Preparation of cash flow statement using the direct method
The Cash Flow Statement has three sections: operating activities, investing activities, and financing activities. The direct and indirect methods used in developing this financial statement are primarily different in the structure of the operating activities section.
The Direct Method
The direct method of developing the cash flow statement lists operating cash receipts (e.g., receipt from customers) and cash payments (e.g., payments to employees, suppliers, operations, etc.) in the operating activities section. In this section, any interest paid on outstanding debt is also reported along with all income taxes paid. Using the direct method, the result is cash receipts minus cash disbursements, and the final figure is net cash flows from operations.
Operating Section Format
The direct method is also called the income statement method. The simplest format of the direct method looks something like this:
Cash Flow from Revenue
– Cash Payments for Expenses
= Income Before Income Taxes
– Cash Payment for Income Taxes
= Net Cash Flow From Operating Activities
The first two line items, cash flow from revenue and cash payments from expenses, are subject to the problems of complexity discussed above.
Here’s an example of what you may encounter. Let’s say you are accounting for all your payments to suppliers for the time period. In addition to maintaining a high level of detail for that account, you have to keep the same level of detail in the other accounts those payments affect, such as inventory accounts payable and cost of goods sold. When you think of every transaction that can entail, few firms can manage it even though the Financial Accounting Standards Board (FASB) prefers this method.
Four Key Steps to Preparing the Statement of Cash Flows
The four steps required to prepare the statement of cash flows are described as follows:
Step 1.
Prepare the operating activities section by converting net income from an accrual basis to a cash basis.
This step can be done using one of two methods—the direct method or the indirect method. Because more than 98 percent of companies surveyed use the indirect method, we will use the indirect method throughout this chapter. The appendix describes the direct method.
The indirect method begins with net income from the income statement and makes several adjustments related to changes in current assets, current liabilities, and other items to arrive at cash provided by operating activities (or used by operating activities if the result is a cash outflow). Cash provided by operating activities represents net income on a cash basis. It tells the reader how much cash was received from the daily operations of the business.
Step 2.
Prepare the investing activities section by presenting cash activity for noncurrent assets.
This step focuses on the effect changes in noncurrent assets have on cash. Noncurrent asset balances found on the balance sheet, coupled with other information (e.g., cash proceeds from the sale of equipment) are used to perform this step.
Step 3.
Prepare the financing activities section by presenting cash activity for noncurrent liabilities and owners’ equity.
This step focuses on the effect changes in noncurrent liabilities and owners’ equity has on cash. Noncurrent liabilities and owners’ equity balances found on the balance sheet, coupled with other information (e.g., cash dividends paid) are used to perform this step.
Step 4.
Reconcile the change in cash.
Each section of the statement of cash flows described in steps 1, 2, and 3, will show the total cash provided by (increase) or used by (decrease) the activity. Step 4 simply confirms that the net of these changes equates to the change in cash on the balance sheet.
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