Question

Cash Flows from Operating Activities—Indirect Method

The net income reported on the income statement for the current year was $261,800. Depreciation recorded on equipment and a building amounted to $78,300 for the year. Balances of the current asset and current liability accounts at the beginning and end of the year are as follows:

	End of Year		Beginning of Year
Cash	$71,730		$74,600
Accounts receivable (net)	90,950		92,060
Inventories	179,330		158,600
Prepaid expenses	9,970		10,520
Accounts payable (merchandise creditors)	80,120		83,250
Salaries payable	11,550		10,370

a. Prepare the Cash Flows from Operating Activities section of the statement of cash flows, using the indirect method. Use the minus sign to indicate cash out flows, cash payments, decreases in cash, or any negative adjustments.

Statement of Cash Flows (partial)
Cash flows from operating activities:
Net income	$
Adjustments to reconcile net income to net cash flow from operating activities:
Depreciation
Changes in current operating assets and liabilities:
Net cash flow from operating activities		$

b. If the direct method had been used, would the net cash flow from operating activities have been the same?

Answer 1

(a) cash flow from operating activities using indirect method.  

Statement of cash flow

Cash flow from operating activity Net income $2,61,800 Adjustments- +Depreciation $78,300 Changes in operating assets and liabilities + Account receivables $1,110 - inventories $20,730 + Prepaid expenses $550 -Account Payables $3,130 +Salary payable $1,180 Net cash flow from operating activity $3,19,080

(b)if direct method has been used, net cash flow from operating activities will not be same.

Reason-

While preparing the Cash Flow Statement as per Direct Method, items like Depreciation, Amortisation of Intangible Assets, Preliminary Expenses, Debenture Discount etc are ignored from Cash Flow Statement since the Direct Method includes only Cash Transactions and Non-Cash Transactions are omitted.

Likewise, no adjustment is made for Loss/Gain on the Sale of Fixed Assets and Investments while preparing the Cash Flow Statement as per the Direct Method.

Whereas, While preparing the Cash Flow Statement as per the Indirect Method, Non Cash and Non Operating charges in the Income Statement are added back to the Net Profits while Non-Cash & Non-Operating Credits are deducted to calculate the Operating Profit before Working Capital Changes. The Indirect Method of preparating of Cash Flow Statement is a partial conversion of accrual basis profit to Cash basis profit. Further, necessary adjustments are made for Increase/Decrease in Current Assets and Current Liabilities to obtain Net Cash Flows from Operating Activities as per the Indirect Method.