To convert an indirect statement of cash flows to a direct basis, the analyst would: A) subtract any depreciation that was included in the cost of goods sold. B) add decreases in inventory to the cost of goods sold. C) subtract decreases in accounts receivables from net sales. D) add decreases in accounts payable to the cost of goods sold Comments people…
depreciation is ignored in the direct method. So a is wrong. Change in Inventory is added to Sales. So B is wrong. Decrease in AR is ADDED to Net Sales. So C is wrong. Leaves D as the right answer.
Here is the weird explanation: Answer is A: Decreases in inventory represent a source of cash so these would be added to the negative cost of goods sold figure (i.e. make it less negative). Any depreciation and/or amortization included in the cost of goods sold does not represent an actual use of cash, so this amount should be added to the negative cost of goods sold figure (i.e. make it less negative). A decrease in accounts receivables represents an increase in cash so this should be added to the sales figure. Decreases in accounts payable represent a use of cash so these should be subtracted from the negative cost of goods sold figure (i.e. make it more negative).
I think the answer choice in this one is wrong. A) subtract any depreciation that was included in the cost of goods sold. B) add decreases in inventory to the cost of goods sold. C) subtract decreases in accounts receivables from net sales. D) add decreases in accounts payable to the cost of goods sold A is wrong. Given depreciation is Not used in the Direct Method. B is right. Decrease on Inventory would be add on to the negative COGS to make it less negative. Decrease on Inventory is a Source of cash. Decrease is AR is Added To Net Sales – Source of Cash. Decrease in AP is a Use of Cash. So it is subtracted from the COGS.
I am also for D…
I was always for B… Remember Net Sales + Change in AR. AR Increase ==> Change in AR is a decrease AR Decrease ==> Change in AR is an increase COGS + Change in AP + Change in Inv. Inventory is a CURRENT ASSET Inv Increase ==> Change in AR is a decrease Inv Decrease ==> Change in AR is an increase AP is a CURRENT Liability AP Increase ==> Change in AP is an Increase AP Decrease ==> Change in AP is a decrease Use this to remember your flows. Use the sign on the Increase or Decreased component, and then always ADD to the Net Sales or COGS figure. I also used the convention A ==> Net Sales + Change in AR B ==> COGS + Change in AP + Change in Inv. I am ignoring the Taxes, Interest here. *** Then CFO ==> A - B
this is what i found from Schweser: (I know its lengthy) The only difference between the indirect and direct methods of presentation is in the cash flow from operations (CFO) section. CFO under the direct method can be computed using a combination of the income statement and a statement of cash flows prepared under the indirect method. There are two major sections in CFO under the direct method: cash inflows (receipts) and cash outflows (payments). We will illustrate the conversion process using some frequently used accounts. Please note that the list below is for illustrative purposes only and is far from all-inclusive of what may be encountered in practice. The general principle here is to adjust each income statement item for its corresponding balance sheet accounts and to eliminate noncash and nonoperating transactions. Cash collections from customers: Begin with net sales from the income statement. Subtract (add) any increase (decrease) in the accounts receivable balance as reported in the indirect method. If the company has sold more on credit than has been collected from customers, accounts receivable will increase and cash collections will be less than net sales. Add (subtract) an increase (decrease) in unearned revenue. Unearned revenue includes cash advances from customers. Cash received from customers when the goods or services have yet to be delivered is not included in net sales, so the advances must be added to net sales in order to calculate cash collections. Cash payments to suppliers: Begin with cost of goods sold (COGS) as reported in the income statement. If depreciation and/or amortization have been included in COGS (they increase COGS), these items must be added back to COGS when computing the cash paid to suppliers. Reduce (increase) COGS by any increase (decrease) in the accounts payable balance as reported in the indirect method. If payables have increased, then more was spent on credit purchases during the period than was paid on existing payables, so cash payments are reduced by the amount of the increase in payables. Add (subtract) any increase (decrease) in the inventory balance as disclosed in the indirect method. Increases in inventory are not included in COGS for the period but still represent the purchase of inputs, so they increase cash paid to suppliers. Subtract an inventory write-off that occurred during the period. An inventory write-off, as a result of applying the lower of cost or market rule, will reduce ending inventory and increase COGS for the period. However, no cash flow is associated with the write-off. Other items in a direct method cash flow statement follow the same principles. Cash taxes paid, for example, can be derived by starting with income tax expense on the income statement. Adjustment must be made for changes in related balance sheet accounts (deferred tax assets and liabilities, and income taxes payable). Cash operating expense is equal to selling, general, and administrative expense (SG&A) from the income statement, increased (decreased) for any increase (decrease) in prepaid expenses. Any increase in prepaid expenses is a cash outflow that is not included in SG&A for the current period.
D sounds correct, but A as well. Looking at the answer, the mindset of the person who made the question makes D incorrect as they are subtracting from a negative COGS , which is in fact adding, but quite an odd way of wording it in the question.