Book 6 Exam 3 AM Q. #47

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jond2062

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An analyst gathered the following data about a company:
- Collections from customers are $5,000
- Depreciation is $800
- Cash expenses (including taxes) are $2000
- Tax rate = 30%
- Net cash increased by $1,000

If inventory increases over the period by $800, cash flow from operations equals:

A. $1,600
B. $2,400
C. $3,000
D. $4,000

The correct answer is C, but I don't understand why the change in inventory is not included in the calculation using the direct method. Obviously depreciation and the tax rate are irrelevant and so is the net cash increase of $1,000. So my calculation would be $5,000 - $800 (inventory) - $2,000 = $2,200. Anybody know why it's incorrect to take into account the purchase of inventory?
 
I'm stuck on this question as well. Can anyone help? Surely it is incorrect.
 
The indirect method says: let's start with net income (which we know is not all cash) and adjust for items included therein where more or less cash was expended/received than the amounts shown on the income statement.

The direct method basically says, screw all that crap, just tell me how much cash I took in for each line item and how much cash i put out.

And that's what they gave you:

- Cash expenses (including taxes) are $2000

inventory is the balance sheet side of the expense category CGS, which is included in the cash expense figure above, so no adjustment is needed.
 
Thanks Super. Okay. So if the question did not give cash expenses, but gave sales, cgs, etc. Would you use adj for changes in inventory even though you're using direct method?
 
planner Wrote:
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> Thanks Super. Okay. So if the question did not
> give cash expenses, but gave sales, cgs, etc.
> Would you use adj for changes in inventory even
> though you're using direct method?


Well, if they gave all of those other things (ie the accrual amount rather than the cash amount) you would likely do the indirect method. For example, if they gave sales as you suggested you would need to adjust for change in accts receivable. You can't easily mix and match the two methods.

If they asked what was the amount of cash expended for inventory and gave you CGS, then you would adj for changes in inventory.
 
Thanks Super.

Schweser notes starts with sales, cgs for direct method. It was the first I saw with cash expense (that I recall)...

Thanks again! I certainly would have missed the question on Saturday.
 
I have official CFA book. On volume 3 page, 130. Exhibit 36-4, it does deduct the increase of inventory. If inventory increases by $800, the company must have paid $800 cash. Also inventory changes are not part of cash expenses. So I still do not get it.



Edited 1 time(s). Last edit at Tuesday, May 29, 2007 at 01:53AM by disptra.
 
aw man.. I made the question more complicated for myself =P.... It should have been obvious that it was just collections less {{{{CASH}}}} expenses......!!!
 
yickwong Wrote:
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> aw man.. I made the question more complicated for
> myself =P.... It should have been obvious that it
> was just collections less {{{{CASH}}}}
> expenses......!!!
How about if inventory decreases? Do you still count it as cash expenses?
 
Thank goodness for the search function, I was just trying to figure this out.

You know that inventory is included because it says cash expenses including taxes, which taxes care of cash inputs, cash expenses, cash interest, and cash taxes (all from pg 56 in book 3)

Thanks for helping out Super I
 
Thanks for all the responses. That's basically the same conclusion that I came to, in that because they say cash expenses, using inventory would be double counting. Still, it was frustrating.
 
cfaboston28 Wrote:
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> 5000-2000 + 800 of dep and -800 of Inventory
> increase) gives you 3000


That is pure coincidence, and the fact that you don't see it is BAD.


You don't learn this by robotically trying to memorize rules... you need to fundamentally understand how the financial statements relate to each other.


Direct method mean you add up cash inflows, subtract cash outflows by income statement category.

Indirect method mean start with net income and adjust that balance where changes in balance sheet accounts reflect that differences exist between the amounts included on the income staement account and actula cash expended/received.

What you did above was a hash total of numbers, and you won't be so lucky on the real test to stumble into the right answer.
 
Ok. This sounds ok. But I do not think it says it like that in officical book. I do not have Schweser book. I think in real exams, it will not be so vague like this. I did all the exercises in officical book for cash flow. It is all pretty clear what it means. I am actually going for Dec. exam. So still have plenty of times to improve my understanding. :)

jeremyb Wrote:
-------------------------------------------------------
> Thank goodness for the search function, I was just
> trying to figure this out.
>
> You know that inventory is included because it
> says cash expenses including taxes, which taxes
> care of cash inputs, cash expenses, cash interest,
> and cash taxes (all from pg 56 in book 3)
>
> Thanks for helping out Super I
 
It seems no one even care what official books says. Is exam given by CFA or Schweser? It is just weird.
 
disptra Wrote:
-------------------------------------------------------
> It seems no one even care what official books
> says. Is exam given by CFA or Schweser? It is
> just weird.


No idea what you are babbling about. We care about understanding how to address these issues in real life situations (or in the short run, for the test).

Perhaps what you THINK the "official book" says is not what it ACTUALLY says.
 
While inventory changes belongs to cash inputs, cash expense is a separate category.
Where does it say "Cash expenses (including taxes) " include cash inputs in official book? That is what I did not fully get. And if inventory decreases which mean you should add cash back. Did you still count it as expenses?

All of these I am talking about are on official book(Volume 3 page, 130. Exhibit 36-4).

These are my questions. Can you explain this to me?
Thanks!



Edited 1 time(s). Last edit at Tuesday, May 29, 2007 at 05:12PM by disptra.
 
First, we can all agree (I think) that the question is poorly worded.

In general, info will be provided so that you can use either the direct method, or the indirect, BUT NOT BOTH. They may try to trick you by throwing in some extra info related to the method you shouldn't use, but there will be complete info on only one method.

Given that they say "collections from customers" and not revenue, and don't give info on accounts receivable, they must be looking at the DIRECT method.

Cost of Goods sold is an EXPENSE. When they say "cash expenses" it seems clear, issues with wording aside, that they are adressing all expenses, including the cash expense outlays related to CGS. It doesn't say "excluding CGS".

Inventory increase is MEANINGLESS. It has nothing to do with cash spent. You could be using FIFO, which would naturally increase inventory and tells you nothing about what you spent.

BI + P - EI = CGS

The cash component is the "P" in that formula. Just randomly adding in the increase in EI to your CFO when you have no other info about the other components is completely useless in arriving at P.


I don't have the CFAI books . So my main question is, once again, are you positive that on the pages you refer to it is talking about the DIRECT method and not the INDIRECT method? I'm pretty sure you are misinterpreting and mixing up the two methods and their application.

Remember, cash is cash is cash is cash.

A reduction in inventory doesn't create cash under the direct method. The inventory related cash outflow is the purchase total, irrespective of whether ending inventory goes up, down or sideways.



Edited 1 time(s). Last edit at Tuesday, May 29, 2007 at 05:59PM by Super I.
 
Can you borrow a book from someone and read it? Also look at all of exercises. I think all of those include changes of inventory for calucation of direct method. I mean direct method. I thought I have cleared about this. Then you guys really confused my again. :) I will read it again tonight. Anyway, I will go with CFAI book. I do not really care about what Schweser says.
 
Don't get confused disptra, working capital accounts ARE included under both methods. What the posts above are just trying to say is that here it already is included with cash expenses.
 
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