Detailed Answer
Answer (A) is correct. The following is the net cash flow from operating activities calculated using the indirect method:
Net income...................................... $2,000,000
Add: decrease in inventory................... 100,000
Add: increase in accounts payable ..........200,000
Add: depreciation expense........ ...........400,000
Minus: increase in net accounts receivable (300,000)
Minus: gain on sale of securities ............(700,000)
Net cash provided by operating activities $1,700,000
The adjustment from cost of goods sold (an accrual accounting amount used to calculate net income) to cash paid to suppliers requires two steps: (1) from cost of goods sold to purchases and (2) from purchases to cash paid to suppliers. The $100,000 decrease in inventory is added to net income. It indicates that purchases were $100,000 less than cost of goods sold. The $200,000 increase in accounts payable is added to net income. It indicates that cash paid to suppliers was $200,000 less than purchases. Thus, the net effect of the changes in inventory and accounts payable is that cash paid to suppliers was $300,000 ($100,000 + $200,000) less than the accrual basis cost of goods sold. Depreciation expense ($300,000) is a noncash item included in net income. Hence, it is subtracted from net income. The net accounts receivable balance increased by $300,000, implying that cash collections were less than sales. If sales, collections, write-offs, and recognition of bad debt expense were the only relevant transactions, $300,000 should be subtracted from net income. Use of the change in net accounts receivable as a reconciliation adjustment is a short-cut method. It yields the same net adjustment to net income as separately including the effects of the change in gross accounts receivable, bad debt expense (a noncash item resulting in an addition), and bad debt write-offs (a subtraction to reflect that write-offs did not result in collections). The sale of securities is an investing activity. It also is subtracted from net income.