Question

Items that are added back to net income in determining cash provided by operating activities under the indirect method do not include: a. depreciation expense. c. amortization expense. b. an increase in inventory. d. loss on sale of equipment.

Short answer

Option b, an increase in inventory, is not added back to net income.

Step-by-step solution

Understand the Indirect Method

The indirect method of cash flow statement starts with the net income and adjusts for non-cash transactions and changes in working capital to determine the net cash provided by operating activities. This method involves adding back non-cash expenses and losses and subtracting gains and changes in working capital.

Identify Non-Cash Expenses

Identify the non-cash expenses that are typically added back to net income because they do not involve actual cash outflow. This includes depreciation expense and amortization expense, as these are accounting allocations rather than actual cash expenditures.

Consider Losses and Gains

Losses that occurred without a cash outflow, such as a loss on sale of equipment, are added back to net income. Conversely, gains would be subtracted as they do not represent real cash inflow.

Evaluate Changes in Working Capital

Changes in working capital, such as inventory, are considered. An increase in inventory is subtracted from net income because it represents cash that has been spent on purchasing inventory that has not yet been sold.

Determine the Correct Answer

Among the given options, determine which is not added back to net income when calculating cash flows from operating activities using the indirect method. Options a, c, and d are non-cash or loss adjustments and thus added back. Option b (increase in inventory) represents an actual cash outflow and thus is not added back.

Key concepts

Non-Cash Transactions

Non-cash transactions play a crucial role in the indirect method of cash flow reporting. These transactions are those that affect the calculation of net income without creating actual cash inflows or outflows. In fact, they can significantly impact a company's financial statements.
Depreciation and amortization are prime examples of non-cash transactions. Although recorded as expenses on the income statement, they don't reflect an actual outgoing cash flow. Thus, they are added back to net income when calculating cash provided by operating activities.

• Depreciation refers to the allocation of the cost of tangible assets over their useful lives.
• Amortization, on the other hand, applies to intangible assets, spreading their cost out over time.

Losses, like those on the sale of equipment, also don't involve cash outflow at the moment. Therefore, while calculating cash flow, these are added back to the net income.
Understanding these transactions allows businesses to gain a clearer view of their cash situation, distinguishing between accounting measures and actual liquidity.

Working Capital Adjustments

Working capital adjustments are adjustments made to account for changes in current assets and liabilities. These adjustments are crucial for comprehensively understanding cash flow from operating activities using the indirect method. Working capital ensures a company can meet its short-term liabilities.
The main components of working capital adjustments include inventories, receivables, and payables. Changes in these items can significantly impact cash flow calculations:

• An increase in inventory means more money is tied up in stock, reducing cash flow, thus subtracted from net income.
• A decrease in inventory or receivables, however, indicates cash inflow, and is thus added back.
• On the flip side, an increase in accounts payable, where a company borrows from suppliers, represents a cash inflow since actual cash has not yet left the company.

Adjustments in working capital provide a clearer picture of the cash available for business operations, emphasizing the importance of thoroughly examining these elements in cash flow analysis.

Operating Activities

Operating activities are central to a company's cash flow statement. They represent the core business actions generating revenue, such as production, sales, and delivery of a company's products or services. The indirect method starts with net income and makes necessary adjustments to reveal cash generated by these activities.
In this section, businesses adjust for non-cash transactions and gains or losses unrelated to operating activities. Since net income includes items like non-cash expenses, gains, and losses, the statement starts by reconciling these to focus solely on cash movement.

• Operating cash flow excludes non-operating income, such as one-time sales of assets or investments, focusing purely on regular business activities.
• Investors rely on this metric to judge the efficiency and effectiveness of the company's core business model in generating cash.

By adapting the income statement to the cash flow statement through these adjustments, businesses can better understand their financial health and operational performance.