A few questions on Indirect cash flow statements

CFA Level I FRA
#1

Hello all, After reviewing LOS 27.f (in the 2014 Kaplan guide), I have a few questions about indirect CF statements. (Page 120): An income statement for 2007 shows “Gain from sale of Land” as $10000. The balance sheet from 2006/2007 shows land valued at $40000 in 2006 and $35000 in 2007. This leads me to two questions:

a.) Why do you subtract gains or add losses? If you had a gain from a sale of land, wouldn’t that represent a flow of cash? b.) When computing “cash from sale of land” why is “decrease in assets” not a negative number? I presume a decrease in assets listed ($5000) is from the difference in land value ($40000 in 2006 and $35000 in 2007) but wouldn’t that represent a decrease and not an increase in the cash recieved? How does a decrease in an asset lead to a positive cash flow? To find “cash from sale of land” the book uses the formula:

Decrease in assets + gain on sale = 5000 + 10000 = 15000.

(Page 119): Why is depreciation listed as a positive cash flow?

(Page 119):“Increase in interest payable” is listed as a positive cash flow. The way I understand it is that in this context, an increase in interest payable, or taxes payable, etc means that it is an increase in taxes payable in the future which translates to a decrease in taxes presently (i.e. it’s a zero sum game, the amount of money paid is the same - all that matters is when it’s actually paid)

Thanks!

#2

Keep in mind your starting point using the indirect method is net income so you need to reverse out any changes that were made to get back to CFO. Subtracting gains and adding losses from CFI and CFF. Adding back non-cash charges (depreciation). Regarding operating accounts, keep in mind sources and uses of cash. This means under the indirect method, assets have an inverse relationship (add decreases/subtract increases) and liabilities have a direct relationship (add increases and subtract decreases).

#3

Perhaps this is related to what I asked, perhaps it isn’t: The book says that: "Subtract gains on the disposal of assets. Proceeds on thge sale of fixed assets are an investing cash flow. Since gains are a portion of such proceeds, we need to subtract them from net income in calculating CFO under the indirect method. Conversely, a loss would be added back to net income in calculating CFO under the indirect method."

I understand that you subtract out a gain from a sale of a fixed asset because it is an investing CF and we are looking for operating CF’s, but what I don’t understand is why we ad in a loss on that same investing CF. Regardless of whether you realize a gain or loss isn’t it still an investing CF and therefore not relevant in calculating the CFO?

#4

You are right to say the above, i quote “… therefore not relevant in calculating the CFO…”

" Since gains are a portion of such proceeds, we need to subtract them from net income in calculating CFO under the indirect method. Conversely, a loss would be added back to net income in calculating CFO under the indirect method"

We add loss on disposal of fixed assets as this has reduced our net income earlier; hence we have to add it back. Likewise, a gain on disposal of fixed assets have increased our net income previously and hence it need to be removed (i.e. subtract from net income)

If some numbers will help:

Operating Profit : 1,000

Gain on disposal of Machine A: 500

Loss on disposal of Machine B: (300)

EBIT: 1,200

Less interest and tax: (600)

Net Income: 600

When we use indirect method of computing CFO, we start with Net Income of $600; then we make the necessary adjustment for non-cash items such as depreciation/amortization and non-CFO items such as gain/loss on fixed assets:

Net Income: 600

Add Loss on disposal of B: 300

Less Gain on disposal of A: (500)

***** *****

CFO XXX

Hope it helps a bit :slight_smile:

Ernest

#5

Net income contains cash and non-cash items.

We want to “edit” net income so any effects of non-cash items are removed, creating a “stripped down” net income devoid of any non-cash items.

But isn’t adding depreciation expense back in more or less implying that it’s a cash expense? Aren’t we looking for strictly cash transactions?

Thank you for your detailed response.

#6

It would. But it’s CFI, not CFO, so you remove it when you’re calculating CFO.

If you look at debits and credits, this is very easy. The decrease in assets is a credit, and the gain on the sale is a credit; the cash received is a debit:

  • Dr Cash $15,000
  • Cr Assets $5,000
  • Cr Gain on Sale $10,000

The other way to look at it is that the gain on the sale is the difference between the sales price (which we’re assuming is all cash) and the basis (the asset value on the balance sheet):

Gain on Sale = Cash Received – Sold Asset’s Basis

Cash Received = Gain on Sale + Sold Asset’s Basis

When the asset is sold, the asset is removed from the balance sheet, so

Decrease in Assets = Sold Asset’s Basis

Combining these gives us:

Cash Received = Gain on Sale + Decrease in Assets

It isn’t. Nor is it a negative cash flow. When creating the income statement we subtracted depreciation as if it were a cash outflow; adding it back merely adjusts that subtraction because it isn’t a cash outflow.

This is the same as depreciation, above. When we create the income statement, we list Interest Expense as if we paid cash for all of it. If our interest payable increased, then we didn’t pay some of it in cash, so we have to add it back, to correct the overstatement.

You’re welcome.

Take a look at the articles I wrote on CFO; they may help:

#7

If you look at debits and credits, this is very easy. The decrease in assets is a credit, and the gain on the sale is a credit; the cash received is a debit:

  • Dr Cash $15,000
  • Cr Assets $5,000
  • Cr Gain on Sale $10,000

Why is the cash recieved a debit? Unfortunately, my reccolection of college accounting isn’t that great! I know to subtract or add depending on what we’re dealing with, but I’m not sure as to the reasoning behind it.

My last noobie question of the night is:

In your link, you say that:

Removing any items from the income statement that aren’t cash

then go on to say:

Expense Accounts: the most common noncash expense accounts are depreciation and amortization, less common are depletion and accretion. These amounts must be added to Net Income to arrive at CFO.

I thought that we were suposed to remove all non-cash transactions yet it seems like with adding back depreciation, we are doing just that: adding back in non-cash transactions?

As always, thank you for your help.

#8

Can I offer my opinion, though the question is directed towards S2000.

I think I know where you are coming from. When you say remove, you are thinking in the way that - these items should be subtracted from the net income i.e. by subtracting, it constitutes to removing them.

I guess you are too bothered with the word ‘remove’? In the context of removing depreciation expense, we are trying to remove the “reduction effect” that the depreciation expenses had on the Net Income previously. To achieve this, we add back to remove this “reduction effect”. This step is “remove all non-cash transactions”.

#9

Credits and debits: http://financialexamhelp123.com/credits-and-debits/.

The short answer is that assets have debit balances, while liabilities and equity have credit balances.

What we’re doing is counteracting the transaction on the income statement. Think of the income statement as pretending that everything it mentions is cash: all revenues are cash, and all expenses are cash. We know that that isn’t true, so we have to counteract the ones that are incorrect. We reduce Sales by the increase in A/R because the increase in A/R represents credit sales, not cash sales: the amount in Sales is higher than the cash received, so we subtract it. Similarly, we eliminate Depreciation because we know that that expense wasn’t cash; to counteract an expense that is too high, we add back depreciation.

As always, you’re quite welcome.

#10

That is kind of what I figured but I wasnt 100% sure. Thank you. I have another question that I will post here because it is related to my original question:

Given the following information:

Net income ------------------------------45

Depreciation -----------------------------75

Taxes paid -------------------------------25

Interest paid ------------------------------5

Dividends paid ---------------------------10

Cash from sale of building ----------------40

Sale of preferred stock -------------------35

Repurchase of common stock ------------30

Purchase of machinery -------------------20

Issuance of bonds ------------------------50

Debt retired: issued common stock -------45

Paid of long term borrowings -------------15

Profit on sale of building ------------------20

Cash flow from operations is?

A few pages before this problem we were given an example. The book instructed us to “subtract gains or add losses [from net income] that resulted from financing or investing cash flows.” Why doesn’t that include items like “Debt retired: issued common stock” or “Purchase of machinery”? Why aren’t those financing and investing activities subtracted from net income?

By the way, the book answer is: Net income - profit on sale of building + depreciation = 100. I got the correct answer by:

Net income + Depreciation + Taxes paid + Interest paid - Dividends paid - Cash from sale of building = 45 + 75 + 25 + 5 - 10 - 40 = 100

Is my method correct or did I arrive at it by luck?

#11

Interest paid (US GAAP or IFRS) and tax paid (US GAAP and IFRS) are already included in Net Income so sont need to include them again if not we are double counting. Have the question show: Change in interest payable and tax payable; then the change can be added/subjected to correctly adjust the interest and tax respectively.

Dividend paid is a CFF cash flow not CFO .

We subtract gain from sale of building as we want to remove it; this item is under CFI not CFO. However, you are right to identify sales of building as CFI just that is not the cash from sales of 40 .

hope it helps a bit :slight_smile:

#12

Because they don’t appear on the income statement. We make adjustments to items on the income statement that aren’t cash (or aren’t operations); if non-CFO items don’t appear on the income statement, we ignore them.

Luck.

You shouldn’t add Taxes Paid: tax expense is included on the income statement, and taxes paid is a CFO outflow.

You shouldn’t add Interest Paid: interest expense is included in the income statement, and interest paid is a CFO outflow.

You shouldn’t include Dividends Paid: that’s CFF, not CFO, and it doesn’t appear on the income statement.

#13

Thank you for that. It’s starting to come together…slowly.

Depreciation is added back in because while it is an “expense” it doesn’t represent an actual cash outflow, correct? Whereas taxes/interest represent actual outflows of cash?

#14

Yes!

#15

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Hi,

I have a quick question on the Statement of Cash Flow. When company buys PPE on 50% credit (0% Interest and balance payable after 15 months), do we put full amount of the PPE in the CFI? If I put only 50% of the amount paid then my Cash Ending balances do not tally and the balance sheet does not tally.

Can someone please guide.

The PPE Payables are shown in the CFO (change in operating assets and liabilities)

#16

Properly, you should show a CFI outflow for the full amount of the PP&E and a CFF inflow for 50% of the PP&E.

In practice, many companies will simply show a cash outflow for 50% of the PP&E.

Either way, everything should balance. If it doesn’t balance, you’ve done something weird.

#17

Thanks ! I took the 50% CFI and left out the PPE payables from the CFO