Problem 15 - Accounting

Question

Sanhueza, Inc., reported a net cash flow from operating activities of \(\$ 162,500\) on its statement of cash flows for the year ended December 31, 2010. The following information was reported in the Cash Flows from Operating Activities section of the statement of cash flows, using the indirect method: \(\begin{array}{lr}\text { Decrease in income taxes payable } & \$ 3,500 \\\ \text { Decrease in inventories } & 8,700 \\ \text { Depreciation } & 13,400 \\\ \text { Gain on sale of investments } & 6,000 \\ \text { Increase in accounts payable } & 2,400 \\ \text { Increase in prepaid expenses } & 1,350 \\\ \text { Increase in accounts receivable } & 6,500\end{array}\) Determine the net income reported by Sanhueza, Inc., for the year ended December 31 , \(2010 .\)

Step-by-Step Solution

Answer

The net income for 2010 is \( \$169,650 \).

Step 1: Start with Net Cash Flow from Operating Activities

The net cash flow from operating activities, using the indirect method, was reported as \( \$162,500 \). This provides a starting point for our calculation of the net income.

Step 2: Adjust for Non-Cash Expenses

Add back non-cash expenses to the net cash flow. The main non-cash expense reported is depreciation, \( \\(13,400 \). So, add this to the net cash flow: \[ \\)162,500 + \\(13,400 = \\)175,900 \]

Step 3: Adjust for Gains and Losses

Subtract non-operating gains from the adjusted net cash flow. The gain on the sale of investments is \( \\(6,000 \). Subtract this to adjust the cash flow:\[ \\)175,900 - \\(6,000 = \\)169,900 \]

Step 4: Adjust for Changes in Working Capital

Adjust the result by accounting for changes in working capital components:- Decrease in income taxes payable (\\(3,500): Subtract this as it indicates less cash paid out.- Decrease in inventories (\\)8,700): Add this back as it results in more cash.- Increase in accounts payable (\\(2,400): Add this back.- Increase in prepaid expenses (\\)1,350): Subtract this as it indicates more cash tied up.- Increase in accounts receivable (\\(6,500): Subtract this as it indicates less cash received.Calculate these adjustments: \[ \\)169,900 - \\(3,500 + \\)8,700 + \\(2,400 - \\)1,350 - \$6,500 \]

Step 5: Calculate the Final Net Income

Perform the calculation with all adjustments: \[ \\(169,900 - \\)3,500 + \\(8,700 + \\)2,400 - \\(1,350 - \\)6,500 = \\(169,650 \] Thus, the calculated net income for Sanhueza, Inc., for the year ended December 31, 2010, is \( \\)169,650 \).

Key Concepts

Understanding Net Cash Flow

Net cash flow from operating activities is a crucial part of a company's financial statement. It represents the amount of cash generated by a company's normal business operations, indicating the company's ability to generate sufficient cash flow to maintain or expand operations.

To determine net cash flow, companies often adjust net income by changing non-cash expenses, gains, and losses. Depreciation, a non-cash expense, is added back to the net cash income since it doesn't involve any actual outflow of cash. This adjustment helps provide a clearer picture of the cash generated by operations.

Subsequently, any gains, like those from the sale of investments, are deducted. These gains increase net income, but they don't enhance operating cash flow since they're unrelated to core operations.

Overall, knowing the net cash flow helps stakeholders understand not just how much money a company earns, but how much actual cash is generated through its core business processes.

Demystifying the Indirect Method

The indirect method is a popular approach for preparing the cash flows from operating activities section of a statement of cash flows. Unlike the direct method, which records all individual cash transactions, the indirect method starts with net income and applies various adjustments to it.

The basic principle here is to remove the effects of accrual accounting by adjusting net income for non-cash transactions and changes in working capital. This includes adding back depreciation, subtracting gains, and adjusting for changes in account balances like receivables and payables.

Using the indirect method simplifies the preparation of cash flow statements for many firms. It aligns with the accrual accounting approach and is often more convenient, as it utilizes information readily available in financial statements.

Working Capital Adjustments Explained

Working capital adjustments are essential to reconcile net income with net cash flow under the indirect method. They include changes in current assets and liabilities (such as inventories, receivables, payables, and expenses).

Here's how these adjustments typically work:

• Decrease in current liabilities (e.g., income taxes payable) indicates cash outflow, so we subtract this amount.
• Decrease in inventories reflects less cash tied up in stock, resulting in added back cash.
• Increase in payables suggests that expenses weren't settled immediately, so this amount is added back.
• Increase in prepaid expenses means more cash is devoted to expenses paid upfront, thus reducing cash.
• Increase in receivables indicates sales have been made, but cash isn’t received yet, so it reduces net cash flow.

By analyzing these changes, the indirect method ensures the resultant cash flow from operating activities accurately reflects the cash generated by the business's core operations.