Which of the following is a nonoperating item that requires adjustment to net income under the indirect method when preparing the statement of cash flows?

• A. Gain on sale of equipment
• B. Prepaid insurance
• C. Depreciation expense
• D. Accrued service revenue

Answer: (A)

Verified step by step guidance

1. Understand the indirect method for preparing the statement of cash flows. This method starts with net income and adjusts for non-cash items, changes in working capital, and nonoperating items to calculate cash flows from operating activities.
2. Identify nonoperating items. Nonoperating items are gains or losses that are not part of the core business operations, such as gains or losses from the sale of equipment.
3. Recognize that a 'Gain on sale of equipment' is a nonoperating item. It is included in net income but does not represent cash generated from operating activities. Therefore, it requires adjustment to net income under the indirect method.
4. Understand why other options do not qualify as nonoperating items: Prepaid insurance and accrued service revenue are working capital adjustments, while depreciation expense is a non-cash item that is added back to net income under the indirect method.
5. Adjust the net income by subtracting the gain on sale of equipment (since it increases net income but does not represent cash inflow from operations). This ensures the statement of cash flows accurately reflects cash generated from operating activities.