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.
