SCF Inidrect Method.. again

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lola

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I'm just reviewing the indirect method for constructing SCF and I'm confused by what's accounted for when adjusting net income.

Why aren't interest expense and current taxes added/subtracted from net income using the indirect method? I thought those were operating items as well?

TIA.
 
Interest Expense and Taxes should not be added/subtracted using the INDIRECT method. Only changes in working capital accounts such as accounts receivables/payables, depreciation, inventory etc . . . You subtract interest expense and taxes using the DIRECT method.
 
Interest expense and taxes are included in net income. Because the indirect method begins with net income, adding or subtracting these amounts is unnecessary. Think of the indirect method as being a bottoms up approach. The alternative, the direct method, employs a top down approach and subtracts cash interest and cash tax expense directly from cash sales.

Hope this helps.
 
Hi Lola,

Net income is already net of interest expenses and taxes. There is no reason to add or subtract these to arrive at change in cash. An "expense" does not constitute a source or use of cash. Say, if you have a ton of expenses but the cash does not leave the building, you would accumulate a large payable. The increase in payable would be an add-back because you have more cash lying around. The opposite is the case if you have cash leaving the building, but you haven't actually recorded the expense yet. This is called a prepaid expense. If you pay for something before you recognize it in the income statement, it is tantamount to a receivable (of services or inventory etc..) and your cash goes down. Prepaids are also recorded on the balance sheet as a current asset.

Joey, am I missing something?

D.



Edited 1 time(s). Last edit at Thursday, June 14, 2007 at 05:55PM by Danteshek.
 
How the heck do I know? It's Super I who knows everything there is to know about this.
 
This one is easy: You make adjustments for only NON-CASH items in the indirect method

Taxes and Interest are clearly not non-cash.
 
Maybe this helps:

http://www.analystforum.com/phorums/read.php?11,536337,536402#msg-536402

You'll have to adjust for taxes only when it is a deferred tax asset/liab.-ie non cash
 
Just a follow up on the direct/indirect methods: I read the lengthy discussion on DTL back in May, as well as the notes thoroughly and so if Deferred taxes are a non-cash item, why do we need to add it to cash collections to arrive to CFO under the DIRECT method?

From what I inderstand under the indirect method, we only account for non-cash items and for the direct method, only for cash items, which deferred taxes are not.

What am I missing?
 
for direct method 'changes' in deferred taxes is what you should be looking out for. change (gain or loss) in any asset or liability will lead to cash inflows or outflows.

change in cash positions => consider under DIRECT

I wish to restate my previous post on indirect method:

it involves a)non-cash + b) other changes in the current assets and current liabilities

while direct method simply examines all items that cause cash to flow in or out.


sorry if i caused any more confusion!
 
Both methods essentially look at cash inflows and outflows.The only extra step for indirect method is the elimination of non-cash items.
 
Dsylexic Wrote:
-------------------------------------------------------
> for direct method 'changes' in deferred taxes is
> what you should be looking out for. change (gain
> or loss) in any asset or liability will lead to
> cash inflows or outflows.

Agreed, but changes in deferred taxes will lead to FUTURE cash inflows/outflows. In the current period there is no impact on cash (i.e. it's deferred), therefore it's a non-cash item. That's the essence of my confusion.

So why are we putting a non-cash item under direct method? Is this the only item I should watch out for? I don't want them throwing a curve ball at me and expecting me to account for another non-cash item on the exam.
 
Lola

Not sure of the 'future' part:
eg: DTL at begining of year was 100. At the end of the year it decreased to say 80.
So this 'change' can only be explained by an outflow of 20 THIS year.

same for accounts payable/receivable -would you consider them as non-cash?. well maybe,but they change depending on cash inflow/outflow.

i would keep this uncomplicated by remembering: for direct method -examine each item to see if it causes cash to flow in or out.

ditto for indirect method .in addition for indirect ,since we dealing with the NI ,eliminate non-cash stuff like depcn.
 
I don't have a copy of a text in front of me, but here's what I think the confusion/problem is.

The direct method that they show really isn't a pure direct method.

That would lmean that they gave you info that looked like this:

Cash Received from sales
cash disburesed for inventory
cash disbursed fro other expenses
cash receivedf rom other income
cash disbursed for taxes
etc.


The examples I remember seeing are more of a hybrid approach - they give you the direct cash outlays/inflows for some items like sales and maybe inventory, but then you need to back into the other line items. So for example instead of saying that you paid (physically disbursed) $100 in taxes, they will give you the income statement line amount and you need to back into the actual cash disbursed by adjusting that figure for changes in the taxes payable and deferred tax accounts.

Hope this helps. This is a complicated topic, and to really learn it you need to understand the concept, not just the mechanical process.
 
Thanks, Dsylexic and Super I. I'm working through some examples and I'm finally starting to get my head wrapped around this thing.

The one thing that I still don't get though is: Why 'Gain on the sale of old machinery' is CFO under the Indirect method, while 'Gain from the sale of land' is CFI under the Direct method.

Any insight is greatly appreciated.
 
great question!
i am unable to articulate exactly why, but this is clearly because land is not depreciated on the books while plan/machinery is.

anyone else wants to chip in?
 
gain on sale of anything is never part of CFO.

the concept is that the whole proceeds of the sale is CFI.

So if you sold something with a book basis of $800 for $1000 you have a $200 gain included in net income. To back that out and just show the $1000 proceeds as CFI you need to subtract the $200 gain from net income.

once again, I think the direct/indirect method confusion is just a matter of presentation, and that if you look at the examples in detail you'll see that you're always negating any gain or loss in CFO and showing gross proceeds in CFI.
 
so Super, there is no special treatment for land asset -right?. back the gains out from NI to get the correct CFO.

i just looked up some I/S in edgar and saw that gain/loss from landand PPE both are parts of 'other income'.

aargh.. just a little self doubt is good enoguh to throw me into a tizzy
 
Thank you both. You guys have been tremendously helpful, I really appreciate you spending the time.

I'm finally ok with it. I understand that in order to reconcile income to CFO and to prevent double-counting, gains and losses need to be removed from net income. Schweser doesn't explain this in great detail and I found the format they present it in quite confusing.

Thanks again.
 
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