Question

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. There can be various circumstances under which net income could be positive and still operating cash flows would be negative:

(a) Net income is an accounting profit that is not measured by cash receipts and cash payouts. Companies may make credit sales and receive no cash payments from customers at the time, but still record revenues in computing net income

(b) When net income includes a non-recurring item (for eg. gain on sale of investments). Such amount would be reduced from the net income to calculate cash flow from operations and if such gain is greater than the net income, cash flow from operations would be negative.

(c) When deduction for depreciation is greater than net income.

(d) Cash paid to increase certain operating assets for the year, such as inventory purchase, is a form of cash outflow that, if large enough, could reduce total cash flow to be negative.

2. The indirect method presents the statement of cash flows beginning with net income or loss, with subsequent additions to or deductions from that amount for non-cash revenue and expense items, resulting in cash flow from operating activities.

3. Unlike the indirect method, the direct method only takes the cash transactions into account and produces the cash flow from operations. Although the method for calculating cash flow from operations is quite different under the two methods, the net balance of Cash flow from operations will still be the same under the two methods.