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Home Statement of Cash Flows Statement of Cash Flows - Direct Method
 
 

Statement of Cash Flows - Direct Method:

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Definition and Explanation:

Normally, two methods are used to prepare statement of cash flows. One is the direct method and other is the indirect method. On this page we are going to explain direct method. This method is also known as income statement method. This method reports cash receipts and cash disbursements from operating activities. The difference between theses two amounts is the net cash flow from operating activities. In other words, the direct method deducts from operating cash receipts the operating cash disbursements. This method results in the presentation of condensed cash receipts and cash disbursements statement.

The direct and indirect methods are different only to the extent of calculation of cash flows from operating activities. The cash flow from investing activities and financing activities are calculated in the same way under both the methods.

Example:

To illustrate direct method of statement of cash flows, we will use the first year of operation for  Tax Consultants Inc. The company started on 1st January 2003, When it issued 60,000 shares of $1 par value common stock for $60,000 cash. The company rented its office space and furniture and equipment, and it performed tax consulting services throughout the first year. The comparative balance sheets at the beginning and end of the year 2003 appear as follows:

Tax Consultants Inc.
Comparative Balance Sheets

Assets

Dec. 31, 2003 Jan. 1, 2003 Change (Increase/Decrease)
Cash $49,000 $-0- $49,000 Increase
Accounts receivable 36,000 -0- 36,000 Increase
 

 
Total $85,000 -0-  
 

 

Liabilities and Stockholders' Equity

     
Accounts payable $5,000 $-0- $5,000 Increase
Common stock ($1 par) 60,000 -0- 60,000 Increase
Retained earnings 20,000 -0- 20,000 Increase
 

 
Total $85,000 $-0-  
 

 

The income statement and additional information for tax consultants Inc. are as follows:

Tax Consultants Inc.
Income Statement
For the year ended Dec. 31, 2003

Revenues $125000
Operating expenses 85000
 
Income before income taxes 40,000
Income tax expenses 6,000
 
Net income $34,000
 

Additional Information:
Examination of selected data indicates that a dividend of $14,000 was paid during the year.

Read the following 3 steps for the preparation of statement of cash flows of Tax consultant Inc. carefully:

Step 1: Determine the Change in Cash:

To prepare a statement of cash flows, the first step is to determine the change in cash. This is a simple step. Tax Consultants Inc. had no cash on hand at the beginning of the year 2003, but $49000 was on hand at the end of the year 2003. Thus the change in cash for 2003 was an increase of $49,000.

Step2: Determine Net Cash Flow From Operating Activities:

Under generally accepted accounting principles, most companies use the accrual basis of accounting, requiring that revenue be reported when earned and that expenses be recorded when incurred. Net income may include credit sales that have not been collected in cash and expenses incurred that may not have been paid in cash. Thus, under accrual basis of accounting, net income will not indicate the net cash flow from operating activities.

To arrive at net cash flow from operating activities, it is necessary to report revenues and expenses on a cash basis. This is done by eliminating the effects of income statement transactions that did not result in a corresponding increase or decrease in cash. The relationship between net income and net cash flow from operating activities is graphically depicted as follow:

Net income versus Net cash Flow From Operating Activities

cash flow statement direct method

The conversion of net income to net cash flow from operating activities may be done through either a direct or indirect method. But on this page we will discuss only direct method.

As indicated from the accrual basis income statement, Tax Consultants Inc. reported revenues of $ 125,000. However, because the company's accounts receivable increased during 2003 by $36,000, only 89,000 ($125000 - $36,000) in cash was collected on these revenues. Similarly, Tax Consultants Inc. reported operating expenses of $85,000, but accounts payable increased during the period by $5,000. Assuming that these payables related to operating expenses, cash operating expenses were $80,000 ($85,000 - $5,000). Because no taxes payable exist at the end of the year, the $6,000 income tax expenses for 2003 must have been paid in cash during the year. Then the computation of net cash flow from operating activities is as follows:

Cash collected from revenues $89,000
Cash payment for expenses 80,000
 
Income before income taxes 9,000
Cash payments for income taxes 6,000
 
Net cash provided by operating activities $3,000
 
   
"Net cash provided by operating activities" is the equivalent of cash-basis net income.
"Net cash used by operating activities" is equivalent to cash-basis net loss

Step 3: Determine Net Cash Flows from Investing and Financing Activities:

Once the net cash from operating activities is computed, the next step is to determine whether any other changes in balance sheet accounts caused an increase or decrease in cash.

For example, an examination of the remaining balance sheet accounts for Tax Consultation Inc. shows that both common stock and retained earnings have increased. The common stock increase of $60,000 resulted from the issuance of common stock for cash. The issuance of common stock is a receipt of cash from a financing activity and is reported as such in the statement of cash flows. The retained earnings increase of $20,000 is caused by two items:

  1. Net income of $34000 increased earnings.
  2. Dividends declared of $14,000 decreased retained earnings.

Net income has been converted into net cash flow from operating activities, as explained earlier. The additional data indicate that the dividend was paid. Thus, the dividend payment on common stock is reported as a cash outflow, classified as a financing activity.

The statement of cash flows of Tax Consultants Inc. is as follows:

Tax Consultants INC.
Statement of Cash Flows
For the year ended December 31, 2003

Cash Flows from Operating Activities    
Cash collected from revenues   $89,000
Cash payment for expenses   80,000
   
Income before income taxes   40,000
Income tax expenses   6,000
   
Net cash provided by operating activities   $3,000
Cash Flows from Investing Activities    
Issuance of common stock 60,000
Payment of cash dividends (14,000)  
 
 
Net cash provided by financing activities   46,000
   
Net increase in cash   49,000
Cash, January 1 2003   -0-
   
Cash, December 31, 2003   $49,000
   

As indicated, the $60,000 increase in common stock results in a cash inflow from a financing activity. The payment of $14,000 in cash dividends is classified as a use of cash from a financing activity. The $49000 increase in cash reported in the statement of cash flows agrees with the increase of $49,000 shown as the change in the cash account in the comparative balance sheet. There were no investing activity effecting cash during the year.

Advantages of Direct Method:

The principle advantage of direct method is that it shows operating cash receipts and payments. That is, it is more consistent with objective of a statement of cash flows - to provide information about cash receipts and cash payments - than the indirect method, which does not report operating cash receipts and payments. Supporters of the direct method contend that knowledge of the specific source of operating cash receipts and the purpose for which operating cash payments were made in past periods is useful in estimating future operating cash flows. Furthermore, information about amounts of major classes of operating cash receipts and payments is more useful than information only about their arithmetic sum (the net cash flow from operating activities). Such information is more revealing of an enterprise's ability to:

  1. generate sufficient cash from operating activities to pay its debts.

  2. reinvest in its operations.

  3. to make distributions to its owners.

Many companies indicate that they do not currently collect information in a manner that allows them to determine amounts such as cash received from customers or cash paid to suppliers directly from their accounting system. But supporters of the direct method contend that the incremental cost of assimilating such cash receipts and payments data is not significant.

More study material from this to
 

More study material from this topic:

Definition, Explanation and Purpose of the Statement of Cash Flows
Classification of Cash Flows
Format and Sections of Statement of Cash Flows
Steps in Preparing Statement of Cash Flows
Statement of Cash Flows - Direct Method
Statement of Cash Flows - Indirect Method
Direct versus Indirect Method of Cash Flows

 

 
 

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Financial Accounting Topics


  Introduction to Accounting
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  Transactions and Accounting Equation
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Accounting for Bills of Exchange
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  Special Journals
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  Cash Book
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Bank Reconciliation Statement
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  Final Accounts
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  Work Sheet
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  Capital and Revenue Items
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  Valuation of Inventories
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  Accounts of Non-profit Making Organizations
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  Statement of Cash Flows
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  Accounting Ratios Analysis
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  Depreciation, Provisions and Reserves
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  Accounting Dictionary
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  Financial Calculators
 
 
 
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  Financial Statements
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  Cost Volume Profit Relationship
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  Variable Costing System
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  Materials and Inventory Cost Control
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  Activity Based Costing System
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  Standard Costing and Variance Analysis
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  Balanced Scorecard
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  Capital Investment Analysis/Capital Budgeting
 
 

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