Question

: You are an accountant of a medium-sized manufacturing company. You prepared the income statement for 2018 that showed net income of $10 million and a statement of cash flows, using the indirect method, that showed cash flow from operating activities of negative $10 million. This just didn't make sense to your boss.

Prepare a memo explaining:
1. How net income could be positive and operating cash flows negative. Include in your report:
2. How operating cash flows using the indirect method is determined.
3. Whether or not switching to the direct method would change the amount of cash flow from operations.

Answer 1

1. How net income could be positive and operating cash flows negative.

The income summary, which, gives the net income, is prepared under the accrual system of accounting.

Accrual basis of accounting mandates that:

*revenues be recognized when the right to get them arises and not when they are received in cash, and

*expenses be recognized when the obligation to pay them arises and not when they are paid.

Hence, it follows that the income statement includes incomes that have not been received in cash and also expenses that have not been paid in cash. Further, it includes only the revenues and expenses that can be related to the period for which it is prepared.

The cash flow statement, on the other hand, includes only cash flows and they also include the cash flows relating to revenues/expenses of the earlier periods. Hence, a cash flow statement for a period may have lower collections from receivables when compared with the credit sales made during the period and further they may have cash outflows on account of expenses that have already been accounted in the prior years' income statements and thus were appearing as liabilities. Because of this, it is possible that the cash outflows on account of operating activities is less than the cash inflows from operating activities, thereby resulting in a negative operating cash flow.

2. How operating cash flows using the indirect method is determined.

While preparing the cash flow statement under the indirect method, it is first assumed that all the net income is received in cash and then adjustments are made for amounts which have not been received in cash.

A specimen of a cash flow statement [Operating section] under the indirect method is given below:

STATEMENT OF CASH FLOWS
Cash flows from operating activities:
Net income		$          21,100
Adjustments to reconcile net income to net cash provided by operations:
Income statement items not affecting cash:
Depreciation expenses	$         14,200
Changes in current operating assets and liabilities:
Decrease in accounts receivable	$            4,100
Increase in inventory	$        -39,500
Decrease in accounts payable	$          -2,900
Decrease in salaries payable	$              -200	$        -24,300
Net cash used by operating activities		$          -3,200

As can be seen, the net income is at first assumed to be received in cash and then adjustments are made for amounts not received in cash or amounts not paid in cash as also amounts received/paid relating to the previous period.

The adjustments are made for:

*Non cash items like depreciation & amortization, loss/sale on asset, and

*Changes in current assets [other than cash] and current liabilities.

Increase in current assets and decrease in current liabilities are shown as deductions and the decrease in current assets and increase in current liabilities are shown as additions,
3. Whether or not switching to the direct method would change the amount of cash flow from operations.

No, switching to direct method will not affect the amount of cash flow from operations.