Question

Assume that the indirect method is used to determine net cash provided by (used in) operating activities and that prepaid insurance decreased during the year. that decrease is added to net income because:

Multiple choice
A. the company paid additional premiums this period in excess of the insurance expense recorded on the income statement.
B. a decrease in prepaid insurance causes an increase in insurance expense and a decrease in net income, but it does not involve cash, so it is added back to net income.
C. it includes the impact of increasing cash and increasing net income.
D. it accounts for purchasing more insurance during the period than has been expensed.

Answer 1

Option A is correct because the decrease in prepaid insurance indicates that the company paid more in insurance premiums than what was expensed, leading to an adjustment where the decrease is added back to net income in the cash flow statement.

Step-by-step explanation:

When using the indirect method for calculating net cash provided by (used in) operating activities, changes in current assets like prepaid insurance are reconciled against net income. If prepaid insurance decreases, this implies that the insurance expense recorded on the income statement was less than the cash actually paid for insurance premiums, leading to a temporary increase in net income that did not affect cash.

Therefore, option A is correct: the company paid additional premiums during the year in excess of the insurance expense recorded on the income statement, so the decrease in prepaid insurance is added to net income in the cash flow statement to reconcile the difference.

With the indirect method, cash flow is calculated by adjusting net income by adding or subtracting differences resulting from non-cash transactions. Non-cash items show up in the changes to a company’s assets and liabilities on the balance sheet from one period to the next. Therefore, the accountant will identify any increases and decreases to asset and liability accounts that need to be added back to or removed from the net income figure, in order to identify an accurate cash inflow or outflow.