Thursday, 17 November 2016

Why the increase in inventory is added to net income for preparing cashflow statement under indirect method

There are a few facts that needs to be considered, before we find the reason for adding the increase in inventory, back to the net income.

1. Whenever a purchase is made, for replenishing the inventory, it can be either done by paying in cash or in credit.

2. Purchase in cash is a real cash outflow.

3. All accounts payables are non cash expenses which reduces the net income EXCEPT PURCHASES.

4. The reason that purchase payables are NOT non cash expenses is because, the other side of the payable entry is a debit to the purchase accounts, not an expense account. Therefore, the payables in purchases do not cause a non cash expense in the income statement.

5. When all the increase in payables are added back to net income, which is the normal procedure for calculating the cash flow statement under indirect method, the purchase payable is also added back along with it. Since purchase payable is NOT a non cash expense, it should not be added back to the net income at all. However it is added back along with all the other payables.

6. So the first mission is to reverse the adjustment of adding back the purchase payables.

7. When calculating net income, a non cash expense called COGS is also subtracted from the gross income. This non cash expense of COGS needs to be adjusted to arrive at the cash flow statement. This is the second mission.

8. Purchases never comes in an income statement. Therefore, the actual cash payed in purchases need to be inserted into the net income to arrive at the cash flow statement which is the third mission.

To summarise,

In order to arrive at the cash flow statement, three missions have to be achieved.

Mission 1. Purchase payables, which are added back with all the other payables, while preparing the cash flow statement needs to be reversed, as it doesn't have a non cash expense counter part in the income statement.

Mission 2. COGS needs to be adjusted, as it is a non cash expense in the income statement needs to be adjusted.

Mission 3. Cash purchases have to be inserted into the net income, as they are not part of the net income calculation.

Now.

we know that ΔI=     Purchases-COGS

and               -ΔI=    -Purchases+COGS

Net income  -ΔI=     Net Income-Purchases+COGS

                         =      Net Income-Cash Purchase-Purchase Payable+COGS

                         =      Net Income-Mission 3-Mission 1 + Mission 2


So by reducing the increase in inventory from the net income, we achieve all the necessary missions to arrive at the cash flow statement, by adjusting for cash flow from purchases.

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