Welcome to Accounting 101 episode 13 how to dominate in Direct Cash Flow statements fake cash method. If you recall from our episode on the introduction to financial statements, there were two methods used to present the statement of cash flows the direct method and the indirect method the indirect method is much more commonly used and today we are going to go over a trick to help you make the dreaded indirect cash flow statement, very understandable. If you have not listened to episode one and two and probably episode for you may want to listen to those episodes before continuing to listen to this episode. This method is only going to be valuable if you understand the L ra Concepts from episode 2, you should recall from episode 4 that the statement of cash flows is broken up into three reporting sections. In investing and financing it goes in that order operation Iraqi freedom for me. If you think of something else that works for you good cash flow from operating activities or the activities from your ongoing operations. This is going to be the cash flow from transactions that affect the net income of the company cash flow from investing activities are the activities from Capital expenditures, which is another way of saying the purchase of fixed assets. It's also Investments made and any game gains or losses from Investments. This is going to be the cash flow from transactions that affect non-current assets of the company cash flow from financing activities are the activities from loans and the activity between the company and the owners of the company. This is going to be the cash flow from transactions that affect the debt and Equity of the company. So on the statement of cash flows, you will always see the beginning cash balance and this will agree to last periods ending cash balance if you look at the balance sheet from Period you will also see an ending cash balance on the statement of cash flows and this will agree to the ending cash balance on the balance sheet for this period the indirect cash flow statement starts with net income. And then it makes adjustments to cash for income and expense items that do not affect cash. Keep in mind that we are using an accrual method of accounting so our net income is being affected by sales or expenses where money has not yet changed hands. So for example, if we had a 1 million dollar sale on the last day of the year that is going to be in our net income, but we did not receive any cash for it. So what we are doing in the indirect method is we are unwinding these things to get to the actual change in cash for the period. So the indirect method looks at the changes in balance sheet accounts to determine the cash effects in essence. What you were doing is solving algebraically for cash if we know that assets equals liabilities. These plus Equity we can break down our assets into cash and non-cash assets. So if we express that same equation as cash assets plus non-cash assets equals liabilities plus Equity. We can subtract non-cash assets from both sides that leaves us with cash equals liabilities plus Equity - non-cash assets, and that's what we're doing here in the indirect method. Did but it's not formatted like that at all when you're doing this in the real world. You should be working off a template from last year and that's going to make knowing which accounts are going to be affected in each section pretty easy. You only need to be on the lookout for unusual items in your accounting class. There's a chance that you will have to create an indirect statement of cash flows from scratch or the professor fills in part of it or you're being asked how a change in this account or that account affects cash. The point of this episode is not to tell you what goes in each section. You need to memorize that yourself the point here is to show you how to figure out whether the item will be an increase or a decrease to cash. Let's get into the fake cash method and do a few examples to illustrate. So let's assume from last period to this period our accounts receivable increased by twenty thousand dollars and we had 100,000 dollars of net income in this period what would our cash flow from operations look like assuming these are the only transactions that occurred. Let's first look at it logically. Lee say our accounts receivable balance was 50,000 at the end of last period and now it's 70,000 the end of this period the numbers don't really matter, but that's our twenty thousand dollar increase. Well, we know that in order to increase our accounts receivable, we would have had to debit accounts receivable for $20,000 because it's an asset and at the same time we would have made a credit to sales for $20,000. That's the net result of the transactions that we would have made. It could have been multiple transactions. Well what that means is that our 20,000 dollar increase in accounts receivable is sitting in our one hundred thousand dollars of net income, which means that our cash flow from operations is only 80,000 in that example. No, the fake cash method. Does this you make a fake journal entry to record the change in the account you are looking at and then you balance the transaction with an entry to fake cash. We know that a journal entry must always balance. There must be an equal number of debits and credits. If you have to make a debit to fake cash, that means the cash is being increased for that item. If you have to make a credit to fake cash, that means cash is being decreased for that item. So when you were looking at the cash flow statement and you see an increase in accounts receivable for $20,000 accounts receivable is an asset which means that it has a normal debit balance. So in order to increase accounts receivable by twenty thousand dollars from last period to this period we would need to debit accounts receivable. So you should create a journal entry debit accounts receivable for $20,000 credit fake cash for $20,000. This represents a decrease in cash because we made a credit to fake cash. I say fake cash because this is not a real journal entry. It's not being recorded anywhere. You're just jotting it down on a piece of paper. This is just a trick to tell you whether cash is being increased or decreased on the cash flow statement. So once again if you have to make a debit to To fake cash. That means cash is being increased for that item. If you have to make a credit to fake cash, that means that cash is being decreased for that item because remember cash is an asset with a normal debit balance. So a debit will increase it and a credit will decrease it. So if you know your aleready, there's nothing you need to remember to utilize this fake cash method. So again, our accounts receivable balance increased by Twenty. Dollars from the end of last period to the end of this period we see it right there in our 2 year comparative balance sheet. So we make our fake journal entry. We debit accounts receivable for $20,000 and we credit fake cash for $20,000. That means an increase in accounts receivable of $20,000 is a $20,000 decreased to cash on our indirect cash flow statement. This works with any of the accounts, but you need to know the AL re part of this you need to identify the type of account and whether it has a normal debit or credit balance for this to work. So let's say that our accounts payable increased by ten thousand dollars from the end of last period to the end of this period Well accounts payable is a liability account, which means it has a normal credit balance. So in order to increase accounts payable, we would have to credit it for $10,000. This means that we would make a ten thousand dollar debit to fake cash, which represents that this transaction would increase our cash flow. Let's look at that logically, if our accounts payable increased by ten thousand dollars, that means that within our net income. There are ten thousand dollars worth of expenses that we used. It's payable for and we have not yet paid for it doesn't matter how complicated the item sounds you can break down the debits and credits just like this. So let's say that are accrued expense payable decreased from the end of last period to the end of this period by $25,000. Okay, so accrued expense payable is a liability in order to decrease a liability. You have to debit it. So debit accrued expense payable for $25,000 credit fake cash for $25,000. So a 25 thousand dollar decrease in our accrued expense payable means a 25,000 dollar reduction to cash on the cash flow statement. Thinking logically if we reduced a liability by 25,000 from one period to the next we would have had to expend 25,000 dollars of cash to do. So, that's the fake cash method now that you know this you should not feel intimidated at all. When you see an indirect cash flow statement and you need to figure out whether you should increase this or decrease that another obvious thing to keep in mind is that non-cash expenses like depreciation and amortization or added back to net income. You don't need a method to figure that out. A out most of the cash changes that happen in the investing and financing sections are pretty obvious as well. You need to nail focus on which accounts are affected in each section and some of the other tricky parts of the statement of cash flow such as where to show gains on sales of assets Etc. You don't need me to tell you which items go in which section you need to open your text book to the chapter on statement of cash flows and you need to create yourself some index cards while you're in your textbook doing that. You should look at an example of the indirect cash flow statement and prove out the changes to cash using this fake cash method. It should then make a lot of sense to you. And that's when you're going to see how valuable this method is. Keep in mind that when you do everything right here the change in cash that you calculate on the indirect cash flow statement will be the difference between the beginning cash balance and the ending cash balance and the beginning and ending cash balance is can be traced to your balance sheets. I hope you all find this method is useful as I have as I continue to stress. This is all about the debits and the credits L re is the language that you must know. Please spend a minute to rate and review the show. So that others can find it. I appreciate those of you who have already taken the time to do so. If you have any questions, or you have a topic that you would like me to break down send me an email at Jimmy dot Stewart CPA at gmail.com. I'd be happy to spend the time to help you better understand any of these Concepts. Thanks for listening. I'll speak to you next time.
Example # 1 Our Accounts Receivable balance increased by $20,000 from the end of last period to the end of this period. 1. Accounts Receivable is an asset, so it must be debited to increase its balance. 2. Create journal entry:                                                              Debit    Credit Accounts Receivable                  $20,000           Fake Cash                                            $20,000 3. A $20,000 increase in Accounts Receivable = $20,000 cash flow reduction on the statement of cash flows. Example # 2 Our Accounts Payable balance increased by $10,000 from the end of last period to the end of this period. 1. Accounts Payable is a liability, so it must be credited to increase its balance. 2. Create journal entry:                                                                Debit     Credit Fake Cash                                         $10,000         Accounts Payable                                   $10,000 3. A $10,000 increase in Accounts Payable = $10,000 cash flow increase on the statement of cash flows. Example # 3 Our Accrued Expense Payable decreased by $25,000 from the end of last period to the end of this period. 1. Accrued Expense Payable is a liability, so it must be debited to decrease its balance. 2. Create journal entry:                                                               Debit     Credit Accrued Expense Payable            $25,000             Fake Cash                                             $25,000 3. A $25,000 reduction to Accrued Expense Payable = $25,000 cash flow decrease on the statement of cash flows. 