Adjustments from Accrual to Cash
When the statement of cash flows (SCF, cash flow statement) is prepared using the indirect method, it begins with the company's net income for the accounting period. If the income statement was prepared using the accrual method of accounting, the net income must be adjusted for
- expenses that were not paid during the current accounting period
- revenues which did not result in cash receipts in the current period
Accounts Payable Increases When Bills Are Not Paid
If the balance in a company's Accounts Payable account has increased, accountants will assume that the company did not pay for all of the expenses that were included in the current period's income statement. As a result, the company's cash balance should have increased by more than the reported amount of net income.
SCF Adjustment for an Increase in Accounts Payable
To illustrate, assume that the income statement reports $20,000 of revenues, $15,000 of expenses, and the resulting net income of $5,000. If the company's accounts payable had increased by $900, the company must not have paid for $900 of the expenses reported on the income statement. Therefore, the company's cash balance would increase by $5,900. Expressed differently, the revenues of $20,000 minus the $14,100 of cash paid for expenses ($15,000 minus the $900 of expenses not yet paid) means an increase in cash of $5,900. Hence, the positive adjustment of $900 converts the accrual accounting net income of $5,000 to be the cash amount of $5,900.
An Increase in Accounts Payable is Favorable for a Company's Cash Balance
It may help to view the positive amounts on the SCF as being favorable or good for a company's cash balance. An increase in accounts payable is a positive adjustment because not paying those bills (which were included in the expenses on the income statement) is good for a company's cash balance.