Below is the question from the Q-Bank. My question is why Prepaid exp which has increased during the month is substracted, my understanding is that using indirect method prepaid exp should added instead. Thanks in advance. The following information is from the balance sheet of Silverstone Company: * Net Income for 5/1/05 to 5/31/05: $8,000 Balance 5/01/05 Account Balance 5/31/05 $2,000 Inventory $1,750 $1,200 Prepaid exp. $1,700 $800 Accum. Depr. $975 $425 Accounts payable $625 $650 Bonds payable $550 Using the indirect method, calculate the cash flow from operations for Silverstone Company as of 5/31/05: A) Increase in cash of $8,025. B) Increase in cash of $8,125. C) Increase in cash of $7,725. D) The indirect method cannot be calculated from the information provided. The correct answer is B) Increase in cash of $8,125. Silverstone Company’s cash flow from operations would be calculated as +Net Income $8,000 + Inventory $250 - Prepaid exp. $500 + Depreciation $175 + A/P $200 = $8,125.
Prepaid expense is a cash outflow - it should be subtracted. Non-cash expenses should be added back.
General rule: Asset account increase is a decrease in the cash; asset account decrease is a increase in the cash. Prepaid expenses is an asset account that increases, so we need to decrease cash. Why is that? Increase in prepaid expense means that certain expense was paid in advance before the actual recognition of the revenue that is associated with that expense (cash out). Decrease in prepaid expense means that we have recognized the revenue that goes with the prepaid expense BUT there was not any actual cash outflow since we have already paid for that expense.
Thanks alpenchev. Now that looks crystal clear to me.