Question

Why is it necessary to convert accrual-based net income to a cash basis when preparing a statement of cash flows?

Answer 1

Answer: It is necessary to convert accrued based net income to a cash basis when preparing a statement of cash flows because thats the very main motive of cash flow statement-to see from where cash is coming/going and how much the ACTUAL cash is being given/received.

As you might be aware that in cash flow statement, opening cash and cash equivalent balance is added to the "NET income/decrease in cash" to get the "Closing balance of cash". The net Income considered will ofcourse consist of some "accrued" part because accounting is done on ACCRUAL CONCEPT.

Accrued Income is not actually earned in cash, and hence if it included in Net Income it wont result in finding corrent cash inflows and outflows or closing cash balance. For example, when sales are made on credit, Net Income gets increased, so does the balaance in Accounts Receivables. But the transanction didnt affect the CASH balance at all. It is therefore that "Increase in Accounts Receivables" is deducted in "Cash flow from Operating Activities" while preparing cash flow statement.

Lets understand from an example. Lets just say that there are only two items in balance sheet at year beginning which are Equity-$20000, and cash $20000. Now during the year, lets say just one transaction happened of SALE of $5000, $2000 of which in cash, while $3000 on Credit (Accrued income). This will result in Net Income of $5000, cash balance in $22000 and Accounts Receivables in $3000.

Now, in cash flow statement, Accrued income paart will be converted to cash. Increase in Accounts receivables will be deducted from total Net Income to match and prepare correct cash flow statement.

Operating Activities
Net Income 5000
-Inc in Accounts receivables 3000

Net Increase in cash 2000
+Cash at beginning 20000
Cash at end 22000

Basically, accrued net income gets converted to cash basis because only cash transactions that have affected/affect the Net income are considered for cash flow statement.