Australia The change in Inventory pruchased and its impact on cash flow from operating activities under indirect method

[Adam Zhu]

Hi, I am wondering why does an increase in inventory purchased on credit would result in subtracting it from net profit under the indirect method to compute cash flow from operating activities?
I know the textbook says as it is a current asset, when it increases, we subtract it from the net profit.
But if the inventory is purchased on credit, the journal entry would only be Debiting inventory, crediting accounts payable. I mean, there is no revenue or expense involved.

Thank you!

 

[kirby]

" if the inventory is purchased on credit, the journal entry would only be Debiting inventory, crediting accounts payable. I mean, there is no revenue or expense involved."

Absolutely correct.

Now go back to the Cash Flow Statement and read it closely:
"Cash flows from Operating Activities:
Net Income
Adjustments for Non Cash Activities

So the Cash Flow statement is not adjusting Net Income. It is adjusting the cash flow from the net income.
Also, the change in Accts Payable is used as an adjustment: If net A/P increases, it is considered that it saved an outflow of cash - so this is reported as a source of cash. Again, this is shown as an adjustment to Cash Flows from Operating Activities.

 

[Adam Zhu]

" if the inventory is purchased on credit, the journal entry would only be Debiting inventory, crediting accounts payable. I mean, there is no revenue or expense involved."

Absolutely correct.

Now go back to the Cash Flow Statement and read it closely:
"Cash flows from Operating Activities:
Net Income
Adjustments for Non Cash Activities

So the Cash Flow statement is not adjusting Net Income. It is adjusting the cash flow from the net income.
Also, the change in Accts Payable is used as an adjustment: If net A/P increases, it is considered that it saved an outflow of cash - so this is reported as a source of cash. Again, this is shown as an adjustment to Cash Flows from Operating Activities.

Hi, thank you for your reply. But what do you mean by "Cash Flow statement is not adjusting Net Income. It is adjusting the cash flow from the net income", can you elaborate on that?
Thank you!

 

[kirby]

One of the purposes of the cash flow statement is to show how much of the net income comes from cash and not just accrued income. So the cash flow statement says "This is net income and now here are the items that affect that amount to come to how much cash came from operations." Another way to think about this is assume the cash flow statement is saying "Here is net income and ALL that net income came from receipt and disbursement of cash EXCEPT for these items and that net result will give you the cash that came from operations."

 

[JD Scott and Co]

Hi - it doesn't.
Your initial entry is correct, but there is no P&L impact at that point in time. Lets say you purchase $100 of inventory on credit. You get the following:
Thus you start with Net Profit $0
Mvt in Inventory $100
Mvt in Creditor ($100)
Net cash from opertions $0

So, no cash movement.