Lesson Objectives:- Exemplifying where inventory is listed on the balance sheet
- Adjusting for inventory on the cash flow statement
- How to determine whether inventory is a use vs. source
We looked at the first step of preparing the cash flow statement of recording the net income and accounts receivable adjustment. The net income figure will slowly be converted from an accrual basis to a cash basis as we go through the steps of recording each entry on the cash flow statement.
The next step for preparing the cash flow statement will be to adjust for any other current assets, including inventory. If we look at our balance sheet example, the inventory figure is $10,000.
Let's take a look at the cash flow statement we started preparing in the last lesson and record the adjustment for inventory.
We already have the net income figure and adjustment for the accounts receivable. Now, let's add another adjustment for inventory. Between 2012 and 2013, the inventory increased by $10,000.
Since inventory is an asset that is increasing, it is considered a use of cash. We are making the assumption for this classification given the fact that the company purchases the asset using cash instead of accounts payable.
To demonstrate inventory as a use of funds on the cash flow statement, we will treat this entry as we are purchasing the inventory on a cash basis as opposed to consuming it or owing the funds as a liability.
As you can see from the example above, the inventory figure of $10,000 is subtracted on the cash flow statement. This will get us one step closer to converting the net income figure from the accrual basis to the cash basis that we need.
Next, let's understand how the entry would work if the inventory figure was being consumed as an expense.
In contrast, if inventory was decreasing then we would treat it as a source of cash instead because the inventory is expensed. Instead of using inventory, this type of transaction would be recorded as the cost of goods sold, in which the journal entry would be a debit and the inventory figure would be credited.
Since the net income figure already accounts for cost of goods sold, we would end up needing to add back in the $10,000 figure.
In the next lesson, we will be covering how current liabilities are recorded on the cash flow statement.