Question

Problem 1

On January 2, 20x5, Abigail Co. sold inventory to a customer on the following terms: $200,000 payable for 5 years on December 31 of each year (i.e. the first payment is due on December 31, 20x5). Abigail’s incremental borrowing rate is 5% and the customer’s incremental borrowing rate is 6.5%.

Describe the impact of the above on the Statement of Cash Flow for the year ended December 31, 20x5. For cash flow from operations, describe the impact for both the indirect and direct methods.

Answer 1

Describe the impact of the above on the Statement of Cash Flow for the year ended December 31, 20x5

For preparing a cash flow statement we must take into account the value of the accounts.

So, the fact of selling the inventory (200,000) on account payable for 5 years means a reduction of 200,000 on the value of the inventory for this ending year 20x5, which is considered a positive cash flow, as well as an increase of accounts receivable, considered a negative cash flow. The interest paid due to the incremental borrowing rate will also affect the operating activities cash flow.

For cash flow from operations, describe the impact for both the indirect and direct methods.

First, let´s say that the indirect method uses some accounts that not necessarily refer to tangible cash, such as depreciation and amortization. While the direct method just focuses on the accounts that represent tangible cash and also uses the actual cash inflows and outflows(not the accrued ones like the indirect method does).

For the indirect:

This method uses the accrual accounting information, which means that the total amount of sales will be recognized to calculate the gain or loss. The accounts receivable will present the increase regarding to the part of the sale that is still on account, plus the inventory decrease. so, the cash flow obtained with this method is not necessarily the actual one.

For the direct method

The sales will be represented by the actual cash received this year based on the portion of the sale, the accounts receivable will present the increase, which is considered negative and the costs of the goods sold is also taken into account on this method. The decrease on the inventory is considered a positive cash flow, though.

The impact of having an incremental borrowing rate affects the amount of interest expense that will be paid, which reduces the net operating cash flow.