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Home Statement of Cash Flows Direct Versus Indirect Method of Cash Flows
 
 

Direct Versus Indirect Method of Cash Flows:

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Learning Objectives:

  1. What is the difference between direct and indirect method of cash flow statement?

  2. Calculate net cash provided or used by operating activities using direct and indirect method.


If you are really serious about learning cash flows from operating activities then read this page very carefully. You will find significant improvement in your understandings.

Two different methods available to adjust income from operations on an accrual basis to net cash flow from operating activities are the indirect (reconciliation) method and the direct (income statement) method.

Indirect Method or Reconciliation Method:

Indirect method is the most widely used method for the calculation of net cash flow from operating activities. Under this method, net cash provided or used by operating activities is determined by adding back or deducting from net income those items that do not effect on cash. The following are the common types of adjustments that are made to net income to arrive at net cash flow from operating activities.

Adjustments Needed to Determine Net Cash Flow from Operating Activities Using Indirect Method

Net Income
Additions Deductions
Depreciation expense Amortization of bond premium
Importance of intangibles and deferred charges Decrease in deferred income tax liabilities
Amortization of bond discount Income on investment in common stock using equity method
Increase in deferred income tax liability Gain on sale of plant assets
Loss on investment in common stock using equity method Increase in receivables
Loss on sale of plant assets Increase in inventories
Loss on written down of assets Increase in prepaid expenses
Decrease in receivables Decrease in accounts payable
Decrease in inventories Decrease in accrued liabilities
Decrease in prepaid expenses  
Increase in accounts payable  
Increase in accrued liabilities  

The additions and deductions listed above reconcile net income to net cash flow from operating activities, illustrating the reason for referring to the indirect method as reconciliation method.

Note: Direct and indirect methods are different only to the extent of the calculation of cash flows from operating activities, cash flows from investing and financing activities are calculated in the same manner.

Example:

Cash flow from operating activities:
Net income 117000
Adjustments to reconcile net income to net cash used/provided  by operating by activities:
   Depreciation expenses 14,800
   Amortization of trade mark 2,400
   Amortization of bond premium (1,000)
   Equity in earnings of Porter Co. (3,500)
   Gain on condemnation of land (8,000)
   Loss on sale of equipment 1,500
   Increase in deferred tax liabilities 3,000
   Increase in accounts receivable (net) (53,000)
   Increase in inventories (152,000)
   Decrease in prepaid expenses 500
   Increase in accounts payable 1,000
   Increase in accrued liabilities 4,000  
   Decrease in income tax payable (13,000) 203,500
 

Net cash used by operating activities (86,500)

Direct Method or Income Statement Method:

Under the direct method the statement of cash flows reports net cash flow from operating activities as major classes of operating cash receipts (e.g., cash collected from customers and cash received from interest and dividends) and cash disbursements (e.g., cash paid to suppliers for goods, to employees for services, to creditors for interest, and to government authorities for taxes).

The direct method is explained on cash flow statement direct method page. This method is illustrated here in more detail to help you understand the difference between accrual based income and net cash flow from operating activities and to illustrate the data needed to apply the direct method.

Suppose a company which began business on January 1, 2005, has the following balance sheet information:

  December 31
  2005 2004
Cash $159,000 0
Accounts receivable 15,000 0
Inventory 160,000 0
Prepaid expenses 8,000 0
Property, plant, and equipment (net) 90,000 0
Accounts payable 60,000 0
Accrued expenses payable 20,000 0

Company's December 31, 2005, income statement and additional information are:

Revenues from sales   $780,000
Cost of goods sold   450,000
   
Gross profit   330,000
Operating expenses $160,000  
Depreciation 10,000 170,000
 

Income before income taxes   160,000
Income tax expenses   48,000
   
Net income   $112,000
   

Additional Information:
(a). Dividends of $70,000 were declared and paid in cash.
(b). The accounts payable increase resulted from the purchases of merchandise.
(c). Prepaid expenses and accrued expenses payable relate to operating   expenses.

Under the direct method, net cash provided by operating activities is computed by adjusting each in the income statement from the accrual basis to the cash basis. To simplify and condense the operating activities section, only major classes of operating cash receipts and cash payments are reported. The difference between these major classes of cash receipts and cash payments is the net cash provided by operating activities as show below:

Net Cash Provided by Operating Activities

direct_versus_indirect_method_of_cash_flows

An efficient way to apply the direct method is to analyze the revenues and expenses reported in the income statement in the order in which they are listed. Cash receipts and cash payments related to these revenues and expenses should then be determined. The direct method adjustments for the company in 2005 to determine net cash provided by operating activities are presented in the following sections.

Cash Receipts from Customers:

The income statement of the company reported revenues from customers of $780,000. To determine cash receipts from customers, it is necessary to consider the change in accounts receivables during the year. When accounts receivable increase during the year,  revenues on an accrual basis are higher than cash receipts from customers. In other words, operations led to increased revenues but not all of these revenues resulted in cash receipts. To determine the amount of increase in cash receipts, deduct the amount of the increase in accounts receivable from the total sales revenue. Conversely, a decrease in accounts receivable is added to sales revenues, because cash receipts from customers then exceed sales revenue. In our example, accounts receivable increased by $15,000. Thus, cash receipts from customers were $765,000, computed as follows:

Revenues from sales $780,000
Deduct: Increase in accounts receivable 15,000

Cash receipts from customers $765,000

Cash receipts from customers may also be determined from an analysis of the accounts receivable account as shown below:

Accounts Receivable

1/1/05       Balance                            -0-
                Revenue from sales       780,000
 Receipts from customers                765,000
12/31/05    Balance                          15,000  

The relationship between cash receipts from customers, revenues from sales, and changes in accounts receivable are shown below:

Formula to compute cash receipt from customers

Cash receipts from customers

= Revenues from sales { + Decrease in accounts receivable
or
- Increase in accounts receivable

Cash Payments to Suppliers:

In our example, company reported cost of goods sold on its income statement of $450,000. To determine cash payment to suppliers, it is first necessary to fine for the year. To find purchases, cost of goods sold is adjusted for the change in inventory. When inventory increases during the year, it means that purchases this year exceed cost of goods sold. As a result, the increase in inventory is added to cost of goods sold to arrive at purchases.

In 2005 the company's inventory increased $160,000. Purchases, therefore, are computed as follows:

Cost of goods sold $450,000
Add: Increase in inventory 160,000

Purchases $610,000

After purchases are computed, cash payments to suppliers are determined by adjusting purchases for the change in accounts payable. When accounts payable increase during the year, purchases on an accrual basis are higher than they are on a cash basis. As a result, an increase in accounts payable is deducted from purchases to arrive at cash payments to suppliers. Conversely, a decrease in accounts payable is added to purchases because cash payments o suppliers exceed purchases. Cash payment to suppliers are $550,000 computed as follows:

Purchases $610,000
Deduct: Increase in accounts payable 60,000

Cash payments to suppliers $550,000

Cash payments to suppliers may also be determined from an analysis of the accounts payable account as shown below:

Accounts Payable

    Revenue from sales                       550,000 1/1/05     Balance                            -0-
              Revenue from sales       610,000
  12/31/05    Balance                          60,000

The relationships between cash payments to customers, cost of goods sold, changes in inventory, and changes in accounts payable are shown below:

Formula to compute cash payments to suppliers

Cash payments to suppliers

= Cost of goods sold { + Increase in inventory
or
- Decrease in inventory
{ + Decrease in accounts payable
or
- Increase in accounts payable

Cash Payments for Operating Expenses:

In our example, the operating expenses of $160,000 are reported on the income statement of the company. To determine the cash paid for operating expenses, this amount must be adjusted for any changes in prepaid expenses and accrued expenses payable. For example, when prepaid expenses increased $8,000 during the year, cash paid for operating expenses was $8,000 higher than operating expenses reported on the income statement. To convert operating expenses to cash payments for operating expenses, the increase of $8,000 must be added to operating expenses. Conversely if prepaid expenses decrease during the year, the decrease must be deducted from operating expenses

Operating expenses must also be adjusted for changes in accrued expenses payable. When accrued expenses payable increase during the year, operating expenses on an accrual basis are higher than they are on a cash basis. As a result, an increase in accrued expenses payable is deducted from operating expenses to arrive at cash payments for operating expenses. Conversely, a decrease in accrued expenses payable is added to operating expenses because cash payments exceed operating expenses. The cash payments for operating expense of the company in our example is $148,000 computed as below:

Operating expenses $160,000
Add: Increase in prepaid expenses 8,000
Deduct: Increase in accrued expenses payable (20,000)

Cash payments to suppliers $148,000

The relationships among cash payments for operating expenses, changes in prepaid expenses, and changes in accrued expenses payable are shown below:

Formula to compute cash payments for operating expenses

Cash payments for operating expenses

= Operating expenses { + Increase in prepaid exp.
or
- Decrease in prepaid exp.
{ + Decrease in accrued exp. payable
or
- Increase in accrued exp. payable

Depreciation expense has not been considered, because depreciation is a non-cash expense.

Cash Payments for Income Taxes:

The income statement of the company in our example shows income tax expenses $48,000. This amount equals the cash paid because the comparative balance sheet indicates no income tax payable at either the beginning or end of the year.

Summary of Net Cash Flows from Operating Activities - Direct method:

The computations illustrated above are summarized in the following schedule:

Accrual Basis to Cash Basis

Accrual Basis   Adjustments Add
(Subtract)
Cash Basis
Revenue from sales $780,000 - Increase in accounts receivable $(15,000) $765,000
Cost of goods sold 450,000 + Increase in inventory 160,000  
    - Increase in accounts payable (60,000) 550,000
Operating expenses 160,000 + Increase in prepaid expenses 8,000  
    - Increase in accrued expenses (20,000) 148,000
Depreciation expenses 10,000 - Depreciation expenses (10,000) -0-
Income tax expenses 48,000       48,000
 
     
Total expenses 668,000       746,000
 
     
Net income $112,000   Net cash provided by operating activities $19,000
 
     

Presentation of the direct method for reporting net cash flow from operating activities takes the following form:

Cash received from operating activities:
Cash received from customers $765,000
Cash payments:
To suppliers $ 550,000
For operating expenses 148,000
For income taxes 48,000 746,000


Net cash provided by operating activities $19,000

If the company uses the direct method to present the net cash flows from operating activities, it will provide a separate schedule of the reconciliation of net income to net cash provided by operating activities. The reconciliation assumes the identical form and content of the indirect method of presentation as shown below:

Cash flow from operating activities:
Net income $112,000
Adjustments to reconcile net income to net cash used by operating by activities:
   Depreciation expenses 10,000
   Increase in accounts receivable (15,000)
   Increase in inventories (160,000)
   Increase in prepaid expenses (8,000)
   Increase in accounts payable 60,000
   Increase in accrued expenses payable 20,000 $(93,000)
 

Net cash provided by operating activities $19,000

The reconciliation may be presented at the bottom of the statement of cash flows when the direct method is used or in a separate schedule.

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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  Introduction to Accounting
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  Analysis of Business Transactions
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  Journal, Ledger and Trial Balance
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  Special Journals
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