Question

Statement of Cash Flows

The indirect method of preparing Cash Flows from Operating Activities in the Statement of Cash Flows starts with accrual net income, and makes adjustments to convert it to net cash provided (used) by operating activities.

REQUIRED: Explain how and why the following three items would be handled in the conversion of accrual net income to net cash provided (used) by operating activities.

(1) Depreciation Expense

(2)   An increase in Accounts Receivable

(3) An increase in Wages Payable

Answer 1

(1) Depreciation expense is added back to net income in the statement of cash flows because there is no actual cash outflow in this transaction. Depreciation expense is just the writing off of the assets that were bought at some previous date and had to be used over for certain years. Depreciation expense is basically the charging the cost of assets to the business over its useful life.

(2) An increase in Accounts receivable means Increase in credit sales. The sale are recorded on accrual basis in income statement. That means the sales amount includes credit sales also for which cash is yet to be received. Therefore, an increase in accounts receivable is subtracted while calculating cash flow from operationg activities.

(3) An increase in wages payable is added while calculating cash flows from operating activities. This is beacuse an increase in wages payable means there was an amount of wages thata was to be paid in this period but is outstanding. That means there was no actual cash outflow og this amount. But as the accounts are prepared on accrual basis the wages charged in income statement also include the amount of these outstanding wages. So, in order to show the effect of no actual cash outflow, the increase in wages payable is added back while calculating cash flow from operating activities.