Cash flow report with Prepaid expenses & a Debit Note

I am having trouble recording entries for a pre-paid expense (Insurance) and a Debit Note

I have created a Test company and entered a few transactions to see if I can understand what I am doing wrong.- I added 20,000 to bank account posted to Retained Earning on 1 Jan 2020

I have an invoice from an Insurance company for the year 1 July 2020 to 30 June 2021 whereas my financial year is 1 Jan - 31 Dec

The cost is € 100 per month so the initial invoice was for € 1200 on 1 July 2020
I negotiated a rebate for two months which was granted - I entered a Debit Note on 1 Sept 2020 for € 200
I paid the balance of the amount due on 1 Oct 2020 € 1,000
At the year end, I entered a journal entry on 31 Dec 2020 to transfer € 600 to pre-paid expenses
At the start of the new year, I entered a journal entry on 1 Jan 2021 to transfer from pre-paid expenses to Insurance for 2021

The transactions are
Purchase invoice


Debit Note

Payment

Journal entry 31 Dec

Journal entry 1 Jan

P & L 2020 and 2021

B/S 2020 and 2021

Cash flow report

My comment is that I would have expected the Cash Flow Statement to show
image

Any comments?

Let’s begin by observing that the bottom line in both Manager and your “expected” spreadsheet are identical. The first difference is that for 2020, Manager reports cash flow adjustments for Insurance and Accounts payable, while you consolidated the net adjustment in Prepaid expenses. Why?

You must remember that the figures on the cash flow statement are not account balances, but adjustments to changes in account balances. With the indirect method, the total of debits and credits to all P&L accounts are already included in the net income figure that starts the process. The adjustments stem from transaction effects that are not in the P&L account balances at year-end.

So the (800.00) reduction on the cash flow statement is offsetting 800.00 of increase in profit due to two transactions. One is the 200.00 debit note, which increased net profit by reducing Insurance expense on the P&L. When an expense account decreases during the year, that is equivalent to having received cash back for the expense. Since the net income number already includes the effect of this “refund of cash,” the cash flow statement subtracts that amount from net income.

The second transaction that must be offset is the transfer of expense to Prepaid expenses. That increased your net profit by transferring 600.00 from the Insurance expense account to the balance sheet. So net profit must be reduced by the same amount to evaluate cash flow. The sum of corrections for those two transactions accounts for the (800.00) adjustment under Insurance. Don’t think of that entry as reducing your Insurance expense, which was already accounted for in the net profit number. Instead, think of it as reducing your net profit because of transactions that affected the Insurance account via the balance sheet.

Manager’s cash flow statement also shows a positive adjustment of 200.00 for Accounts payable. This offsets the reduction to Accounts payable from the debit note. The debit note worsened your net profit by effectively buying down your liability. So the cash flow statement adds back the buy-down amount.

Turning to 2021, your net profit already includes the expenditure of 600.00 from Prepaid expenses on the balance sheet for Insurance on the P&L. But no money actually moved. Since buying insurance in 2021 would otherwise look like a reduction in net profit, entailing a reduction in cash, the cash flow statement adds that amount back.

I know that is a lot of word salad. Much of it is counter-intuitive. Sometimes, it helps to look at the direct method version of a cash flow statement. Think about every entry in terms of what it would due to a nominal cash supply, not what it does to profit. And keep sight of the fact that one purpose of the cash flow statement is to relate the balance sheet to the P&L.

Generally, when looking at indirect method cash flow statements, these guidelines may help:

  • Asset account increases: subtract amount from income
  • Asset account decreases: add amount to income
  • Liability account increases: add amount to income
  • Liability account decreases: subtract amount from income

So in your example, for 2020:

  • Prepaid expenses asset account increased, so 600.00 was subtracted from income, due to activity in the Insurance account on the P&L
  • Accounts payable liability account decreased, so 200.00 was subtracted from income, also due to activity in the Insurance account on the P&L
  • Accounts payable liability account decreased, so 200.00 was added to income, due to the balancing post directly to that account.

Why, you might ask, are both legs of the debit note transaction represented on the cash flow statement (where they cancel each other out), but only one leg of the prepaid expense journal entry shows up? The answer is that, in the case of the debit note, the effective cash position of the business changed. Putative cash used to “buy down” the Accounts payable liability came from the supplier in the form of a discount. But in the case of the journal entry, the putative cash was retained within the business in the form of a prepaid expense asset that had already been purchased.

Thanks, Tut.

Very clear - however, I think that when we prepare our annual accounts they are prepared using the method I used in the Excel sheet.

They only adjustment that is made to the operating profit is that the Depreciation charge is added back. All the other adjustments such as those I described above are included in the Changes in Working Capital figures.

I understand that the net result is the same but generally, when I look at companies accounts, they more often than not the Cashflow Report shows Changes in Working Capital equal to the differences in the Balance Sheet at the start and end date of the period concerned so I was expecting Manager to do the same.

I find lots of differences in how cash flow statements are prepared. Part of that is that different standards organizations dictate different procedures for where certain things are reported. Also, accountants have preferences, particularly as to which section of the report various activities get categorized into. In the case of the indirect method, some reports begin with net profit, others with operating profit, still others with profit after taxes…

I don’t think there is much question: the cash flow statement is the hardest financial statement to understand, especially since many numbers will not match either the balance sheet or P&L.

That’s why I quite like the Indirect method starting with the Net Profit and just using the difference in the two B/S. I will continue preparing it by hand as the Chart of Accounts is small enough to do that easily.

But I can see why some would like to see the income and expenses adjustments broken out and reported separately.

@Joe91 Journal entry needs to have an option where you can select that for cash flow statement purposes, it is a cash transaction. Currently all journal entries are “filtered” out on cash flow statement but I can see that there are journal entries where they should be included.

I would prefer the indirect CFS to be in the format described by Joe91.

The latest version (22.10.10) is fixing this issue. Basically Debit Notes and Credit Notes should have been included which is now fixed.

Also, Journal Entry has new checkbox

image

(maybe too long. will need to figure out shorter label)

This will allow journal entries to be selectively included on cash flow statement. There is another topic in ideas category which will eventually allow to mark any balance sheet account as cash account. This would mean Manager could generate cash flow statements (besides other financial reports) with just journal entries. This would be useful if Manager is used as a report generator in its most basic form (without enabling any modules).

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You can call it: “cash transaction for cash flow statement only” or “cash transaction for cash flow statement”

Why not just use 'to include in cash flow (statement) ’

Will be misleading because actual cash may not be part of the exchange.

Not clear because Journal entries are included in cash flow statement direct indirect method.

@lubos your label is long but very clear.

@Abeiku I did not write cash transaction, I wrote

Yeah, sorry I failed to select all the relevant text but the point stands

How is this different from @Lubos ?