Page 635 - Accounting Principles (A Business Perspective)

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To illustrate why we deduct the gain on the disposal of a noncurrent asset from net income, assume that Quick
sold the equipment just mentioned for USD 9,000. The journal entry to record the sale is:
Cash (+A) 9,000
Accumulated depreciation 3,000
Equipment (-A) 10,000
Gain on sale of equipment (+SE) 2,000
To record disposal of equipment at a gain.
Quick shows the USD 9,000 inflow from the sale of the equipment on its statement of cash flows as a cash inflow
from investing activities. Thus, it has already recognized the total USD 9,000 effect on cash (including the USD

2,000 gain) as resulting from an investing activity. Since the USD 2,000 gain is also included in calculating net
income, Quick must deduct the gain in converting net income to cash flows from operating activities to avoid
double-counting the gain.
Steps in preparing statement of cash flows

Accountants follow specific procedures when preparing a statement of cash flows. We show these procedures
using the financial statements and additional data for Welby Company in Exhibit 128.
After determining the change in cash, the first step in preparing the statement of cash flows is to calculate the
cash flows from operating activities, using either the direct or indirect method. The second step is to analyze all of
the noncurrent accounts and additional data for changes resulting from investing and financing activities. The third
step is to arrange the information gathered in steps 1 and 2 into the proper format for the statement of cash flows.

The direct method converts the income statement from the accrual basis to the cash basis. Accountants must
consider changes in balance sheet accounts that are related to items on the income statement. The accounts
involved are all current assets or current liabilities. The following schedule shows which balance sheet accounts are
related to the items on Welby's income statement:
Income statement Related balance Cash flows from
Items sheet items Operating
activities
Sales Accounts receivableCash received from
customers
Cost of goods sold Accounts payable Cash paid for
and merchandise merchandise
inventory
Operating expenses and taxes Accrued liabilities Cash paid for
and prepaid operating expenses
expenses
For other income statement items, the relationship is often obvious. For instance, salaries payable relates to
salaries expense, federal income tax payable relates to federal income tax expense, prepaid rent relates to rent
expense, and so on.
The table below shows how income statement items are affected by balance sheet accounts:
Accrual Basis Cash basis
(cash flows from
operating activities)
Sales + Decrease or – Increase in =Cash received from customers
Accounts Receivable
+ Increase or – Decrease in
Merchandise Inventory
Cost of goods sold and =Cash paid for merchandise
+ Decrease or – Increase in
Accounts Payable
Decrease or – Increase in
Operating expenses related accrued liability
And =Cash paid for operating expense

Accounting Principles: A Business Perspective 636 A Global Text