During November and December, Family Health Care used the accrual basis of ac-
counting. The November financial statements are illustrated in Exhibits 3 through 6 of
this chapter. The December financial statements for Family Health Care are illustrated
in the Illustrative Problem at the end of this chapter. The net cash flows from operat-
ing activities and net income for November and December are shown below.Net Cash Flows from
Operating Activities Net Income
November $(1,690) $ 6,390
December 8,760 $10,825Under the accrual basis, net cash flows from operating activities will normally not
be the same as net income. The difference can be reconciled by considering the effects
of accruals and deferrals on the income statement. Exhibit 10 illustrates the November
reconciliation of Family Health Care’s net income with operating cash flows from op-
erations.
In Exhibit 10, we begin with net income. We then add or deduct the effects of
accruals or deferrals that influenced net income under the accrual basis but did not
result in the receipt or payment of cash. We thus arrive at net cash flows from operating
activities.
The effect of an accrual or deferral on the income statement and net income is re-
flected in its net increase or decrease during the period. For example, during November,
depreciation expense of $160 was recorded (a deferred expense) and thus deducted in
arriving at net income. Yet, no cash was paid. Thus, to arrive at cash flows from op-
erations, depreciation expense is added back to net income. Likewise, accounts payable
increased during November by $140, and a related expense was recorded. But again,
no cash was paid. Similarly, wages payable increased during November by $220, and
the related wages expense was deducted in arriving at net income. However, the $220
was not paid until the next month. Thus, for November, the increases of $140 in ac-
counts payable and $220 in wages payable are added back to net income.
The increase in unearned revenue of $1,440 represents unearned revenue for four
months for land rented to ILS Company. ILS Company initially paid Family Health
Care $1,800 in advance. Of the $1,800, one-fifth ($360) was recorded as revenue for
November. However, under the cash basis, the entire $1,800 would have been recorded
as revenue. Therefore, $1,440 (the increase in the unearned revenue) is added back to
net income to arrive at cash flows from operations.
During November, accounts receivable increased by $2,650 and thus was recorded
as part of revenue in arriving at net income. However, no cash was received. Thus, this
increase in accounts receivable is deducted in arriving at cash flows from operations.122 Chapter 3 Accrual Accounting Concepts
Net income $ 6,390
Add:
Depreciation expense $ 160
Increase in accounts payable 140
Increase in wages payable 220
Increase in unearned revenue 1,440 1,960Deduct:
Increase in accounts receivable $(2,650)
Increase in prepaid insurance (7,300)
Increase in supplies (90) (10,040)
Net cash flows from operating activities $ (1,690)Exhibit 10
November’s
Reconciliation of Net
Income and Cash
Flows from Operations