Reconciling Net Income to Cash Flow From Operations: Noncash Adjustments
Companies that report cash flows using the direct method must reconcile changes in cash to net income. This reconciliation is equivalent to the indirect method of presentation. The reconciliation begins with net income from the income statement. The adjustments generally fall into two categories: non-cash adjustments and working capital adjustments.
Noncash adjustments relate to expenses recorded on the income statement for which no cash was paid. The most common of these adjustments is for depreciation and amortization, but there can be many others. Consider the non-cash adjustments reported by AT&T:
In each of the three years presented, the non-cash expense related to depreciation and amortization was larger than net income. In addition, AT&T recorded seven other types of non-cash adjustments:
- Undistributed earnings from investments in equirt affiliates: AT&T accounted for its partial ownership of Cingular wireless using the equity method, under which it recorded a proportionate share of Cingular’s net income on its own income statement. However, it did not actually receive cash from Cingular (which used the funds for its own growth) so AT&T must deduct the net income associated with Cingular when reconciling net income to cash flow from operations.
- Provision for uncollectible accounts: AT&T estimates the portion of its accounts receivable that will not be paid and deducts the expected amount from net income. The estimate must be added back (and any actual bad debt expense will be deducted through working capital adjustments.)
- Amortization of investment tax credits: The reverse of fixed asset depreciation and amortization, the amortization of a liability must be deducted.
- Deferred income tax (benefit) expense: Any expense put off to another year is added back to net income, while delayed benefits must be subtracted.
- Net gains on sales of investments: such gains are not considered operating items, and instead are reported as adjustments to cash flows from investing activities.
- Income from discontinued operations can no longer be considered an operating cash flow.
- Retirement benefit funding: Companies report a smoothed amount on the income statemtent related to the expenses associated with funding retirement plans for employees. The cash flow statement requires all contributions to be reported as cash flows in the associated year.
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
