Hello and welcome everyone. In this lesson we will repeat the process of preparing the first section, of the cash flow statement, for operating activities. But instead of using the direct method, in this lesson, I will focus on the indirect method. Which calls for converting all the revenues and the expenses, and the income statement, all together, to the corresponding cash flows indirectly. How am I going to do that? By actually taking the net income, making some adjustments, and converting that in to the net cash flow, from operating activities. That is why it is referred to as the indirect method. Because it converts all the revenues and expenses all together. It's not like individual revenue by revenue, and individual expense by expense as in the direct method. But here I'm converting the net income, into a net cash flow from operating activities. Let's get started. I will summarize the steps to be followed in four groups of adjustments. Let's take a look at each one of them. Number 1, I am going to start with, exclude the non-cash components from the net income. Such as depreciation and any unrealized gains or losses on investments that were included in the net income. Obviously any expenses will be added, any revenues and gains will be deducted. Because I wann exclude the gains and I want to exclude the losses. Number 2, exclude some gains and losses on selling long term assets to avoid double counting as these gains and losses are included as part of the investing activities. Here we're actually talking about real gains, okay? Those are cash gains, those are not realized. But actually I will exclude those because they will be included in the investing activities, with the selling price of the selling of those assets. Third, exclude net changes in accruals which affected the net income but did not have any cash consequences. Since these represent exchange of goods and services for which cash did not exchange hands yet. As I did with the accruals, then obviously I need to do with the deferrals, and that's the fourth grouping. Include some deferrals' transactions which were not included in net income but have cash consequences. Since these transactions represent exchange of cash for which goods and services did not exchange hands yet. Let me summarize, those four adjustments into a graphical representation in the four groupings. As you can see on the left hand side, I have the net income. That I want to convert into the net cash flow. This will go through four adjustments. Groups of adjustment. First group, adjustments for non-cash items. Second group, adjustment for other items, that's what I said about the actual gain, realized gains and losses so that I avoid double-counting. I will deduct any increases in accrued revenues and obviously add the decreases. And I will deduct any decreases in accrued expenses. And obviously if I am deducting the decreases, for accrued expenses, then I will actually add the increase. Because obviously as you know, accrued expenses and accrued revenues can either increase or decrease. Fourth groupings, for the deferred revenues and the deferred expenses. I will deduct the decrease in deferred revenue, and if I'm deducting the decrease in deferred revenue then I will add the increases in deferred revenues. The second one, I will deduct the increase in deferred expenses. And if I am deducting the increase in deferred expenses, then I will add the decreases. Sounds too complicated. Obviously, I grouped the first two groupings, as you can see on the right hand side. Now I combined the first two groupings into one grouping, and it's called, combine the two of them, adjustments for non-cash items, and adjustment for other items. Those are actually one grouping in the indirect method. And the second grouping are all the adjustments that I need to do for the changes in accrued revenue, accrued expenses, deferred revenue, deferred expenses. All as changes together, add deduct, add deduct, add deduct. Sounds easy, [LAUGH] I don't think that people will act the same thing here, because sounds too complicated. Do you want to simplify it more? Let me simplify it more, so that we can actually remember it, instead of adding deducting, adding deducting. Am I going to memorize this? Actually not, I have a better way to capture the second group of adjustments. Since accrued revenues, and deferred expenses are assets. While on the other hand, deferred revenues, and accrued expenses are liabilities. Then we actually can look at the signs, and we can summarize the adjustments to the changes in accruals and deferrals in the indirect method, in the following simple rule. Simply deduct the increase in related operating assets. What are related operating assets? Any assets, any assets that you're going to find. I actually will take the net income, and deduct the increase in this related operating assets. Accrued revenue, deferred expenses, all those assets, any increase will be deducted and any decrease will be added. So that's on the side of the asset. What about the liabilities? What do I mean by accrued expenses, and deferred revenues? What am I going to do with that? Deduct the decrease. In related operating liabilities. If I'm deducting the decrease in related operating liabilities, then I'm obviously adding the increase in any of those operating liabilities. Then now it's basically a summary of what you need to adjust assets versus liabilities. If any of those deferrals and accruals, are in the assets, I will add the decrease and deduct the increase. If they are related to the liability side, I will deduct the decrease and add the increase. In conclusion, under the indirect method of preparing the operating activities section of the cash flow statement. We make the necessary adjustments to the net income to indirectly convert all the revenues and the gains. All the expenses and losses combined, embedded into the net income, into the corresponding cash flows. And infer that from the net income indirectly by making the previous adjustments. The necessary adjustments are summarized simply into groups. One, adjustments for non-cash items and other items. Second groupings are adjustments for the net changes in all accruals and deferrals relating to the operating activities. Thank you.
