“Please explain……I think my problem is interpreting the question incorrectly” – Greg.
MCQ – Statement of Cash Flows
The following information is extracted from the financial statements of Foster Machines.
Net income $15,000
Depreciation on equipment $2,500
Dividend income $2,500
Interest income $5,000
Increase in accounts receivable $8,000
Increase in current liabilities $6,500
Redemption of bonds $7,500
The cash flows from operations were calculated to be $23,500. Assuming that the company follows U.S. GAAP, which of the following is a potential error in the calculation of cash flow from operations?
1. Dividend income and interest income were added back to net income to calculate cash flows from operations. (correct)
2. Redemption of bonds was included in cash flow from operations.
3. The increase in accounts receivable was added to net income whereas it should have been deducted.
4. Depreciation on equipment was not added back to net income for calculating cash flows from operations.
Correct answer: (1) Dividend income and interest income were added back to net income to calculate cash flows from operations.
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We are given a potentially erroneous cash flows from operations of $23,500 so we have to compute for the correct (should be) cash flows from operations to see which items were incorrectly included or excluded.
As discussed, interest received and dividends received from debt and equity investments are considered as cash from operating activities.
Therefore, there is no need to add the items in the computation. Also, the redemption of bonds is considered as cash outflows (reduction) from financing activities.
|Depreciation on equipment||2,500|
|Increase in current accounts receivable||-8,000|
|Increase in current liabilities||6,500|
|Net Cash Inflow from Operating Activities (CFO)||16,000||CORRECT|
|Computed Net Cash Inflow from Operating Activities||23,500||ERRONEOUS|
|Less: Net Cash Inflow from Operating Activities (CFO)||16,000||CORRECT|
In the computation above, we have arrived at a difference of $7,500 which means that CFO is overstated by $7,500.
The $7,500 overstatement resulted from erroneously adding Dividend Income of $2,500 and Interest Income of $5,000 for a total of $7,500.
Although $7,500 is the same amount as the redemption of the bond, it cannot be the answer because it is a reduction of cash flows.
Therefore, in a different scenario, computed net cash inflows from operating activities will be understated by the redemption of bonds instead of being overstated.
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Below you’ll find an example of a mini-lesson that helped my student, Greg, understand how to identify the potential error in the calculation of cash flows.
Greg didn’t have any study materials before finding CMA Exam Academy so he opted for my Complete Course to gain access to the ultimate toolkit for the CMA exam preparation.
Until our next lesson,
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