Problem 4 - Accounting

Question

Indicate whether each of the following would be added to or deducted from net income in determining net cash flow from operating activities by the indirect method: a. Decrease in accounts receivable \(\quad\) g. Increase in notes receivable due in b. Increase in notes payable due g. Increase in notes receivable in 90 days to vendors h. Depreciation of fixed assets c. Decrease in salaries payable i. Increase in merchandise inventory d. Decrease in prepaid expenses j. Amortization of patent e. Gain on retirement of long-term debt \(\mathrm{k}\). Loss on disposal of fixed assets f. Decrease in accounts payable

Step-by-Step Solution

Answer

Add: a, d, h, j, k. Deduct: c, e, f, g, i.

Step 1: Understanding the Indirect Method

The indirect method starts with net income and makes adjustments for changes in account items on the balance sheet, adding or deducting these from net income to reflect operating cash flow. The primary focus is on non-cash items and changes in working capital.

Step 2: Analyze Each Item

Consider each item given and determine if it should be added to or deducted from net income in the indirect cash flow statement. **a. Decrease in accounts receivable**: When accounts receivable decrease, it indicates cash collection, so add to net income. **b. Increase in notes payable**: This doesn't directly affect operating cash flow, but increase implies cash wasn't spent, so it doesn't aid operations cash. **c. Decrease in salaries payable**: This implies cash outflow for salaries, so deduct from net income. **d. Decrease in prepaid expenses**: As this indicates expense recognition with no cash payment, it increases cash so add to net income. **e. Gain on retirement of long-term debt**: A gain is deducted because it doesn't represent operating cash flow. **f. Decrease in accounts payable**: This suggests cash payment outflow, so deduct from net income. **g. Increase in notes receivable**: This suggests cash has not turned to cash flow, so deduct from net income. **h. Depreciation of fixed assets**: Add back to net income as this is a non-cash expense. **i. Increase in merchandise inventory**: This uses up cash, so deduct from net income. **j. Amortization of patent**: Add back as it's a non-cash expense. **k. Loss on disposal of fixed assets**: Add to net income as it represents a non-cash item reducing income.

Step 3: Organize Adjustments

List which adjustments to add and which to deduct: Additions: - Decrease in accounts receivable - Decrease in prepaid expenses - Depreciation of fixed assets - Amortization of patent - Loss on disposal of fixed assets Deductions: - Decrease in salaries payable - Gain on retirement of long-term debt - Decrease in accounts payable - Increase in notes receivable - Increase in merchandise inventory

Step 4: Apply to Determine Cash Flow

Using this list, apply adjustments to net income: add non-cash expenses and elements signaling cash accruals, and subtract gains/situations where cash expenditure increased net income without actual cash flow. This helps determine the actual net cash flow from operating activities.

Key Concepts

Net Income Adjustments

Net income is the starting point for calculating cash flow from operating activities using the indirect method. However, net income needs to be adjusted to reflect the actual cash that was brought in or spent during the period.
These adjustments include:

• Adding back non-cash expenses, like depreciation and amortization, that reduced net income.
• Subtracting gains from the sale of assets which increase net income but do not involve cash.
• Adjusting for changes in current assets and liabilities, as these signify cash flows, such as receivables collected or expenses paid.

Making these adjustments provides a clearer picture of cash movements rather than accounting profits.

Non-Cash Expenses

Non-cash expenses are costs that reduce net income in accounting records but do not require cash outflow during the accounting period.
Key examples include:

• Depreciation: A method of allocating the cost of a tangible asset over its useful life. It's added back because it doesn't involve actual spending of cash.
• Amortization: Similar to depreciation but for intangible assets such as patents. It’s also added back to net income since it is a non-cash charge.

Both these are subtracted from revenue to calculate net income, not affecting cash flow directly. Thus, they must be added back to net income when using the indirect method to determine cash flows.

Operating Activities

Operating activities encompass the primary revenue-generating activities of a company. These include cash inflows and outflows related to providing goods and services.
When constructing a cash flow statement using the indirect method, cash from operating activities adjusts net income for:

• Changes in current assets and liabilities, showing how circulating cash is impacted by business operations.
• Non-cash expenses that have been recorded against net income but don't impact cash flow directly.

The focus is to display how cash is generated and spent in day-to-day business operations, excluding financing and investing activities.

Working Capital Changes

Working capital changes refer to the adjustments in current assets and liabilities that impact cash flow from operating activities.
Here’s how these adjustments work:

• **Decrease in accounts receivable**: Typically an increase in cash, as more customers have paid their dues, adding cash to operations.
• **Decrease in prepaid expenses**: Implies that less cash is tied up in prepayments, releasing cash back into operations.
• **Increase in merchandise inventory**: Suggests that cash has been used to stock products, thus decreasing available cash.
• **Changes in accounts payable and salaries payable**: Reflect when cash is actually going out, compared to when expenses are recorded.

By adjusting for these changes, we can understand how much cash is available for operating activities, indicating liquidity freed up or tied down by business operations.