BUS103: Introduction to Financial Accounting

There is an indirect and direct method for calculating cash flows from operating activities.

Learning Objective

• Explain the direct method for preparing the statement of cash flows

Key Points

• 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 than the indirect method.
• The most common example of an operating expense that does not affect cash is a depreciation expense.

Term

• asset

  Something or someone of any value; any portion of one's property or effects so considered

Example

• This is an example of using the direct method for calculating cash flows. To find out the cash inflow from a customer, we need to know the sales revenue, but the sales revenue is also affected by the accounts receivable account. If the sales revenue is 300, and the accounts receivable increases by 20, then the cash received from customers would be 280. To determine the cash paid to suppliers, you need to look at both the inventory and the accounts payable account, and then determine their effect on the cost of goods sold. For example, if the cost of goods sold was 220, and inventory increased by seven, and the accounts payable decreased by fifteen, the cash paid to suppliers would be 242. You add seven because the inventory increased, and you add fifteen because the accounts payable decreased, which means more money was paid. The cash paid for interest is determined by the bond interest expense and discount on the bonds payable. For example, if the interest expense is ten dollars, and the unamortized discount decreases by three dollars, then the cash paid for interest is seven dollars.

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. Two different methods 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 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, and so on)
• subtract beginning assets (prepaid rent, inventory, and so on)
• subtract ending payables (tax, interest, salaries, accounts payable, and so on)
• add ending payables (tax, interest, salaries, accounts payable, and so on)

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.

The Indirect Method

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 included in net income but did not affect cash.

Source: Boundless
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