The indirect method is commonly used to calculate cash flows from operating activities in a cash flow statement. It starts with net income and adjusts it for non-cash expenses, certain non-operating items, and changes in operating assets and liabilities.
In this accounting question, the financial records of Saro Corporation and its subsidiaries for Year 1 are provided. Students need to identify the relevant adjustments and calculate the net cash provided by operating activities.
The Following Data Were Reported by a Corporation: Question
Question: The following data were taken from the records of Saro Corporation and subsidiaries for Year 1.
| Particulars | Amount |
|---|---|
| Net income | $10,000 |
| Depreciation, depletion, and amortization | $8,000 |
| Disposals of property, plant, and equipment (book value) for cash | $1,000 |
| Deferred income taxes for Year 1 (noncurrent) | $400 |
| Undistributed earnings of unconsolidated affiliates | $200 |
| Amortization of discount on bonds payable | $50 |
| Amortization of premium on bonds payable | $60 |
| Decrease in noncurrent assets | $1,500 |
| Cash proceeds from exercise of stock options | $300 |
| Increase in accounts receivable | $900 |
| Increase in accounts payable | $1,200 |
| Decrease in inventories | $850 |
| Increase in dividends payable | $300 |
| Decrease in notes payable to banks | $400 |
Determine the amount of cash flows from operating activities for Year 1 using the indirect method.
Options
| A. $17,940 | B. $19,340 |
| C. $20,840 | D. $21,140 |
Correct Answer
Option B: $19,340
Based on the indirect method and the standard classification of cash flow items, the net cash provided by operating activities is $19,340.
Explanation: Calculation of Cash Flows from Operating Activities
The indirect method starts with net income and adjusts it for non-cash expenses, relevant non-operating items, and changes in operating assets and liabilities.
The basic formula is:
Cash Flow from Operating Activities = Net Income + Adjustments for Non-Cash Items − Increases in Operating Assets + Decreases in Operating Assets + Changes in Operating Liabilities
Step 1: Start with Net Income
The net income reported by Saro Corporation for Year 1 is $10,000.
This is the starting point for calculating cash flows from operating activities under the indirect method.
Step 2: Add Depreciation, Depletion, and Amortization
Depreciation, depletion, and amortization amount to $8,000.
These expenses reduce net income but do not represent current-period cash payments. Therefore, they are added back to net income.
Net income = $10,000
Add: Depreciation, depletion, and amortization = $8,000
Subtotal = $18,000
Step 3: Adjust for Deferred Income Taxes
Deferred income taxes for Year 1 are $400. Assuming this amount represents deferred tax expense, it is added back because it is a non-cash expense included in net income.
Subtotal = $18,000 + $400 = $18,400
Step 4: Adjust for Undistributed Earnings of Affiliates
Undistributed earnings of unconsolidated affiliates are $200.
Under the equity method, earnings recognized by the investor may not have been received in cash. Therefore, the undistributed earnings are deducted when calculating operating cash flow.
Subtotal = $18,400 − $200 = $18,200
Step 5: Adjust for Bond Discount and Premium Amortization
The company reported two bond-related adjustments:
- Amortization of discount on bonds payable: $50
- Amortization of premium on bonds payable: $60
Amortization of a bond discount is generally added back because it increases interest expense without an equivalent current-period cash payment.
Amortization of a bond premium is generally deducted because it reduces interest expense without an equivalent current-period cash receipt.
Net adjustment = $50 − $60 = −$10
Subtotal = $18,200 − $10 = $18,190
Step 6: Adjust for Changes in Operating Assets and Liabilities
Changes in operating assets and liabilities affect the operating cash flow calculation.
| Particulars | Adjustment | Amount |
|---|---|---|
| Increase in accounts receivable | Deduct | −$900 |
| Increase in accounts payable | Add | +$1,200 |
| Decrease in inventories | Add | +$850 |
| Net adjustment | +$1,150 |
An increase in accounts receivable is deducted because some revenue has not yet been collected in cash.
An increase in accounts payable is added because some expenses or purchases have not yet been paid in cash.
A decrease in inventory is added because less cash remains tied up in inventory.
Subtotal = $18,190 + $1,150 = $19,340
Why Are the Other Items Excluded?
Not every item in the question is included in operating cash flow.
| Transaction | Treatment |
|---|---|
| Disposal of property, plant, and equipment for cash | Generally an investing activity; any gain or loss on disposal is adjusted separately if included in net income |
| Decrease in noncurrent assets | Not automatically an operating adjustment; classification depends on the nature of the change |
| Cash proceeds from exercise of stock options | Financing activity |
| Increase in dividends payable | Generally a financing-related liability, not an operating adjustment |
| Decrease in notes payable to banks | Financing activity |
These items are excluded from the operating cash flow calculation because they relate to investing activities, financing activities, or changes that cannot be classified as operating adjustments from the information given.
Final Answer
Using the indirect method, the calculation is:
Net income: $10,000
Add depreciation, depletion, and amortization: $8,000
Add deferred income tax expense: $400
Deduct undistributed earnings of affiliates: $200
Add bond discount amortization: $50
Deduct bond premium amortization: $60
Deduct increase in accounts receivable: $900
Add increase in accounts payable: $1,200
Add decrease in inventories: $850
Net Cash Provided by Operating Activities = $19,340
Therefore, the correct answer is Option B: $19,340.
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