Bad5shah

Consider the following:

Argument #1:	The indirect method presents a firm’s operating cash receipts and payments and is thus more consistent with the objectives of the cash flow statement.
Argument #2:	The indirect method provides more information than the direct method and is more useful to analysts in estimating future operating cash flows.

Which of these arguments support the use of the indirect method for presenting cash flow from operating activities in the cash flow statement?

A) Argument #2 only.

B) Neither argument.

C) Argument #1 only.

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It is the direct method, not the indirect method, that presents operating cash receipts and payments and is thus more consistent with the objectives of the cash flow statement. The direct method provides more information than the indirect method and is preferred by analysts who are estimating future cash flows.

Bad5shah

The difference between cash flow from operations (CFO) under the direct method and CFO under the indirect method is:

A) balanced by an opposite difference in cash flow from investing.

B) disclosed as a reserve in the footnotes to the cash flow statement.

C) always equal to zero.

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The direct and indirect methods are two ways of presenting the same total for cash from operations.

Bad5shah

Use the following information to calculate cash flows from operations using the indirect method.

• Net Income: $12,000
• Depreciation Expense: $1,000
• Loss on sale of machinery: $500
• Increase in Accounts Receivable: $2,000
• Decrease in Accounts Payable: $1,500
• Increase in Income taxes payable: $500
• Repayment of Bonds: $3,000

A) Increase in cash of $7,500.

B) Increase in cash of $10,500.

C) Increase in cash of $9,500.

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Cash flow from operations would be calculated as +Net Income $12,000 + Depreciation $1,000 + Loss on sale of machinery $500 − A/R $2,000 − A/P $1,500 + Income taxes payable $500 = $10,500.
Repayment of Bonds is a financing activity and would not be included with operating activities. Depreciation is not a cash flow activity and is therefore always added back to net income to calculate CFO. The loss on the sale of machinery is not a cash outflow so it is also added back to calculate CFO. Accounts receivable is subtracted when there is an increase as this increases net income but does not affect cash.

Bad5shah

Use the following financial data for Moose Printing Corporation to calculate the cash flow from operations (CFO) using the indirect method.

• Net income: $225
• Increase in accounts receivable: $55
• Decrease in inventory: $33
• Depreciation: $65
• Decrease in accounts payable: $25
• Increase in wages payable: $15
• Decrease in deferred taxes: $10
• Purchase of new equipment: $65
• Dividends paid: $75

A) Increase in cash of $248.

B) Increase in cash of $173.

C) Increase in cash of $183.

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CFO for Moose Printing Corporation is calculated as follows:
+Net Income $225 − A/R $55 + Inventory $33 + Depreciation $65 − A/P $25 + Wages Payable $15 − Deferred taxes $10 = $248.
The purchase of new equipment would be an investing activity and, therefore, would not be included in the CFO. Dividends paid would be a financing activity and would not be included in the CFO.

Bad5shah

Darth Corporation’s most recent income statement shows net sales of $6,000, and Darth’s marginal tax rate is 40%. The total expenses reported were $3,200, all of which were paid in cash. In addition, depreciation expense was reported at $800. A further examination of the most recent balance sheets reveals that accounts receivable during that period increased by $1,000. The cash flow from operating activities reported by Darth should be:

A) $1,200.

B) $1,000.

C) $2,200.

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Net income is ($6,000 – 3,200 – 800)(1 – 0.4) = $1,200. Adjustments to reconcile net income to cash flow from operating activities will require that depreciation ($800) be added back, and increase in accounts receivable ($1,000) be subtracted: $1,200 + 800 – 1,000 = $1,000.

Bad5shah

Convenience Travel Corp.’s financial information for the year ended December 31, 2004 included the following:

Property Plant & Equipment	$15,000,000
Accumulated Depreciation	9,000,000

The only asset owned by Convenience Travel in 2005 was a corporate jet airplane. The airplane was being depreciated over a 15-year period on a straight-line basis at a rate of $1,000,000 per year. On December 31, 2005 Convenience Travel sold the airplane for $10,000,000 cash. Net income for the year ended December 31, 2005 was $12,000,000. Based on the above information, and ignoring taxes, what is cash flow from operations (CFO) for Convenience Travel for the year ended December 31, 2005?

A) $12,000,000.

B) $8,000,000.

C) $13,000,000.

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Using the indirect method, CFO is net income increased by 2005 depreciation ($1,000,000) and decreased by the gain recognized on the sale of the plane [$10,000,000 sale price − ($15,000,000 original cost − $10,000,000 accumulated depreciation including 2005) = $5,000,000]. $12,000,000 + $1,000,000 − $5,000,000 = $8,000,000.

Bad5shah

The following information is from the balance sheet of Silverstone Company:Net Income for 5/1/05 to 5/31/05: $8,000

Balance 5/01/05	Account	Balance 5/31/05
$2,000	Inventory	$1,750
$1,200	Prepaid exp.	$1,700
$800	Accum. Depr.	$975
$425	Accounts payable	$625
$650	Bonds payable	$550

Using the indirect method, calculate the cash flow from operations for Silverstone Company as of 5/31/05:

A) Increase in cash of $7,725.

B) Increase in cash of $8,125.

C) Increase in cash of $8,025.

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Silverstone Company’s cash flow from operations would be calculated as +Net Income $8,000 + Inventory $250 - Prepaid exp. $500 + Depreciation $175 + A/P $200 = $8,125.
Bonds payable is a financing activity and would not be included in the cash flow from operations. The indirect method takes the change in the non-cash accounts and decreases or increases net income to get to the change in cash flow.

Bad5shah

An analyst compiled the following information for Universe, Inc. for the year ended December 31, 20X4:

• Net income was $850,000.
• Depreciation expense was $200,000.
• Interest paid was $100,000.
• Income taxes paid were $50,000.
• Common stock was sold for $100,000.
• Preferred stock (eight percent annual dividend) was sold at par value of $125,000.
• Common stock dividends of $25,000 were paid.
• Preferred stock dividends of $10,000 were paid.
• Equipment with a book value of $50,000 was sold for $100,000.

Using the indirect method and assuming U.S. GAAP, what was Universe Inc.’s cash flow from operations (CFO) for the year ended December 31, 20X4?

A) $1,050,000.

B) $1,015,000.

C) $1,000,000.

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Cash flow from operations (CFO) using the indirect method is computed by taking net income plus non-cash expenses (i.e. depreciation) less gains from the equipment sale. Note that cash flow from operations must be adjusted downward for the amount of the gain on the sale of the equipment. Cash flow from operations is ($850,000 + $200,000 – ($100,000 − $50,000)) = $1,000,000. Note that interest and income taxes paid are expenses shown on the income statement and will already be factored into net income. The other information relates to financial and investing cash flows.

Bad5shah

When using the indirect method for computing cash flow from operating activities, a change in accounts payable will require which of the following?

A) A negative (positive) adjustment to net income when accounts payable increases (decreases).

B) A positive (negative) adjustment to net income when accounts payable increases (decreases).

C) A negative adjustment to net income regardless of whether accounts payable increases or decreases.

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A decrease in accounts payable represents an outflow. Hence, a negative adjustment will be required. Conversely, an increase represents an inflow and a positive adjustment.

Bad5shah

Given the following information, what is the adjustment to net income when calculating cash flow from operations using the indirect method?

• Increase in accounts payable of $25.
• Sold one share of stock for $15.
• Paid dividends of $10 to shareholders.
• Depreciation expense of $100.
• Increase in inventory of $20.

A) -$50.

B) +$105.

C) -$95.

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Using the indirect method, the increase in accounts payable is a source of cash from operations (+25), depreciation expense is a non-cash expense added back in computing cash from operations (+100), and increase in inventory is a use of cash from operations (-20) = 25 + 100 - 20 = 105. The sale of stock and the dividends paid are financing cash flows that are not included in net income, so they do not require adjustment when calculating CFO.