A decrease in Prepaid Expenses of 10 affects Net Income and cash how?

• A. Net Income decreases by 6; cash increases by 4
• B. Net Income increases by 6; cash increases by 4
• C. Net Income decreases by 10; cash decreases by 10
• D. Net Income unchanged; cash unchanged

Answer: (A)

When prepaid expenses decrease, you’re recognizing an expense for the period. That reduces pretax income by the amount of the decrease, and thus lowers net income. However, that expense also reduces taxable income, creating a tax shield. The cash effect comes from this tax shield, not from a new cash outlay in the period.

With a 40% tax rate, the $10 decrease in prepaid expenses reduces net income by 10 minus the tax savings (40% of 10), which is 6. The tax saving adds to cash flow, increasing cash by 4 (40% of 10). So net income falls by 6 while cash increases by 4. The actual cash outlay for the prepaid balance occurred earlier, so the only cash effect in this period is the tax-related change.