Problem 5 - Accounting

Question

The net income reported on the income statement for the current year was \(\$ 132,000\). Depreciation recorded on store equipment for the year amounted to \(\$ 21,800\). Balances of the current asset and current liability accounts at the beginning and end of the year are as follows: \begin{tabular}{lcr} & End of Year & Beginning of Year \\ \hline Cash & \(\$ 52,300\) & \(\$ 48,200\) \\ Accounts receivable (net) & 37,500 & 35,600 \\ Merchandise inventory & 51,200 & 54,220 \\ Prepaid expenses & 6,000 & 4,600 \\ Accounts payable (merchandise creditors) & 49,000 & 45,600 \\ Wages payable & 26,800 & 29,800 \end{tabular} Prepare the Cash Flows from Operating Activities section of the statement of cash flows, using the indirect method.

Step-by-Step Solution

Answer

The net cash provided by operating activities is \( \$153,920 \).

Step 1: Start with Net Income

Begin with the net income from the income statement, which is given as \( \$132,000 \). This figure will be adjusted to determine cash flows from operating activities.

Step 2: Add Back Non-Cash Expenses

Depreciation is a non-cash expense, meaning it is an accounting expense that does not involve actual cash outflow. Add back the depreciation of \( \$21,800 \) to the net income.

Step 3: Adjust for Changes in Current Assets

Analyze changes in current asset accounts:- Accounts Receivable increased by \( \\(1,900 \) (\( 37,500 - 35,600 \)), which decreases cash flows.- Merchandise Inventory decreased by \( \\)3,020 \) (\( 54,220 - 51,200 \)), increasing cash flows.- Prepaid Expenses increased by \( \$1,400 \) (\( 6,000 - 4,600 \)), decreasing cash flows.

Step 4: Adjust for Changes in Current Liabilities

Analyze changes in current liability accounts:- Accounts Payable increased by \( \\(3,400 \) (\( 49,000 - 45,600 \)), which increases cash flows.- Wages Payable decreased by \( \\)3,000 \) (\( 29,800 - 26,800 \)), decreasing cash flows.

Step 5: Calculate Net Cash Provided by Operating Activities

Sum the adjustments to determine net cash provided by operating activities:\[ \begin{align*}\text{Net Income:} & \quad \\(132,000 \\text{Depreciation:} & \quad +\\)21,800 \\text{Decrease in Accounts Receivable:} & \quad -\\(1,900 \\text{Decrease in Inventory:} & \quad +\\)3,020 \\text{Increase in Prepaid Expenses:} & \quad -\\(1,400 \\text{Increase in Accounts Payable:} & \quad +\\)3,400 \\text{Decrease in Wages Payable:} & \quad -\\(3,000 \\text{Total:} & \quad \\)153,920 \\end{align*}\]

Step 6: Present the Cash Flow from Operating Activities

The Cash Flow from Operating Activities section of the statement of cash flows, using the indirect method, indicates a total of \( \$153,920 \) of net cash provided by operating activities.

Key Concepts

Indirect Method of Cash Flows

The indirect method of cash flow statements is a common approach for identifying cash flows from operating activities. This method begins with net income from the income statement and adjusts it for changes in non-cash items and working capital.
This approach is favored because it reconciles net income, a core performance metric, to the actual cash generated. It's also generally less complex to prepare as most businesses already calculate their income statement.

• Start with Net Income: You initially take the net income, which for this exercise is \( \\(132,000 \).
• Adjust for Non-Cash Items: Add back non-cash expenses like depreciation \(\\)21,800\).
• Examine Working Capital: Adjust for changes in current assets and liabilities to convert accrual basis to cash basis.

This method provides a clear view of how net income translates into cash flow, highlighting adjustments that lead to actual cash flow from operations.

Operating Activities

Operating activities encompass all transactions that are part of the primary business activities of a company. These activities primarily impact the company's net income and cash flow.
In our cash flow statement, operating activities are the first section and are crucial because they indicate how much cash a company generates from its regular business operations. This doesn't include cash from investments or financing.
To determine cash flow from operating activities:

• Begin with the net income from the income statement.
• Adjust for changes in current operating assets and liabilities.
• Include non-cash expenses like depreciation.

Understanding operating activities helps stakeholders assess whether the company's core operations are sustainable and profitable over time.

Current Assets

Current assets are short-term assets expected to be converted into cash, sold, or consumed within a year. These items are vital in assessing a company's liquidity and operational efficiency.
In cash flow calculations using the indirect method, changes in current assets impact cash flows. For example:

• Accounts Receivable: An increase indicates sales made but not yet collected as cash, reducing cash flow by \( \\(1,900 \).
• Merchandise Inventory: A decrease would indicate inventory sold, which boosts cash flow by \( \\)3,020 \).
• Prepaid Expenses: An increase means payments made for future expenses, reducing cash flow by \( \$1,400 \).

Monitoring changes in current assets is essential as it directly affects the cash availability for operations.

Current Liabilities

Current liabilities are obligations a company expects to settle within one year. These can include accounts payable, wages payable, and other short-term debts.
In the cash flow statement, changes in current liabilities also impact the cash flow from operating activities. Consider these changes:

• Accounts Payable: An increase means the company delays payments, hence preserving cash, which increases cash flow by \( \\(3,400 \).
• Wages Payable: A decrease shows payments of previously owed wages, thus reducing cash flow by \( \\)3,000 \).

Understanding current liabilities is crucial as they reveal a company's short-term financial health and its ability to meet immediate obligations.