Preparation of Direct and Indirect Cash Flows

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 prepared using either the direct or indirect method.

The second and third steps in preparing the cash flow statement entail the determination of the total cash flows from investing and financing activities. Irrespective of the method used to prepare the cash flow from the operating activities section, the cash flow from investing and financing activities are each prepared using one format only.

Steps in Preparing Cash Flow from Operating Activities

Under the Direct Method

  • Determination of the Amount of Cash Received from Customers
    • 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.
  • Determination of the Amount that was Paid to Suppliers and Employees
    • 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.
    • 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.
  • Determination of the Amount That was Paid for Other Operating Expenses, Interest, and Income Taxes
    • 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.
    • 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.
    • 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.

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.

Question 1

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.

Question 2

HH & Associates reported a loss of $30,000 on the sale of a production machine. The book value of that machine was $300,000, and the accumulated depreciation expense was $50,000. How much cash did the company receive from the sale of that machine?

  1. $220,000
  2. $250,000
  3. $270,000

Solution

The correct answer is A.

$$ \text{The loss of the machine}’\text{s sale} =\text{Carrying value}-\text{Sales price} $$

Where:

$$ \text{Carrying value}=\text{Book value}-\text{Accumulated depreciation} $$

By adding numbers to the above equations, we find out the following:

$$ \text{Carrying value}=\$300,000-\$50,000=\$250,000 $$

What would make:

$$ \begin{align*} \text{Sale Price} &=\text{Carrying value} \left(\$250,000\right) \\ &-\text{Loss of the machine}’\text{s sale} \left(\$30,000\right) \\ &=\$220,00 \end{align*} $$

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