Net Income

Question: After all noncash and nonoperating items are removed from net income, only the changes in the balance

sheet connector accounts must be utilized to complete the conversion to cash. For Liberto, those balances were

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shown previously.

• Accounts receivable: up $19,000

• Inventory: down $12,000

• Prepaid rent: up $4,000

• Accounts payable: up $9,000

• Salary payable: down $5,000

Each of these increases and decreases was used in the direct method to turn accrual accounting figures into cash

balances. That same process is followed in the indirect method. How are changes in an entity’s connector accounts

reflected in the application of the indirect method?


Answer: Although the procedures appear to be different, the same logic is applied in the indirect method as in

the direct method. The change in each of these connector accounts has an impact on the cash amount and it can

be logically determined. However, note that the effect is measured on the net income as a whole rather than on

individual revenue and expense accounts.

Accounts receivable increased by $19,000. This rise in the receivable balance shows that less money was collected

than the sales made during the period. Receivables go up because customers are slow to pay. This change results

in a lower cash balance. Thus, the $19,000 should be subtracted in arriving at the cash flow amount generated

by operating activities. The cash received was actually less than the figure reported for sales within net income.