Indirect method - why do we adjust for wages variations ?

In order to compute the OCF from the NI in #27, we add the increases in wages payables to the NI in order to compute the CFO ?

Why is this the case ? I thought the OCF already contains the wages and the Net Income should contain the impact of wages, so why do we adjust by ‘Increase in wages payables’ ?

Is it that ‘Increase in wages payables’ in the account for wages not yet paid ?

It is, indeed.

If wages payable increases, you have wage expense (included in net income) which you haven’t yet paid (so no cash outflow).

Same with accounts payable, taxes payable, and so on.

Wages payable are an accrual expense. For accounting purposes, this account is created to help better match the expenses with the time period in which they provide economic benefits. For example, you have an employer who make widgets for you this week, however you will not pay him until next week. This week is the end of the month, so you are created financial statements. If we do not accrue the amount that we owe the employee, then our expenses will be understated. Thus, we create this accrual account titled waged payable, a current liability account. While we did expense this on the IS, we did not actually pay cash for this time.

With your example, to determine OCF, we begin with NI and then adjust for non-cash expenses. An increase in wages payable will decrease the NI, but did we actually pay any cash for this? No. Thus, we must add back this increase to the NI to get the true amount of cash flow.

Hope this helps!

Very simple rule of thumb here:

Increase in liabilities is an addition to C/F from operation, and Increase in assets is a decrease to C/F from operation and vice versa.

Be careful here, this only applies to current assets and liability when dealing with cash flow from operations. An increase in LTD or the like would result in an increase in cash flow from financing activities not operations.

Fixed that for you.

adrost - thanks for bringing this up. i realized this rule was only for CFO. Can you give examples that its different for CFI and CFF?


For cash flow from investing, we are looking at changes in fixed assets primary. Let’s say for example we purchase a truck for $10k on December 31. Since this is an asset, we will record a debit to assets and a credit to cash. Since we capitalized this asset, no expense appear on the IS for this transaction, thus there is no change in NI. However, we did spend $10k in cash, thus we will have a use of cash in the investment section of the CF statement. This will be for the full amount of the asset purchase.

The flip side is the sale of a fixed asset in which we have a cash inflow. While we only record a gain to the extent that the sale price is above the book value of the asset, we should record a cash inflow for the full sales price. Any gain or loss of the sale of a fixed asset will be adjusted for in cash flow from operations.

In general, we simply look at net CapEx or the like to determine the outflow for cash flow from investing.

For cash flow from financing, we look at changes in long-term liabilities and equity. If we issue new debt, we will not see a line item on the income statement that say “proceeds from sale of debt securities”, however we still have an inflow of cash. A simplified journal entry is a debt it cash and a credit to bonds payable; as you can see, no impact on IS accounts. To adjust for this in the cash flow statement, an inflow is recorded in the cash flow from financing.

An outflow example would be the buyback of shares. The simplified journal entry for share repurchase is a debt to treasury stock and a credit to cash. Again, no impact on the IS, and thus must be adjusted for in the cash flow statement by showing a cash outflow from financing activities.

To sum it all up, remember OIF, operating, investing financing. These are the three sections of a cash flow statement. Operating is anything that is related to the ordinary course of business. Investing is anything that is related to the purchase or sale of a fixed asset. Financing is anything related to our capital structure. Think any transaction through and if it impacts the income statement. If it does, then consider if we actually paid cash for it or added an operating asset/liability; if so, adjust for it in the CFO section. For other transaction, if they do not appear on the income statement but were a source or use of cash, they must be adjusted for in the cash flow statement.

I hope this clears things up a bit.

Thanks guys it really helps. I will re-read this again tomorrow (it is 1AM here).