The second type of adjustment used to reconcile net income to cash flows from operations involves changes in the working capital (current asset and current liability) accounts. Net income must be adjusted for the cash flows associated with these changes. Again, we discuss each of the most common working capital adjustments reported in the operating section of the statement of cash flows.
Accounts receivable.
Revenue recognition is based on the economics of a sale rather than the realization of cash. Unless a customer pays in cash, recognition of revenue increases accounts receivable. An increase in accounts receivable indicates that a firm did not collect as much cash as the amount of revenues included in net income, and a decrease indicates that a firm collected more cash than it recognized as revenues. Thus, to account for the amount of revenue that is in net income but does not reflect cash collected, increases in accounts receivable are subtracted from net income; decreases inaccounts receivable are added to net income.
Inventories.
Two features of inventory accounting lead to adjustments to net income in computing operating cash flows. When inventory balances increase, the cash flow statement subtracts this amount because it does imply a cash outlay. Similarly, when inventory balances decrease, the cash flow statement includes a positive adjustment because the decrease is expensed as cost of goods sold, but some of this amount relates to inventorythat was paid for in a prior reporting period.
Prepaid expenses.
Prepaid expenses are simply cash payments that have yet to be expensed. Increases in prepaid expenses indicate cash payments in excess of amounts recognized as expenses in computing net income; decreases in prepaid expenses represent amounts that were expensed but for which there was no equivalent simultaneous cash flow. Thus, the cash flow statement must subtract increases in prepaid expenses or add decreases in prepaid expenses. income statement. For example, suppose a firm was invoiced for services received at the end of the fiscal year but did not pay the invoices until the following fiscal year. The firm would recognize the services as expense and the increase in liabilities. The expense reduces net income, but no cash has been paid, so the amount needs to be added back to net income in computing operating cash flows. On the other hand, decreases in accounts payable and accrued expenses would indicate cash payments of such liabilities exceeded expenses that increased those liabilities, implying net cash outflows
Income taxes payable.
Firms typically do not pay all taxes due for a particular year during that year. Some taxes paid within a year relate to taxes due for the preceding year; some taxes due for the current year are paid the following year. Recall from the earlier discussion about non-working capital adjustments that the addition to (or subtraction from) net income for deferred income tax expense (or benefit) converts income tax expense to income taxes currently payable. The adjustment for changes in income taxes payable similarly converts income taxes currently payable to the income taxes actually paid
Other current assets and liabilities.
In addition to the working capital accounts discussed previously, there are other current accounts such as marketable securities, shortterm investments, commercial paper, and other short-term borrowings. The cash flows pertaining to these items are shown in investing (marketable securities, short-term investments) or financing activities (commercial paper, short-term borrowings
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