American Journal of Business Education – December 2010 Volume 3, Number 12
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Accounting textbooks provide some examples and rationale for the effects of the additions and subtractions
on net income, but they give only fragments of the concept of the reconciliation; i.e., they analyze the effect of just
one addition or subtraction at a time on net income or on operating cash flow. For example, an increase in accounts
receivable is one of the deductions because the increase (accrued revenues) was included in revenue (and net
income) but not in cash. As a result, an increase in accounts receivable is subtracted from net income in the
reconciliation to derive net operating cash flow. However, many students have difficulty understanding the concept
and role of reconciliation. They have trouble understanding why any increase/decrease of balance sheet accounts
should be subtracted from/added to net income to begin with; i.e., the concept of reconciliation. Furthermore, many
students have a hard time understanding the effect of changes in inventories on net income.
Students’ difficulties in understanding the concept of reconciliation may be contributed by incomplete
definitions of the reconciliation/indirect method the standards and textbooks provide and by the fragmented single-
account approach. For example, operating cash flows that do not affect income statement (i.e., cash transactions
dealing with current assets or liabilities) are not specified in the definitions of the reconciliation. Under GAAP, in
Accounting Standards Codification (ASC) 230-10-45-28 (SFAS 95), it defines the reconciliation/indirect method as
follows: ―that which requires adjusting net income of a business entity or change in net assets of an NFP to remove
both of the following: 1) the effects of all deferrals of past operating cash receipts and payments, …. , and all
accruals of expected future operating cash receipts and payments … and 2) all items that are included in net income
that do not affect net cash provided from ...‖ In addition, under IFRS, in International Accounting Standards (IAS)
7.18, it defines that ―the indirect method adjusts accrued basis net profit or loss for the effects of non-cash
transaction.‖ It is clear from these definitions that non-cash transactions, such as depreciation or amortization
expense, be added back to net income since they had a negative effect (the higher the depreciation, the lower the net
income) on net income. Also, an increase in receivables reflects non-cash transaction or an item that is included in
revenues and net income but does not affect net cash. As a result, an increase in receivables will be subtracted from
net income because it had a positive effect (the higher the increase, the higher the non-cash amount contained in
revenue, and the higher the non-cash amount in net income) on net income. However, the definitions do not mention
what happens to a decrease in receivables, a decrease in payables, or any operating items that are not included in the
income statement but do affect net cash (i.e., cash transaction that do not affect net income). Many students are
confused with changes in inventories with respect to the reconciliation because there are other accounts (i.e., cost of
goods sold, purchases, beginning accounts payable, and ending accounts payable) involved at the same time. The
fragmented single-account approach is just not able to explain the effect of this change on net income at all.
This paper will focus on the operating section of the statement of cash flows; i.e., the reconciliation/indirect
method. As a result, we will use operating income instead of net income in the paper. The reconciliation process
requires two types of adjustments to the operating income: 1) to remove effects of accrual-basis operating
transactions that have no effect on cash and 2) to include effects of cash-basis operating transactions that have no
effect on operating income. The adjustments from the former item are clearly identified in ASC 230-10-45-28, IAS
7.18, and SFAS 95 par. 28, and covered in textbooks, but those from the latter are not specified (although shown in
the example), making the definition and explanations incomplete.
To explain why and how the additions and subtractions relate to the reconciliation, one must first define
accrual- and cash-basis accounting methods and demonstrate their relationship, then explain how the role of
reconciliation works based on their relationship, and finally show how the additions and subtractions can be derived
following the reconciliation of accrual- and cash-basis accounting methods.
To help students understand the reconciliation concept of the statement of cash flows, a conceptual
framework is needed, which contains the basics of, and components in, both accrual- and cash-basis accounting;
illustrates how the components of these two methods correspond to, and are reconciled with, each other; and shows
the role of adjustments in the reconciliation.
This paper creates a conceptual framework to present the fundamental logic behind the indirect method for
reconciling operating income to net operating cash flow. Further, the paper applies accounting terms related to ASC
23-10-45-28, lays out the components from both accrual- and cash-basis accounting, demonstrates the relationships
among the components, derives the additions and subtractions, provides the rationale for the reconciliation in the
indirect method, and describes the application of the framework.