Question

When preparing a statement of cash flow using the indirect method, I know we start with the net income amount from the income statement and make adjustments to non cash expenses such as depreciation and amortization. My question is, why is cost of goods sold not included in these non cash expenses? It is a non-cash expense, is it not? A customer could purchase an item on credit, and we would debit cost of goods sold without any cash exchanging hands. So why do we leave this number alone when making adjustments to net income using the indirect method?

Answer 1

Solution:

You are right that cost of goods sold could also be a non cash expense as we can purchase items on credit. However, same is not added to net income considering it as non cash expenses. The reason is that while preparing statement of cash flow using indirect method, net income is adjusted to determined cash flow from operating activities.

In those adjustment, we make adjustment of change in working capital in which increase in current assets reduced from net income, decrease in current assets added to net income, increase in current liabilities added to net income and decrease in current liabilities is reduced from net income.

Therefore after making change in working capital adjustments to net income, all non cash effect of cost of goods sold or credit sales automatically eliminated. Therefore cost of goods sold not separately added to net income to determine cash flow from operating activities.

Depreciation/Amortization are non cash expenses and these are related to Fixed assets of the company that is part of investing activities of statement of cash flow,therfore these are added to net income.

Lets take an example, you have $100 balance in accounts payable at begining of the year. During the year you purchase goods costing $100 on credit and payment for this purchase is not made till end of year. Now you have ending balance in accounts payable $200. Therefore while preparing cash flow statement in increase in accounts payable ($200 - $100) will be added to net income. It means non cash purchase of cost of goods sold automatically added.

Hope your query is resolved.