Cash Flow Statement Example – Direct and Indirect Method

Cash Flow Statement Example – Direct and Indirect Method:

Unlike the major financial statements, cash flow statement is not prepared from the adjusted trial balance. The information to prepare this statement usually comes from three sources:

1. Comparative balance sheets provide the amount of the changes in assets, liabilities, and equities from the beginning to the end of the period.
2. Current income statement data help the reader determine the amount of cash provided by or used by operations during the period.
3. Selected transaction data from the general ledger provide additional detailed information needed to determine how cash was provided or used during the period

Preparing the statement of cash flows from the data sources above involves three major steps:

Step 1. Determine the change in cash:
This procedure is straight forward because the difference between the beginning and the ending cash balance can be easily computed from an examination of the comparative balance sheet.

Step 2. Determine the net cash flow from operating activities:
This procedure is complex. It involves analyzing not only the current year’s income statement but also comparative balance sheets and selected transitions data.

Step 3. Determine net cash flows from investing and financing activities:
All other changes in the balance sheet accounts must be analyzed to determine their effects on cash.

Cash Flow Statement Example:

A Comprehensive illustration

To illustrate a statement of cash flows we will use the first year of operations for Tax Consultants Inc. The company started on January 1, 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 at the end of the year 2003 appear as follows.

The income statement and additional information for Tax Consultation Inc. are as follows.

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

Step 1: Determine the Change in Cash:
To prepare a statement of cash flows, the first step―determining the change in cash―is a simple computation. The company has no cash on hand at the beginning of the year 2003, but $49,000 at the end of 2003. Thus the change in cash for 2003 was an increase of $49,000

Step 2: Determine Net Cash Flow from Operating Activities:
A usual starting point in determining net cash flow from operating activities is to understand why net income must be converted. Under generally accepted accounting principles, most companies must use the accrual basis of accounting, requiring revenues 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 the 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 revenue and expenses on cash basis. This is done by eliminating the effects of statement transactions that did not result in a corresponding increase or decrease in cash.

The conversion of net income into net cash flow from operating activities may be done through either a direct method or an indirect method as explained in the following discussion.

1.Direct Method:

(also called the income statement method) reports cash receipts and cash disbursements from operating activities. The difference between these two amounts in the net cash flow from operating activates. In other words, the direct method deducts from operating cash receipts the operating cash disbursements. The direct method results in the presentation of a condensed cash receipts and cash disbursements statement.

As directed from the accrual based 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 ($125,000 − $36,000) in cash collected on these revenues. Similarly, company reported operating expenses of $85,000, but accounts payable increased during the period by $5,000. Assuming that payable 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 expense for 2003 must have been paid in cash during the year. Then the computation of net cash flow from operating activities is as follows:

“Net cash provided by operating activities” is equivalent of cash-basis net income. (“Net cash used by operating activities” would be equivalent to cash-basis net loss)

2 Indirect Method:

(or reconciliation method) starts with net income and converts it to net cash flow from operating activities. In other words, the Indirect method adjusts net income for items that affected reported net income but didn’t affected cash. To compute net cash flows from operating activities, noncash changes in the income statement are added back to net income, and net cash credits are deducted. Explanations for the two adjustments to net income in this example―namely, the accounts receivable and accounts payable―are as follows.

Increase in Accounts Receivable―Indirect Method:
When accounts receivable increase during the year, revenues on an accrual basis are higher than on a cash basis because goods sold on account are reported as revenues. In other words, operations for the period led to increased revenues, but not all of these revenues resulted in an increase in cash. Some of the increase in revenues resulted in an increase in accounts receivable. To convert net income to net cash flow from operating activities, the increase of $36,000 in accounts payable must be deducted from net income.

Increase in Accounts Payable―Indirect Method:
When accounts payable increase during the period, expenses on an accrual basis are higher than they are on a cash basis because expenses are incurred for which payment has not taken place. To convert net income to net cash flow from operating activities, the increase of $5,000 in accounts payable must be added back to net income.

As a result of the accounts receivable and accounts payable adjustments, net cash provided by operating activities is determined to be $3,000 for the year 2003. This calculation is shown as follows.

Note that net cash provided by operating activities is the same whether the direct or indirect method is used.

Step 3: Determine Net Cash Flows from Investing and Financing Activities:
Once the net cash flows 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 Consultants Inc. shows that both common 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 $34,000 increased retained earnings
2. Dividend declared of $4,000 decreased retained earnings.

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

We are now ready to prepare the statement of cash flows. The statement starts with the operating activities section. Either the direct or indirect method may be used to report net cash flow from operating activates.

The statement of cash flows under indirect method for Tax Consultation Inc. is as follows.

Tax Consultants Inc.
cash flow statement-Indirect Method
For the year ended December 31, 2003

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 $49,000 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.

You may also be interested in other articles from “cash flow statement” chapter:

1. Definition and Explanation of Cash flow statement
2. Understanding Cash Flow Statement-format and sections

3. Cash Flow Statement Example-direct and indirect method

Other Related Accounting Articles:

• Cash Flow Statement
• Definition and explanation of cash flow statement
• Understanding Cash Flow Statement-Format and Sections
• What is Operating Cash Flow?
• Cash Flow Statement Definition
• Understanding Cash Flow Balance