Indirect to Direct Method

Sometimes, a company may prepare the cash flow from the operations section of its cash flow statement using an indirect method. However, users of its financial statements may desire to review the direct-format cash flow from operations. This may arise from the need to review, for example, trends in the cash the company paid to its suppliers and the cash it received from its customers.

It is possible to convert the indirect method to the direct method. The accuracy of this conversion will depend on the accuracy of the adjustments made using data available in published financial reports.

Steps in Converting Cash Flows from Indirect Method to Direct Method

In converting cash flows from the indirect method to the direct method, the following three-step process is applied:

• Net income is disaggregated into total revenues and total expenses;
• Non-operating and non-cash items are removed from aggregated revenues and expense amounts, and the remaining items are broken down into relevant cash flow items and
• Accrual revenues and expenses are converted into cash flow receipts and payments by adjusting for changes in working capital accounts.

Example: Demonstrating Conversion from Indirect to Direct Method of Reporting Cash Flow from Operating Activities

Recall the balance sheet and the income statement of the hypothetical tea processing company, KTDA:

Exhibit A: Income Statement

$$\begin{array}{lc}
\hline \text{KTDA Income Statement Year Ended } 31 \text{ December } \mathbf{2023} \text{ (in ‘000)} \\
\hline \text{Revenue (net)} & \$25,456 \\
\text{Cost of goods sold} & \$11,345 \\
\text{Gross profit} & \$14,111 \\
\text{Salary and wage expense} & \$4,200 \\
\text{Depreciation expense} & \$1,100 \\
\text{Other operating expenses} & \$3,750 \\
\text{Total operating expenses} & \$9,050 \\
\text{Operating profit} & \$5,061 \\
\text{Other revenues (expenses):} & \\
\text{Gain on sale of equipment} & \$220 \\
\text{Interest expense} & (\$250) \\
\text{Total other revenues (expenses)} & (\$30) \\
\text{Income before tax} & \$5,031 \\
\text{Income tax expense} & \$1,510 \\
\text{Net income} & \$3,521 \\
\hline
\end{array}$$

Exhibit B: Balance Sheet

$$\begin{array}{lccc}
\hline \text{KTDA Balance Sheet as of}& &\\\text{31 December 2023 and 2022 (in ‘000)}&& \\
\hline \text{Item} & \text{2023} & \text{2022} & \text{Net Change} \\
\hline \text{Cash} & \$1,327 & \$1,254 & \text{\$73} \\
\text{Accounts receivable} & 1,025 & 986 & 39 \\
\text{Inventory} & 4,025 & 3,856 & 169 \\
\text{Prepaid expenses} & 134 & 179 & \text{(45)} \\
\text{Total current assets} & 6,411 & 6,275 & 136 \\
\text{Land} & 560 & 560 & 0 \\
\text{Buildings} & 3,800 & 3,800 & 0 \\
\text{Equipment} & 9,000 & 8,700 & 300 \\
\text{Less: accumulated depreciation} & (3,600) & (3,300) & \text{(300)} \\
\text{Total long-term assets} & 9,760 & 9,760 & 0 \\
\text{Total assets} & \$16,171 & \$16,035 & 136 \\
\text{Accounts payable} & 3,700 & 3,400 & 300 \\
\text{Salary and wage payable} & 90 & 80 & 10 \\
\text{Interest payable} & 65 & 75 & \text{(10)} \\
\text{Income tax payable} & 60 & 55 & 5 \\
\text{Other accrued liabilities} & 1,150 & 1,120 & 30 \\
\text{Total current liabilities} & 5,065 & 4,730 & 335 \\
\text{Long-term debt} & 3,000 & 3,500 & \text{(500)} \\
\text{Common stock} & 4,000 & 4,500 & \text{(500)} \\
\text{Retained earnings} & 4,106 & 3,305 & 801 \\
\text{Total liabilities and equity} & \$16,171 & \$16,035 & 136 \\
\hline
\end{array}$$

Also, recall that we prepared the indirect cash flow from the operating activities as follows:

$$\begin{array}{lc}
\hline
\text{ Cash flow from operating activities: } & \\
\hline \text{Net income} & \$3,521,000 \\
\text{Depreciation expense} & \$1,100,000 \\
\text{Gain on sale of equipment} & \$(220,000) \\
\text{Increase in accounts receivable} & (\$39,000) \\
\text{Increase in inventory} & \$(169,000) \\
\text{Decrease in prepaid expenses} & \$45,000 \\
\text{Increase in accounts payable} & \$300,000 \\
\text{Increase in salary and wage payable} & \$10,000 \\
\text{Decrease in interest payable} & (\$10,000) \\
\text{Increase in income tax payable} & \$5,000 \\
\hline
\textbf{Total adjustments} & \$1,022,000 \\
\textbf{Cash flow from operating activities} & \$4,543,000 \\
\hline
\text{Increase in other accrued liabilities} & \$30,000 \\
\text{Net cash provided by operating activities} & \underline{\$4,573,000} \\
\hline
\end{array}$$

To convert the above cash flows from operating activities from the indirect method to the direct method, we shall follow the three steps outlined above:

Step 1: Disaggregated net Income into total revenues and total expenses

$$\begin{array}{lc}
\text{Total Revenue} & \$25,676,000 \\
\text{Total Expenses} & \underline{\$22,155,000} \\
\text{Net Income} & \underline{\$3,521,000} \\
\end{array}$$

Step 2: Remove all Non-operating and non-cash items from aggregated revenues and expense amounts, and break down the expenses into relevant cash flow items:

$$\begin{array}{lc}
\hline
\text{Total Revenue less Non-operating item revenues:} & \\
(25,676,000 – 220,000) = & \$25,456,000 \\
\text{Total Expenses less Noncash item expenses} & \\
(22,155,000 – 1,100,000) = & \$21,055,000 \\
\text{Cost of goods sold} & \$11,345,000 \\
\text{Salary and wage expenses} & \$4,200,000 \\
\text{Other operating expenses} & \$3,750,000 \\
\text{Interest expense} & \$250,000 \\
\text{Income tax expense}  & \$1,510,000 \\
\text{Total}  & \$21,055,000 \\
\hline
\end{array}$$

Step 3: Convert Accrual revenues and expenses into cash flow receipts and payments by adjusting for changes in working capital accounts.

This step was dealt with in the previous LOS. So here are the cash flow receipts and payments as previously calculated:
$$\begin{array}{lc}
\hline
\text{Cash paid from customers} & \$25,417,000 \\
\text{Cash paid to suppliers}  & \$11,214,000 \\
\text{Cash Paid to Employees} & \$4,190,000 \\
\text{Cash paid for other operating expenses} & \$3,889,000 \\
\text{Cash paid for income tax}  & \$1,505,000 \\
\text{Cash paid for interest} & \$260,000 \\
\text{Net Cash provided by operating activities} & \$4,573,000 \\
\hline
\end{array}$$

Question

Which of the following is most likely the starting point for converting cash flows from operating activities from indirect to direct?

1. Net income.
2. Cash flow from operations.
3. Cash received from customers.

Solution

The correct answer is A.

The first step in the three-step process for converting cash flows from the indirect method to the direct method is the disaggregation of net income into total revenues and expenses.