Preparation of the Statement of Cash Flows: Direct Method
There is an indirect and a direct method for calculating cash flows from operating activities.
Explain the direct method for preparing the statement of cash flows
- In order to identify the inflows and outflows for operating activities, you need to analyze the components of the income statement.
- Under the direct method, adjustments are made to the ” expense accounts ” themselves.
- The direct method of preparing a cash flow statement results in a more easily understood report, as compared with the indirect method.
- The most common example of an operating expense that does not affect cash is a depreciation expense.
- asset: Something or someone of any value; any portion of one’s property or effects so considered
Calculating Cash Flows
Cash flows refer to inflows and outflows of cash from activities reported on an income statement. In short, they are elements of net income. Cash outflows occur when operational assets are acquired, and cash inflows occur when assets are sold. The resale of assets is normally reported as an investing activity unless it involves the purchase and sale of inventory, in which case it is reported as an operating activity. There are two different methods that can be used to report the cash flows of operating activities: the direct method and the indirect method.
The Direct Method
For items that normally appear on the income statement, cash flows from operating activities display the net amount of cash that was received or disbursed during a given period of time. The direct method for calculating this flow involves deducting from cash sales only those operating expenses that consumed cash. In this method, each item on an income statement is converted directly to a cash basis, and each cash effect is directly reported. To employ this direct method, use the following equation:
- add net sales
- add ending accounts receivable
- subtract beginning accounts receivable
- add ending assets (prepaid rent, inventory, et al)
- subtract beginning assets (prepaid rent, inventory, et al)
- subtract ending payables (tax, interest, salaries, accounts payable, et al. )
- add ending payables (tax, interest, salaries, accounts payable, et al. )
Once the cash inflows and outflows from operating activities are calculated, they are added together in the “Operating Activities” section of the cash flow statement to obtain the net cash flow for a company’s operating activities.
In the indirect (addback) method for calculating cash flows, the accrual basis net income is established first. This net income is then indirectly adjusted for items that affected the reported net income but did not involve cash. The indirect method adjusts net income (rather than adjusting individual items in the income statement) for the following phenomena: changes in current assets (other than cash), changes in current liabilities, and items that were included in net income but did not affect cash.
Preparation of the Statement of Cash Flows: Indirect Method
The indirect method starts with net-income while adjusting for non-cash transactions and from all cash-based transactions.
Explain how to use the indirect method to calculate cash flow
- The indirect method adjusts net income (rather than adjusting individual items in the income statement).
- The most common example of an operating expense that does not affect cash is depreciation expense.
- Depreciation expense must be added back to net income.
- indirect method: a way to construct the cash flow statement using net-income as a starting point, and makeing adjustments for all transactions for non-cash items, then adjusting from all cash-based transactions
- accrual: A charge incurred in one accounting period that has not been paid by the end of it.
- income statement: A calculation which shows the profit or loss of an accounting unit (company, municipality, foundation, etc.) during a specific period of time, providing a summary of how the profit or loss is calculated from gross revenue and expenses.
Calculating Cash Flows
There are two different methods that can be used to report the cash flows of operating activities. There is the direct method and the indirect method.
The indirect method adjusts net income (rather than adjusting individual items in the income statement) for:
- changes in current assets (other than cash) and current liabilities, and
- items that were included in net income but did not affect cash.
The indirect method uses net income as a starting point, makes adjustments for all transactions for non-cash items, then adjusts for all cash-based transactions. An increase in an asset account is subtracted from net income, and an increase in a liability account is added back to net income. This method converts accrual-basis net income (or loss) into cash flow by using a series of additions and deductions. The following rules can be followed to calculate cash flows from operating activities:
- Decrease in non-cash current assets are added to net income;
- Increase in non-cash current asset are subtracted from net income;
- Increase in current liabilities are added to net income;
- Decrease in current liabilities are subtracted from net income;
- Expenses with no cash outflows are added back to net income (depreciation and/or amortization expense are the only operating items that have no effect on cash flows in the period);
- Revenues with no cash inflows are subtracted from net income;
- Non operating losses are added back to net income;
- Non operating gains are subtracted from net income.
Under the indirect method, since net income is a starting point in measuring cash flows from operating activities, depreciation expenses must be added back to net income. So, depreciation expense is shown (or captioned) on the statement of cash flows. Also, in the indirect method cash paid for taxes and cash paid for interest must be disclosed.
Direct Method Versus Indirect Method
Consider a firm reporting revenues of $125,000. During the reporting period, the firm’s accounts receivables increased by $36,000. Therefore, cash collected from these revenues was $89,000. Operating expenses reported during the period were $85,000, but accounts payable increased during the period by $5,000. Therefore, cash operating expenses were only $80,000. The net cash flow from operating activities, before taxes, would be:
Cash flow from revenue: 89,000
Cash flow from expenses: (80,000)
Net cash flow: 9,000
The indirect method would find these cash flows as follows.
Net Income: 40,000
The adjustments for cash flow would then be made to this amount of net income. $36,000 would be subtracted due to the increase in accounts receivable, and $5,000 would be added due to the increase in accounts payable. This leaves us with the amount of $9,000 for net income.