited something other than cash. Let's think about them. Well, depreciation. When you debit depreciation expense, do you know what your credit is? Your credit was accumulated depreciation, not cash. When you debited amortization expense, did you credit cash? Not at all. You credited either accumulated amortization or you credited the intangible itself. The same concept would apply to depletion expense. The same concept would apply to bad debt expense. Those are expenses that reduced your net income, reduced that number that you started with, but it did not consume cash. Once you are going from net income to cash net income, you have to add back those expenses that reduced your net income without reducing your cash. So this is step two. Step three. Step three, I'm going to break it down into two component. You might have gains and you might have losses. What are gains and losses? Let's start with losses. Losses is when the company sells an asset that it has nothing to do with their central operating activities and they incur a loss. A loss means they sold it less than its book value. Instead we compute the book value, the cost of the asset minus any accumulated depreciation. Let's assume McDonald's, McDonald's sells burger and McDonald's owned a piece of land and it has a cost of 2 million and they sold the land for 1,900,000. So they incur the loss of $100,000. That's the loss. So the loss went on the income statement and reduced their net income by $100,000. But did they really lose $100,000 in cash? Not at all. They received $1.9 million. But there was a loss. So the loss, think of the loss, not think of it, it is a non-cash expense. So the loss reduced their income without reducing their cash. You might be saying, didn't they receive $1.9 million in cash? Yes, they did. That $1.9 million will be accounted for in the investing section because selling land is like selling property, plant and equipment. So it will be accounted for. The same concept will apply, but in a reverse, if McDonald's sold that land for 2 million and $100,000, what happened is they will book a gain for $100,000 because the land has a book value of 2 million. That gain increased their income by $100,000. But the cash from the sale will not be accounted for in the operating activities because that's not an operating activity. The whole 2.1 million will be accounted for in the investing. Therefore, if we have any gain, we have to deduct the gain. We have to subtract the gain. I know it's counterintuitive. Where am I deducting the gain and adding the loss? It's a little bit counterintuitive, but if you have to remember on the exam, it's counterintuitive because when you think of losses, you think of deducting. You add the losses. So remember, losses you add gains you subtract. And how do you find out the gains or the losses? If you're given the income statement, you have to scan the income statement. You may not be given the income statement. You could be giving pieces of information here and there about the book value of that land or the book value of that property and its accumulated depreciation. And they may tell you it was sold for a certain amount. If you sold it more than the book value, you have a gain. If you sold it less than the book value, you have a loss. How do I compute my book value? My cost minus accumulated depreciation. The information will have to be given to you somewhere. So that's step three. Step four. Step four is the most important step in my opinion. And step four deals with current assets and current liabilities. And to be more specific, non-cash current assets. And what are current assets? Those are your accounts receivable, your supplies, your inventory, your prepaid. What are your current liabilities? Accounts payable, accrued liabilities, salaries, so on and so forth. Account access payable. Now, what do you have to do with current assets and current liabilities? You have to analyze them. What does analyzing mean? It means figuring out the change from period to period, from the prior year to the current year. And that's why you need two years off balance sheet. Let's look at current assets first. I'll start with the most obvious current asset, prepaid. Let's assume your prepaid went up. Your prepaid was $100. Now you're on the balance sheet, you show your prepaid at $120. What does that mean? It means there was an increase and the increase is $20. What does that mean? It means you acquired, you purchased prepaid. Think about the word prepaid. You prepaid. It means you had to pay cash. If your prepaid went up, it means you are consuming cash. It means your cash went down. Simply put, any time a current asset goes up, your cash goes down. Any time a current asset goes down, your cash goes up. Let's look at inventory. Your inventory went from $100 to $150. It means you have more inventory. It means you are buying more inventory. You might be saying, but you might be buying that inventory on account. Well, that's fine. We're going to account for that shortly. But every time your inventory goes up, your cash goes down by that difference. Now, if your inventory went down, your cash will go up. It means you are selling inventory more than what you are buying for that particular period. The same thing would apply to account receivable. If your account receivable went up, it means you are selling more on credit, on account than you are receiving in cash. That's why any increase gets deducted. Let's talk about liabilities. I believe they're easier to understand. They're both easy to understand, but maybe it's easier to clarify. Let's take accounts payable. If your payables go up, let's start with the payable goes down. If your payable goes down, it means you are paying off your liabilities. When you pay off your liabilities, you pay off your liabilities with cash. It means your cash going down. So, if the change in liabilities is negative, if your liabilities are going down, it means your cash is going down too. So they go the same way. So liabilities and cash go the same way. Liabilities go down, cash goes down. The opposite is true. If your liabilities are going up, if your current liabilities, your account's payable are going up, it means you are buying more goods and services, but you are buying those goods and services on account. Let's summarize the four steps real quick. Step one, start with their income. Hopefully, this will be an easy step. Step two, add non-cash expenses, depreciation, amortization, bed debt expense. Step three, add losses, deduct gains. Step four, analyze current assets and current liabilities. Current assets are cash, are inverse. When one goes up, the other one goes down. Current liabilities and cash, they're positively related. They work the same way. When one goes up, the other one goes up. When one goes down, the other one goes down as well. This is a summary of the operating section using the indirect method. Then we will net all these figures, starting with net income, and we come up with either cash used, it's negative, or cash provided by operating activities, which is net income, what I call net income on a cash basis. In the next session, I'm going to use the same section, the operating section, but I'm going to go over the direct method, how to convert the direct method for that session. Please, if you happen to visit my website for additional lectures, please consider donating. Thank you very much and good luck. Study hard.