Student Forums CMA Part 1 Section A: External Financial Reporting Decisions A.1. Financial Statements 9. Question ID: ICMA 13.P2.2055 (Topic: The Indirect Method)

9. Question ID: ICMA 13.P2.2055 (Topic: The Indirect Method)

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  • #239275

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    This forum is restricted to members of the associated course(s).

    Azhar Hussain
    Participant

    Hi,

    Can you please explain me why Interest expense and income tax expenses are not considered here while calculation cash flow from operating activities

    Garnett Company’s year-end income statement shows the following.

     Revenues  $5,000,000
     Selling and general expenses (including
       depreciation expense of $200,000)
    3,800,000
     Interest expense 50,000
     Gain on sale of equipment 40,000
     Income tax expense (including long-term
        deferred tax expense of $30,000)
    <u>    320,000</u>
     Net income $  870,000

    During the year, Garnett’s noncash current assets rose by $100,000, and current liabilities increased by $150,000. On its statement of cash flows, Garnett would report Cash Provided by Operating Activities of

    regards

    Azhar

     

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  • #239284

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    Lynn Roden
    HOCK international

    Hello Azhar Hussain,

    You are correct that cash paid for interest expense and income tax expense are cash outflows from operating activities, so they are part of (that is, they reduce) net cash provided by operating activities on the Statement of Cash Flows.

    When cash provided by operating activities is calculated according to the indirect method, though, we start with net income. Because interest expense and income tax expense are expenses on the income statement, net income incorporates a reduction for interest expense and income tax expense. Therefore, there is no reason to adjust net income in any way for those two expenses when calculating net cash from operating activities, since net income has already been reduced by them.

    The difference between the amount of interest expensed and the amount of cash paid in interest and the difference between income tax expensed and the amount of cash paid for income taxes are captured in the adjustments made to net income for increases and decreases in the balance sheet amounts related to them when calculating cash provided by operating activities.

    Note that the amounts of cash paid for interest and of cash paid for income taxes need to be disclosed as notes to the Statement of Cash Flows when the indirect method is used to prepare the cash flows from operating activities section of the statement. Since interest and income tax expenses will have been included as reductions to net income and are thereby included in the calculation of net cash provided by operating activities, that information needs to be disclosed separately so that users can know the individual cash item amounts. However, they are not individually part of the calculations done to calculate cash provided by operating activities.

    Lynn

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