Which of the following would be added to net income using indirect method?

The discussion on the indirect method of preparing the statement of cash flows refers to the line items in the following statement and the information previously given about the Brothers' Quintet, Inc. 

Operating activities

Although the total cash provided by operating activities amount is the same whether the direct or indirect method of preparing the statement of cash flows is used, the information is provided in a different format.

The indirect method assumes everything recorded as a revenue was a cash receipt and everything recorded as an expense was a cash payment. Remember that under the accrual basis of accounting, revenues and expenses are recorded following the revenue recognition and matching principles which do not require cash receipts to record revenues or cash payments to record expenses. The operating activities section starts with net income per the income statement and adjusts it to remove the significant non‐cash items.

Significant non‐cash items on the income statement include depreciation and amortization expense and gains and losses from the sales of assets or retirement of debt. As depreciation expense and amortization expense are deducted in calculating net income (expenses are subtracted from revenues to determine net income), and depreciation and amortization expense do not result in cash payments by the company, depreciation expense and amortization expense are added back to net income.

Given the financial statements and information for the Brothers' Quintet, Inc., net income is $6,300. Net income first needs to be adjusted by significant non‐cash items from the income statement: depreciation expense and the loss on the sale of the equipment.

Next, net income is adjusted for the changes in most current asset, current liability, and income tax accounts on the balance sheet. The accounts receivable balance decreased $663 from $19,230 to $18,567. As cash is increased when cash is collected from customers, a decrease in the accounts receivable balance represents an increase in cash. Therefore, the $663 is added back to net income. If the accounts receivable balance increases, the amount of the increase is subtracted from net income, the opposite of what happens when the balance decreases. The inventory balance increased $107. As inventory is purchased, cash is assumed to be paid, so the $107 increase in the inventory balance is subtracted from net income (a decrease in the inventory balance would be added to net income). Similarly, the $142 increase in the prepaid expenses balance is also deducted from net income. The accounts payable balance decreased $919. When cash is paid to a supplier for purchases previously made on account, cash decreases. Thus, a decrease in the accounts payable balance represents a decrease in cash and the $919 decrease is subtracted from net income.

An increase in the accounts payable, or any current liability account balance is added to net income. The wages payable balance increased because a larger accrual was made to represent wages owed at the end of 20X1 than 20X0. Accrued wages are owed but not paid at the end of the month. An increase in a current liability account balance means cash has not been paid and therefore, the $320 increase in the wages payable balance is added to net income. The decrease in the accrued expenses balance of $1,295 is subtracted from net income. Once all of the changes in the current asset, current liability, and income tax accounts have been listed, the total cash provided by (used by) operating activities is determined by totaling all of the activity. Notice the amounts of any decreases are in parentheses.

Investing activities and financing activities
 

The investing and financing sections of the statement of cash flows are prepared in the same way for the indirect method as for the direct method.

The indirect method adjusts net income (rather than adjusting individual items in the income statement) for (1) changes in current assets (other than cash) and current liabilities, and (2) items that were included in net income but did not affect cash.

The most common example of an operating expense that does not affect cash is depreciation expense. The journal entry to record depreciation debits an expense account and credits an accumulated depreciation account. This transaction has no effect on cash and, therefore, should not be included when measuring cash from operations. Because accountants deduct depreciation in computing net income, net income understates cash from operations. Under the indirect method, since net income is a starting point in measuring cash flows from operating activities, depreciation expense must be added back to net income.

Consider the following example. Company A had net income for the year of $20,000 after deducting depreciation of $10,000, yielding $30,000 of positive cash flows. Thus, Company A had $30,000 of positive cash flows from operating activities. Company B had a net loss for the year of $4,000 but after deducting $10,000 of depreciation, it had $6,000 of positive cash flows from operating activities, as shown here:

Company ACompany BNet income (loss)$20,000$(4,000)Add depreciation expense (which did not require use of cash)10,00010,000Positive cash flows from operating activities$30,000$ 6,000

Companies may add other expenses and losses back to net income because they do not actually use company cash in addition to depreciation. The items added back include amounts of depletion that were expensed, amortization of intangible assets such as patents and goodwill, and losses from disposals of long term assets or retirement of debt.

To illustrate the add back of losses from disposals of noncurrent assets, assume that Rumble Corp. sold a piece of equipment for $150. The equipment had a cost basis of $160 and had accumulated depreciation of $100. The cash would be reported in the investing section as proceeds from the sale of a long term asset. The difference between the book value of $60 and the cash received $150 is the gain of $90 which was reported on the income statement but is not a cash item.

Therefore, Rumble subtracts the gain from net income in converting net income to cash flows from operating activities.

The same process would apply to losses on sales of long term assets or retirement of debt. Since the cash will be accounted for in later cash flow sections we want to remove the effect from net income so any accrual-basis losses will be added back to net income.

As a general rule, an increase in a current asset (other than cash) decreases cash inflow or increases cash outflow. Thus, when accounts receivable increases, sales revenue on a cash basis decreases (some customers who bought merchandise have not yet paid for it). When inventory increases, cost of goods sold on a cash basis increases (increasing cash outflow). When a prepaid expense increases, the related operating expense on a cash basis increases. (For example, a company not only paid for insurance expense but also paid cash to increase prepaid insurance.) The effect on cash flows is just the opposite for decreases in these other current assets.

An increase in a current liability increases cash inflow or decreases cash outflow. Thus, when accounts payable increases, cost of goods sold on a cash basis decreases (instead of paying cash, the purchase was made on credit). When an accrued liability (such as salaries payable) increases, the related operating expense (salaries expense) on a cash basis decreases. (For example, the company incurred more salaries than it paid.) Decreases in current liabilities have just the opposite effect on cash flows. A short term notes payable from a bank would be treated as a financing activity and not an operating activity.

Watch the following video example:

You can view the transcript for “Statement of Cash Flows: Operating Activities Example – Financial Accounting video” here (opens in new window).

To summarize, the indirect method for calculating the operating activities of a statement of cash flows includes:

Cash Flows from Operating Activities:
Net Income+ Depreciation Expense (from income statement)+ Losses (from income statement)– Gains (from income statement)+ Amortization, depletion (from income statement)+ DECREASE in Current Assets (other than cash)– INCREASE in Current Assets (other than cash)+ Increase in Current Liabilities– Decrease in Current LiabilitiesNet cash provided by Operating Activities

Here is the income statement for Rumble Corp.:

RUMBLE CORP
Income Statement
Year Ended December 31, 20X1DescriptionAmountTotalIn millionsService Revenue$45,785Subcategory, ExpensesWages11,280Depreciation expense125Other expenses29,832Total ExpensesSingle Line41,237Operating incomeSingle Line4,548Subcategory, Other income and expensesGain on sale of assets90Interest expense(310)Net income before income taxSingle Line4,328Provision for income taxes1,718Net IncomeSingle Line $2,610 Double line

And the comparative balance sheets:

RUMBLE CORP
Balance Sheets
As ofDescriptionAmountTotalIn millionsPanel A – Balance Sheet12/31/X112/31/X0Cash$5,040$1,640Accounts Receivable1,7351,750Equipment24,92024,500Accumulated Depreciation(1,565)(1,540)Total AssetsSingle line
$30,130
Double lineSingle line
$26,350
Double lineAccounts Payable$1,039$1,007Wages Payable13555Income Taxes Payable6042Note Payable – Long Term5000Total LiabilitiesSingle line
1,734Single line
1,104Common Stock13,50012,500Retained Earnings14,89612,746Total Liabilities and Owner’s EquitySingle line
$30,130
Double lineSingle line
$26,350
Double line

And here is the information we need to complete the cash flows from operations section of the statement of cash flows (all numbers represent millions of dollars):

Which of the following would be added to net income using the indirect method of calculating operating cash flows?

Which of the following is not added to net income using indirect method?

Which of the following would be added to net income in the operating activities?

What is included in the indirect method of cash flows?