Preparation of Direct and Indirect Cash Flows

The first step in preparing the cash flow statement involves the determination of the total cash flows from operating activities. The cash flow from the operations section of the cash flow statement can be presented using either the direct or indirect method.

The direct method of cash flow presentation details the primary categories of gross cash receipts and cash disbursements, while the indirect method starts with net income and adjusts for non-cash transactions to reconcile to net cash flow from operating activities.

Note that the cash flows associated with investing and financing activities remain the same, regardless of whether the direct or indirect method is used for presenting operating cash flows.

Companies typically report operating cash flow using the indirect method, but understanding the components of this information allows you to deconstruct an indirect cash flow statement and reconstruct it into an approximate direct cash flow statement. Although this reconstructed statement may not be perfectly precise, it provides a useful alternative perspective.

Steps in Preparing Cash Flow from Operating Activities

While discussing the preparation of direct and indirect cash flow statements, we shall use the income statement and comparative balance sheet of a hypothetical tea processing company, Kenya Tea Processing Company (KTPC).

Exhibit A: Income Statement

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

Exhibit B: Balance Sheet

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

Operating Activities Under the Direct Method

We begin determining the amount of money received from customers, then cash paid to suppliers and employees, and also cash paid for other operating expenses, income taxes, and interest expenses.

• Determination of the Amount of Cash Received from Customers (Cash collections)

Revenue is adjusted by the net change in accounts receivable during the accounting period. If accounts receivable increase during the period, then the revenue on an accrual basis is higher than cash receipts from customers, and vice versa.

There are two methods of determining cash received from customers. The first method is to adjust revenue by the net change in accounts receivable so that:

$$\text{Cash received from customers} = \begin{align}&\text{Revenue}\\ &\textbf{less (plus) increase (decrease)}\\&\text{ in accounts receivable}\end{align}$$

Alternatively, we can use the relationship between the balance sheet and income items as follows:

$$\text{Cash received from customers} = \begin{align}&\text{Beginning accounts receivable}+\\ &\textbf{Revenue}\\&\text{Ending accounts receivable}\end{align}$$

Using the results of the KTPC company, we get the following results (in ‘000):

$$\begin{align}&\textbf{Method 1}\\ &\begin{array}{l|c}
\text { Revenue } & \$ 25,456 \\
\hline \text { Less: Increase in accounts receivable } & (39) \\
\hline \text { Cash received from customers } & \underline{\mathbf{\$ 25 , 417}}
\end{array}\end{align}$$

$$\begin{align}&\textbf{Method 2}\\ &\begin{array}{l|c}
\text { Beginning accounts receivable } & \$ 986 \\
\hline \text { Plus: Revenue } & 25,456 \\
\hline \text { Minus: Ending accounts Receivable } & 1,025 \\
\hline \text { Cash collected from customers } & \underline{\mathbf{\$ 25 , 417}}
\end{array}\end{align}$$

• Determining Amount that was Paid to Suppliers

In identifying purchases from suppliers, the cost of goods sold is adjusted for the change in inventory during the accounting period. If inventory increased during the period, then purchases during the period exceeded the cost of goods sold and vice versa. Once the purchase amount has been determined, the cash paid to suppliers can be calculated by adjusting purchases for the change in accounts payable. If all purchases were made in cash, accounts payable will not change, and the cash outflows will equal purchases. However, if accounts payable increased during the year, then purchases on an accrual basis will be higher than they would ordinarily be on a cash basis, and vice versa.

Mathematically, this can be expressed as:

$$\text{Purchases from suppliers} = \begin{align}&\text{Cost of goods sold less (plus) }\\ &\text{decrease (increase) in inventory}\end{align}$$

Therefore,

$$\text{Cash paid to suppliers} = \begin{align}&\text{Purchases from suppliers less (plus) }\\ &\text{increase (decrease) in accounts payable}\end{align}$$

We can also use the relationship between the balance sheet and income items as follows:

$$\text{Cash paid to suppliers} = \begin{align}&\text{Beginning accounts payable}+\\ &\text{Purchases}-\\&\text{Ending accounts receivable}\end{align}$$

The effect of purchases from supplies on inventory can be seen in the following relationship, which depicts the relationship between balance sheet and income statements:

$$\text{Purchases from supplies} = \begin{align}&\text{Ending inventory }-\\ &\text{Beginning inventory }+\\ &\text{Cost of goods sold}\end{align}$$

Using the balance sheet and income statement of KTPC, we have the following result:
$$\begin{array}{lc}
\hline \text { Cost of goods sold } & \$11,345 \\
\text { Plus: Increase in inventory } & \$169\\
\text { Equals purchases from suppliers } & \$11,514 \\
\text { Less: Increase in accounts payable } & \$300 \\ \hline
\text { Cash paid to suppliers } & \underline{\mathbf{\$11,214}} \\
\hline
\end{array}$$

• Determining Amount that was Paid to Employees

In determining the cash paid to employees, salary and wages expense is adjusted by the net change in salary and wages payable for the year. If the salary and wages payable increase during the year, then salary and wages expense on an accrual basis will be higher than the amount of cash paid for this expense, and vice versa.

Mathematically, we can express the amount paid to employees as:

$$\text{Cash paid to employees} = \begin{align}&\text{Salary and wages expense less (plus)}\\ &\text{increase (decrease) in salary and wages payable}\end{align}$$

Alternatively, we can calculate the amount paid to employees as follows:
$$\text{Cash paid to employees} = \begin{align}&\text{Beginning salary and wages payable }+\\ &\text{Salary and wages expense }-\\ &\text{Ending salary and wages payable}\end{align}$$

Using the balance sheet and income statements of hypothetical company KTPC, we get the following results:

$$\begin{array}{lc}
\hline \text { Salary and wages expense} & \$4,200 \\
\text { Less: Increase in salary and wages payable } & \$10 \\
\text { Cash paid to employees } & \underline{\mathbf{\$4,190}} \\
\hline
\end{array}$$

• Determining Amount That was Paid for Other Operating Expenses

In determining the amount of cash paid for other operating expenses, the other operating expenses amount on the income statement is adjusted by the net changes in prepaid expenses and accrued expense liabilities for the accounting period. If prepaid expenses increase during the period, other operating expenses on a cash basis will be higher than on an accrual basis, and vice versa. If the accrued expense liabilities increase during the period, other operating expenses on a cash basis will be lower than on an accrual basis, and vice versa.

As such, other operating expense is calculated as:

$$\text{Cash paid for other operating expenses } = \begin{align}&\text{Other operating expenses}\\ &\text{less (plus) decrease (increase)}\\ &\text{in prepaid expenses }\\ &\text{less (plus) increase (decrease)}\\ &\text{in other accrued expenses}\end{align}$$

Using the results of the KTPC company, cash paid for other operating expenses is calculated as follows:

$$\begin{array}{lc}
\hline \text { Other operating expenses} & \$3,750 \\
\text { Less : Decrease in prepaid expenses } & (\$45) \\
\text { Less: Increase in other accrued liabilities } & (\$30) \\
\text { Cash paid for other operating expenses } & \underline{\$3,675} \\
\hline
\end{array}$$

• Determining the Amount That was Paid for Interest

In determining cash paid for interest, interest expense must be adjusted by the net change in interest payable for the period. If interest payable increases during the period, then interest expense on an accrual basis will be higher than the amount of cash paid for interest, and vice versa.

Therefore, the amount paid for interest can be expressed as:

$$\text{Cash paid for interest} = \begin{align}&\text{Interest expense less (plus)}\\ &\text{increase (decrease) in interest payable}\end{align}$$

Alternatively, we can calculate the cash paid of interest as:

$$\text{Cash paid for interest} = \begin{align}&\text{Beginning interest payable }+\\ &\text{Interest expense }-\\ &\text{Ending interest payable}\end{align}$$

Using the KTPC’s financial statements, cash paid for interest is calculated as:

$$\begin{array}{lc}
\hline \text { Interest expense} & \$250 \\
\text { Plus: Decrease in interest payable } & \$10 \\
\text { Cash paid for interest } & \underline{\mathbf{\$260}} \\
\hline
\end{array}$$

• Determining Amount that was Paid for Income Taxes

In determining the cash paid for income taxes, the income tax expense amount on the income statement is adjusted by the net changes in taxes receivable, taxes payable, and deferred income taxes for the period. If taxes receivable or deferred tax assets increase during the accounting period, income taxes on a cash basis will be higher than on an accrual basis, and vice versa. If taxes payable or deferred tax liabilities increase during the period, income tax expense on a cash basis will be lower than on an accrual basis, and vice versa.

As such,

$$\text{Cash paid for income taxes} = \begin{align}&\text{Income tax expense less (plus)}\\ &\text{increase (decrease) in income tax payable}\end{align}$$

KTPC’s cash paid for income taxes is calculated as follows:

$$\begin{array}{lc}
\hline \text { Income tax expense} & \$1,510 \\
\text { Less: Increase in income tax payable } & \$5 \\
\text { Cash paid for income taxes } & \underline{\mathbf{\$1,505}} \\
\hline
\end{array}$$

Operating Activities Under the Indirect Method

Under the indirect method, net income is reconciled with operating cash flow by adjusting net income for:

• Non-operating activities. For example, an amount reflecting the sale of equipment would be removed from the operating cash flow section and shown in the investing section of the cash flow statement;
• Non-cash expenses. For example, depreciation expense would be added back to net income because it is a non-cash deduction in the computation of net income and
• Changes in operating working capital items, which include increments and decrements in the current operating asset and liability accounts. Changes in these accounts arise from applying accrual accounting and not cash accounting, i.e., recognizing revenue when earned and expenses when incurred instead of when cash is received or paid. An increase in a current operating asset account is subtracted from net income, while a net decrease is added to net income.

A summary of the adjustment to the net income is given in the following table below:

$$\begin{array}{l|c|c}
\hline \textbf { Item } & \textbf { Additions } & \textbf { Subtractions } \\
\hline \text { Non-cash Items } & & \begin{array}{l}
\text { – Amortization of } \\
\text { bond premium }
\end{array} \\
\hline \text { Non-Operating Items } & \begin{array}{l}
\text { – Loss on sale or } \\
\text { write-down of assets } \\
\text { – Loss on investments } \\
\text { under equity method } \\
\text { – Loss on retirement } \\
\text { of debt }
\end{array} & \begin{array}{l}
\text { – Gain on retirement } \\
\text { of debt. } \\
\text { – Gain on sale of } \\
\text { assets. } \\
\text { – Income on } \\
\text { investments } \\
\text { accounted for under } \\
\text { equity method }
\end{array} \\
\hline \text { Deferred Tax Liability } & \begin{array}{l}
\text { Increase in deferred } \\
\text { income tax liability. }
\end{array} & \begin{array}{l}
\text { Decrease in deferred } \\
\text { income tax liability. }
\end{array} \\
\hline \begin{array}{l}
\text { Changes in Working } \\
\text { Capital }
\end{array} & \begin{array}{l}
\text { – Decrease in current } \\
\text { operating assets } \\
\text { such as accounts } \\
\text { receivable, } \\
\text { inventory and } \\
\text { prepaid expenses. } \\
\text { – Increase in current } \\
\text { operating liabilities } \\
\text { such as accounts } \\
\text { payable and accrued } \\
\text { expense liabilities } \\
\end{array} & \begin{array}{l}
\text { – Increase in current } \\
\text { operating assets. } \\
\text { – Decrease in current } \\
\text { operating liabilities }
\end{array} \\
\hline
\end{array}$$

Returning to KTPC’s financial statements, indirect cash flow from operating activities is calculated as follows:

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

Recall that the cash flows associated with investing and financing activities remain the same, regardless of whether the direct or indirect method. As such, for the KTPC company, cashflow from investing and financing activities is as follows:

$$\begin{array}{lc}
\hline
\textbf{Cash flow from investing activities:} & \\
\hline
\text{Cash received from sale of equipment} & \$220 \\
\text{Cash paid for purchase of equipment} & \underline{\$(1,000)} \\
\text{Net cash used for investing activities} & \$(780) \\
\hline
\textbf{Cash flow from financing activities:} & \\
\hline
\text{Cash paid to retire long-term debt} & \$(500) \\
\text{Cash paid to retire common stock} & \$(500) \\
\text{Cash paid for dividends} & \$(2,720) \\
\text{Net cash used for financing activities} & \$(3,720) \\
\hline
\text{Net Increase in cash} & \$ 73 \\
\text{Cash balance, 31 December 2022} & \$1,254\\
\text{Cash balance, 31 December 2023} & \$1,327 \\
\hline
\end{array}$$

Cash Flow from Investing Activities

Recall that the cash flows associated with investing and financing activities remain the same, regardless of whether the direct or indirect method. Returning to the hypothetical KTPC company, cashflow from investing is as follows:

$$\begin{array}{lc}
\hline
\textbf{Cash flow from investing activities:} & \\
\hline
\text{Cash received from sale of equipment} & \$220 \\
\text{Cash paid for purchase of equipment} & \underline{\$(500)} \\
\text{Net cash used for investing activities} & \$(280) \\
\hline\end{array}$$

In order to determine the cash flow from the sale of equipment, we look into the equipment and the accumulated depreciation accounts, as well as the gain on the sale of equipment. Suppose we assume that all the depreciation is linked to the equipment. In that case, we can calculate cash received from the sale of equipment using historical cost and accumulated depreciation of the equipment sold, as well as the information regarding gain on the sale of equipment from the income statement.

If KTPC made an equipment purchase of USD 500,000 during the period, the historical cost of the equipment sold is calculated as follows:
$$\begin{array}{lc}
\hline \text { Beginning balance equipment } & \$8,700 \\
\textbf { Plus:}\ \text{ equipment purchased } & \$500 \\
\textbf { Minus}\ \text{ ending balance equipment} & (\$9,000) \\
\text { Equals: historical cost of equipment sold } & \$200 \\
\hline
\end{array}$$

The accumulated depreciation is calculated  as follows:

$$\begin{array}{lc}
\hline \text { Beginning balance accumulated depreciation} & \$3,300 \\
\textbf { Plus}\ \text{ depreciation expense } & \$1,100 \\
\textbf { Minus}\ \text{ ending balance accumulated depreciation } & (\$3,600) \\
\text { Equals: Accumulated depreciation on equipment sold } & \$200 \\
\hline
\end{array}$$

Therefore, the cash received from the sale of equipment is calculated as follows:
$$\begin{array}{lc}
\hline \text { Historical cost of equipment sold } & \$200\\
\textbf { Less:}\ \text{ Accumulated depreciation on equipment sold } & \$200\\
\text { Equals: book value of equipment sold } & \$0\\
\textbf { Plus:}\ \text{ gain on sale of equipment } & \$220\\
\text { Equals: cash received from sale of equipment } & \$220\\
\end{array}$$

Cash Flow from Financing Activities

Like cash flow from investing activities, cash flows associated with financing activities remain the same, regardless of whether the direct or indirect method is used. Returning to the hypothetical KTPC company, cashflow from financing is as follows:

$$\begin{array}{lc}
\hline
\textbf{Cash flow from financing activities:} & \\
\hline
\text{Cash paid to retire long-term debt} & \$(500) \\
\text{Cash paid to retire common stock} & \$(500) \\
\text{Cash paid for dividends} & \$(2,720) \\
\text{Net cash used for financing activities} & \$(3,720) \\
\hline
\text{Net Increase in cash} & \$ 73 \\
\text{Cash balance, 31 December 2022} & \$1,254 \\
\text{Cash balance, 31 December 2023} & \$1,327 \\
\hline
\end{array}$$

Note that the dividends paid is calculated using the following formula:

$$\text{Beginning retained earnings +Net Income -Dividends = Ending Retained Earnings}$$

Based on the above formula, the KTPC’s cash paid for dividends is calculated as follows:

$$\begin{array}{lc}
\text { Beginning balance of retained earnings } & \$3,305\\
\textbf { Plus:}\ \text{Net income} & \$3,521\\
\text { Equals: total before distributions} & \$6,826\\
\textbf { Minus:}\ \text{ ending balance of retained earnings} & \$4,106\\
\text { Equals: dividends paid } & \underline{\$2,720}\\
\end{array}$$

Question

Which of the following steps is least likely included in the direct method for preparing cash flows from operations?

1. Adjusting net income for non-cash expenses.
2. Determining how much cash was paid for income taxes.
3. Identifying how much cash was received from customers.

Solution

The correct answer is A.

Adjusting net income for non-cash expenses is one of the indirect methods for preparing cash flows from operations.

Options B and C present steps that are involved in the direct method of calculating cashflows from operating activities.