Putting the statement together¶
You now know how to build each piece: net income adjusted for operating activities, and investing and financing cash flows from the long-term accounts. On the job, nobody hands you the pieces separately. You get a comparative balance sheet, an income statement, and a few extra facts, and you have to produce the whole statement yourself, with one number at the bottom that has to land exactly on the balance sheet's cash line. Get any piece wrong and that number will not match. Get it right and you have proof the statement is complete.
A repeatable six-step procedure¶
Assembling a statement of cash flows is mechanical once you have a procedure. Every time: (1) compute the change in every balance sheet account from last year to this year, (2) classify each change as operating, investing, or financing, (3) build the operating section starting from net income, (4) build investing from the long-term asset accounts, (5) build financing from notes, stock, and dividends, (6) add the three sections to beginning cash and check that you land on ending cash.
Step 2 is where students rush. Every account that changed needs a home. Here is Harbor Music Lessons' balance sheet activity for Year 2, sorted:
| Account change | Amount | Classification |
|---|---|---|
| Accounts Receivable, down $1,200 | $1,200 | Operating (add back) |
| Supplies, down $1,700 | $1,700 | Operating (add back) |
| Prepaid Rent, down $350 | $350 | Operating (add back) |
| Equipment, up $5,000 | $5,000 | Investing (purchase) |
| Accumulated Depreciation, up $2,900 | $2,900 | Operating (depreciation add-back) |
| Accounts Payable, up $1,000 | $1,000 | Operating (add back) |
| Salaries Payable, down $1,250 | $1,250 | Operating (subtract) |
| Income Tax Payable, up $2,500 | $2,500 | Operating (add back) |
| Notes Payable, down $4,000 | $4,000 | Financing (repayment) |
| Retained Earnings, up $32,100 | $32,100 | Already inside net income |
Nothing on that list is left over. That is the real test of step 2: if an account changed and you cannot say which section explains it, you have missed a line.
From pieces to statement¶
Steps 3 through 5 are the sections you already know how to build. Put them in order, add subtotals, and Harbor Music Lessons' Year 2 statement looks like this:
Harbor Music Lessons
Statement of Cash Flows
For the Year Ended December 31, Year 2 (indirect method)
| Line | Amount |
|---|---|
| Net income | $32,100 |
| Depreciation expense | $2,900 |
| Decrease in Accounts Receivable | $1,200 |
| Decrease in Supplies | $1,700 |
| Decrease in Prepaid Rent | $350 |
| Increase in Accounts Payable | $1,000 |
| Decrease in Salaries Payable | ($1,250) |
| Increase in Income Tax Payable | $2,500 |
| Net cash provided by operating activities | $40,500 |
| Purchase of equipment | ($5,000) |
| Net cash used in investing activities | ($5,000) |
| Repayment of notes payable | ($4,000) |
| Net cash used in financing activities | ($4,000) |
| Net increase in cash | $31,500 |
| Cash, beginning of year | $16,500 |
| Cash, end of year | $48,000 |
Every dollar sign in that table came from a balance sheet or income statement line you were given, or from a fact your CFO told you. Nothing is invented, and nothing except net income and dividends ever gets estimated.
Common mistake: the depreciation add-back is not cash coming in
Depreciation Expense of $2,900 shows up as a positive number in the operating section, but no customer paid Harbor Music Lessons $2,900. Depreciation was subtracted once, when it lowered net income, and it is added back once, to undo that subtraction. Net of the two, depreciation's effect on cash is zero, exactly as it should be, since depreciation never involves cash at all.
Reconciling to prove it is complete¶
The last step is the one that catches mistakes the earlier steps cannot. Net change in cash plus beginning cash equals ending cash, and that ending number has to match the Cash balance on this year's balance sheet, dollar for dollar. Harbor Music Lessons' three sections sum to a $31,500 increase; add that to $16,500 of beginning cash and you land on $48,000, exactly the Cash line on the Year 2 balance sheet. If you had missed the Salaries Payable decrease, or classified the equipment purchase as operating, this check would fail and tell you exactly that something is wrong, even though it would not tell you what.
Common mistake: no cash moving does not mean nothing happened
Harbor Music Lessons had no transactions like this in Year 2, but suppose it had bought a $10,000 delivery van by signing a note payable for the full price, with no cash changing hands. That purchase and that borrowing are both real and both significant, so they cannot just vanish from the statement of cash flows. They are disclosed in a separate noncash investing and financing schedule below the statement, not folded into the operating, investing, or financing totals, since neither total actually moved any cash.
Pause and work¶
Build the full statement yourself, starting from a comparative balance sheet, an income statement, and a short list of facts, the way it actually arrives on the job.
Juniper Web Design's operating, investing, and financing sections are filled in for you, including a gain on a sale of equipment and dividends you have to back out of Retained Earnings. Finish the reconciliation: the net change in cash and the ending cash balance.
Now build one all the way through, start to finish, with fresh numbers.
Every number above came from the indirect method, which starts at net income and adjusts it. The direct method gets to the same operating cash flow a completely different way, by adding up actual cash collected and cash paid, and that is where section 5 picks up.