Question

Using the indirect method, which of the following adjustments to convert net income to net cash provided by operating activities is incorrect?

Add to Net Income Deduct from Net Income

Accounts Receivable decrease increase
Prepaid Expenses increase decrease
Inventory decrease increase
Accounts Payable increase decrease

Answer 1

The incorrect adjustments in converting net income to net cash provided by operating activities using the indirect method are an increase in Accounts Receivable and a decrease in Inventory.

Step-by-step explanation:

The adjustments to convert net income to net cash provided by operating activities using the indirect method are necessary to account for non-cash items and changes in working capital. The incorrect adjustment in this case would be increase Accounts Receivable and decrease Inventory.

Under the indirect method, an increase in Accounts Receivable would be deducted from net income, not added, since an increase in Accounts Receivable represents revenue that has been recorded but not yet collected in cash. Similarly, a decrease in Inventory would be added to net income, not deducted, as a decrease in Inventory would represent cash outflows tied to the purchase of inventory.

Therefore, the options that are incorrect are:

Add to Net Income: Accounts Receivable increase

Deduct from Net Income: Inventory decrease

Answer 2

The incorrect adjustment is that an increase in Prepaid Expenses should be deducted from net income, not added. The question focuses on the indirect method for preparing a cash flow statement and the correct adjustments required for converting net income to net cash provided by operating activities.

Step-by-step explanation:

The question pertains to the indirect method of cash flow statement preparation. In this context, various adjustments are made to convert the net income (accrual basis) to net cash provided by operating activities (cash basis). When examining the adjustments provided in the question, the following analysis can be applied:

• If Accounts Receivable decrease, it means that cash has been collected from customers, so we add back the decrease to net income.
• When Prepaid Expenses increase, this indicates that cash has been paid in advance, reducing cash flow, so an increase in prepaid expenses would be subtracted from net income.
• If Inventory decreases, it implies that more inventory has been sold than purchased, releasing cash, hence we add the decrease to net income.
• An Accounts Payable increase suggests that we owe more to suppliers than the expenses reported. This could be due to purchasing on credit, which means cash hasn't been spent yet. Therefore, increase in accounts payable is added to net income.

Based on the above, the incorrect adjustment is related to prepaid expenses. If prepaid expenses increase (indicating an expense paid for in advance that didn't affect cash during the period), it should be deducted from net income, not added to it.