Final answer:
Gains on sale when preparing the Statement of Cash Flows are subtracted from net income to properly reflect the cash flows from operating activities. The gains are adjustments in the reconciliation of net income to net cash provided by operating activities, ensuring accurate representation of cash generated by principal revenue-producing activities. Option 2 is the correct answer.
Step-by-step explanation:
When preparing the Statement of Cash Flows (SOCF), gains on sale of assets are handled in a specific way to ensure that the cash effects of operating activities are accurately reported. The SOCF is divided into three sections: Operating, Investing, and Financing activities. Gains on sale of assets are typically reported in the Investing activities section since they are related to the sale of assets which is a type of investing activity. However, these gains can have an impact on the Operating activities section as well.
Generally accepted accounting principles (GAAP) require that when calculating cash flows from operating activities, gains on sale of assets must be subtracted from net income. This is because the gain is included in the net income figure on the Income Statement, but it does not represent a cash transaction from ongoing operations. Instead, it reflects a transaction that is investing in nature. Therefore, to reconcile net income to net cash provided by operating activities, any gains on sale of assets need to be removed, as the actual cash received from the sale is reported in the cash flows from investing activities section.
For example, if a company sells a piece of equipment and reports a gain, this gain inflates the net income. However, this does not correlate with the cash that has been generated from the company's core operating activities. By subtracting the gain from net income, the SOCF provides a clearer picture of the cash flows that are generated by the company's principal revenue-producing activities. In conclusion, the correct answer is 2) Subtract them from net income.