The account balances for the noncash current assets of Allen Company are as foll
ID: 2505247 • Letter: T
Question
The account balances for the noncash current assets of Allen Company are as follows: Net income for 2012 is $35,000. Depreciation expense is $22,000. Assume that all sales and all purchases are on account. Required A. Prepare the operating activities section of the statement of cash flows, using the indirect method. Explain why cash flow from operating activities is more or less than the net income the period shown. B. What additional information do you n to prepare the operating activities see the statement of cash flows, using the method? Explain the usefulness of each method for mana gerial decision making.Explanation / Answer
Statement of cash flow using the indirect method:-
Particulars
Amount($)
Net Income
35000
Add:- Depreciation
22000
Adjustment for working capital changes:-
Add:- Decrease in accounts receivable
7000
Less:- Increase in inventory
(10000)
Add :- Decrease in prepaid expenses
4000
Net cash inflow from OPERATING Activities
58000
B]under direct method we need the following additional information:-
1]Total sales made
2]Total purchases made
3] Total expenses incurred during the year
Advantage of direct method:-[
..
The direct method of cash flow allows accountants to quickly and easily summarize revenue and expenses and report them on the financial statement. This method requires accountants to report the total operating, investing and financing revenue for a quarter as well as expenses related to these areas. The direct method is easier for analysts and investors to read; however, it only covers revenue and expenses in the current quarter.
..
Easier to Compute
No Extraneous Details
Better Predictive Ability
Considerations
Advantages of indirect method:-[Cited from the following link:- http://www.ehow.com/info_11414663_advantages-indirect-methods-operating-activities.html]
The indirect method of cash flows for operating activities is one of two methods utilized to prepare the statement of cash flows required under both International Financial Reporting Standards and U.S. generally accepted accounting principles, or GAAP. The direct method shows gross cash receipts from customers as well as gross cash payments to vendors and supplies. The indirect method begins with the entity's net profit or loss from the income statement or statement of other comprehensive income, makes adjustments for certain non-cash transactions and then compares the changes in the operational balance sheet accounts during the accounting period.
..
Principal Advantages
Ease of Preparation
Information Provided
Considerations
Statement of cash flow using the indirect method:-
Particulars
Amount($)
Net Income
35000
Add:- Depreciation
22000
Adjustment for working capital changes:-
Add:- Decrease in accounts receivable
7000
Less:- Increase in inventory
(10000)
Add :- Decrease in prepaid expenses
4000
Net cash inflow from OPERATING Activities
58000
B]under direct method we need the following additional information:-
1]Total sales made
2]Total purchases made
3] Total expenses incurred during the year
Advantage of direct method:-[
..
The direct method of cash flow allows accountants to quickly and easily summarize revenue and expenses and report them on the financial statement. This method requires accountants to report the total operating, investing and financing revenue for a quarter as well as expenses related to these areas. The direct method is easier for analysts and investors to read; however, it only covers revenue and expenses in the current quarter.
..
Easier to Compute
- The direct method of reporting cash flow is easier for accountants to compute, as it does not require any complex calculations. This method is straightforward: The accountant lists the business's total operating revenue and subtracts operating expenses to get a net operating income. The accountant does the same thing with financing and investing revenue and expenses. Conversely, the indirect method requires accountants to adjust net income for revenue and expenses that do not produce movement, so the accountant must perform several calculations.
No Extraneous Details
- The direct method summarizes expenses -- for example, it lists the total amount of money paid for utilities in the office space rather than listing each utilities expense. Thus, the report is not cluttered with extraneous details, making it easier for investors and business owners to follow. The lack of details also reduces the risk that people will be confused regarding where money is going when they read the financial statement.
Better Predictive Ability
- Singapore Management University (SMU) states the direct method of cash flow may lead to better predictions of whether a business will succeed or fail than the indirect method does. Analysts can easily see whether a business is making sound financial decisions by examining its cash flow statements if it uses the direct method and thus make accurate predictions. However, SMU states that there is not enough empirical evidence to prove absolutely that the direct method leads to better predictions.
Considerations
- The direct method generally is easier to implement and clearer for analysts to understand. However, this method can be more expensive than the indirect method because the accountant must keep track of more expenses and revenue. In addition, the indirect method shows changes in working capital and provides information about cash flow in periods other than the one covered in the report, which the direct method does not.
Advantages of indirect method:-[Cited from the following link:- http://www.ehow.com/info_11414663_advantages-indirect-methods-operating-activities.html]
The indirect method of cash flows for operating activities is one of two methods utilized to prepare the statement of cash flows required under both International Financial Reporting Standards and U.S. generally accepted accounting principles, or GAAP. The direct method shows gross cash receipts from customers as well as gross cash payments to vendors and supplies. The indirect method begins with the entity's net profit or loss from the income statement or statement of other comprehensive income, makes adjustments for certain non-cash transactions and then compares the changes in the operational balance sheet accounts during the accounting period.
..
Principal Advantages
- Those preparing the financial statements typically prefer the indirect method of cash flows as it requires the tracking of less information and, thus, is easier to prepare than the direct method of cash flows. Users of the financial statement may prefer the indirect method of cash flows as it may present additional financial data to the user of the financial statements.
Ease of Preparation
- The indirect method of cash flows for operating activities is generally considered the easier method to track and prepare. As such, reporting under the indirect method allows the company to reduce the time and personnel directed towards completing and tracking the statement. When outside accountants are used to prepare the financial statements, the indirect method may reduce the cost of preparation. The indirect method is generally considered easier to track and prepare because it primarily focuses on the change in the major operating accounts reported on the balance sheet. These numbers are already tracked and reported in the financial statements. The direct method may require tracking and verifying information not otherwise reported in the financial statements.
Information Provided
- Under certain circumstances, the indirect method of cash flows may provide the user of the financial statements better information than the direct method regarding the sources and uses of cash for operating activities. When the financial statements are not comparative, meaning that the financial statements only provide a single period of financial data, the indirect method of cash flows will provide the user with financial information that cannot be computed otherwise. In addition, when significant non-cash adjustments -- such as depreciation or foreign currency gains or losses -- have occurred during a reporting period, the statement highlights the correlation between the entity's net income and the sources and uses of operating cash.
Considerations
- The indirect method of cash flows does not always provide better information regarding operating activities than the direct method. The direct method, for instance, may provide better information regarding the magnitude of cash transactions. When comparing the amount of cash collections across multiple reporting periods, the direct method of cash flows for operating activities often provides a clearer comparison. This information is not available in a statement of cash flows prepared via the indirect method. In addition, it may be difficult to compare cash flow information between companies or reporting entities when different methods for cash flow preparation are used. When comparison of cash flow information is a goal of financial statement users, it is preferable for the method of cash flow preparation between reporting entities to be convergent.
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