Hello and welcome everyone to our lesson today, we will continue with the direct method of preparing cashflows demon. But this lesson, we will focus on the second half or the other side, expense side. We're going to focus on converting the expenses into the corresponding cash outflows. Before we get started under the direct method, any noncash expenses or any unrealized losses will be simply excluded in total and will not be elicit at all. I just want to exclude it by taking them out completely. Thus, I am going to focus my discussion on the analysis of the changes in accrued and deferred expenses. Let's get started. As you can see, I will summarize this in a graphical representation. On the left-hand side, I have expenses, on the right-hand side, I have cash outflows. There's a black box, a magic box that will convert the expenses into cash outflows. What do I need? I have four steps to convert the expenses into cash outflows in addition to exploring those noncash expenses or focusing on the changes in the frills, integrals. Number 1, exclude expense incurred this period for which cash will be paid next period. Now I have an expense, but the cash will be paid next period. Obviously, I need to exclude those expenses because they are not cash outflows and they are portion of those expenses. Second step include the cash paid this period for which expanse was incurred in a previous period. Because now that needs to be included because it was not element in the expenses, but it's actually a cash outflow. Third, and I think you can expect that by now. Third, I need to exclude the expense incurred this period for which cash was paid in a previous period. Obviously, I need to exclude because it is an expense, but it's not a cash outflow for this period. Finally, in the last step, I need to include, include and exclude. Exclude means deduct, include means add. Include that cash paid, which was paid this period for which expense will be incurred next period. I think this graphical representation simply describes in plain English. Why do I add or deduct, include or exclude any items from expenses to converted into cash outflow? I need to translate the discussion into accounting language. Accounting. We speak debit and credit T-accounts. I presented as you can see, the accrued expense in a T-account. Accrued expense like anything payable, salaries payable, interest payable, wages payable, any payable, accrued expenses. This is a liability, it's a payable. You have the beginning balance on the right-hand side, as you can see, because it's a liability. Then the ending balance also on the right-hand side and this account, because it is actually a liability, it increases in the right-hand side by those expenses that are incurred and will decrease when I pay off by cash paid. Obviously, I have on the right-hand side, the expenses incurred while on the left-hand side, which will decrease the accrued expense, the cash paid. On the other side as you can see in a deferred expense case, a deferred expense is like prepaid rent, prepaid insurance, whatever prepaid advertising, any prepaid expense. This is actually an asset because it reflects expected future benefit. As you can see, the asset has a beginning balance in the debit side and also the ending balance on the debit side. It increases by the cash paid, while it decreases by the expense incurred. We will see from those two accounts that the changes in each of those accounts, how can we analyze? Looking at the accrued expenses, the comparison between what the expense incurred and the cash paid on the right-hand side and the left-hand side. If the expense incurred is more than the cash paid, that will reflect in the ending balance more than the beginning balance. Then I can interpret by looking at the change in the accrued expense, I can simply make an inference about which was higher during the period. If the ending balance was more than the beginning balance in the accrued expense, obviously, the expense incurred is more than the cash paid during the period. While if the accrued expense decreased that actually tells me that the cash paid was more than the expense incurred by the amount of the decrease in the accrued expense by the same amount. The difference between the beginning and the ending is going to be exactly the difference between the expense and the cash paid. The same idea carries forward for the deferred expense, but in the reverse type because deferred expenses is an asset. If the expense the prepaid expense, deferred expenses in general has increased, that means that the cash paid during the period were more than the expense incurred during the period and the opposite is true. If the deferred expense account decreased, then the expense incurred was more than the cash paid during the period by the same difference or the same decrease in the deferred expense. What can we pull out of this analysis of those two accounts? What do you want to say, Adam? This analysis of those two accounts drive us to the following important result. Tying the T-accounts with the figure that I said in plain English to reconcile the expenses with the operating cash outflows, we have to consider the changes in all accrued expense accounts and all the change in all deferred expense accounts. This is because increase in accrued expenses and decrease in deferred expenses will result in expenses for the period being higher than the cash outflows of the same period while the decrease in the accrued expense and the increase in deferred expenses will result in expenses for that period being less than the cash outflows during the same period. Now I explained it in plain English, I translated in T-accounts, debits, and credit. I know that some people love algebra. I will repeat the same logic of what we do by converting the expenses into cash outflows in an algebraic form, like in an equation, like the following, expenses incurred during a specific period, plus the increase in deferred expenses plus the decrease in accrued expenses minus the decrease in deferred expenses minus the increase in accrued expenses will give you the cash outflow paid during the same period. Actually, if you notice in the same equation, I had the increase and the decrease in the accrued expenses. The increase and the decrease in the deferred expenses. That's because I might have multiple accrued expenses and multiple deferred expenses. Some of them increase, some of them decrease. I am presenting that formula, that equation to have all inclusive, all the changes in the deferred expense accounts and all the changes in accrued expense accounts. Some of them increase, some of them decrease. The equation is all inclusive. Hopefully that gives you a good idea and understanding in three different ways, logical displayed English, accounting language, debit and credit, and T-accounts. Then Math, algebra, any form of those, whatever suits you better. Any of those, if you understand it well, that will do the work for you. Thank you very much.
