This article shows the two different methods of preparing a statement of cash flows: direct and indirect.
There is an indirect and direct method for calculating cash flows from operating activities.
Explain the direct method for preparing the statement of cash flows
Something or someone of any value; any portion of one's property or effects so considered
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.
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:
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 included in net income but did not affect cash.
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
A charge incurred in one accounting period that has not been paid by the end of it.
A calculation that 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.
a way to construct the cash flow statement using net-income as a starting point, and making adjustments for all transactions for non-cash items, then adjusting from all cash-based transactions
Two different methods 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:
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 using a series of additions and deductions. The following rules can be followed to calculate cash flows from operating activities:
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.
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