Learning Outcomes
- Distinguish between the direct and indirect methods of preparing a statement of cash flows
Cash flows from operating activities show the net amount of cash received or disbursed during a given period for items that normally appear on the income statement. You can calculate these cash flows using either the direct or indirect method. The direct method deducts from cash sales only those operating expenses that consumed cash. This method converts each item on the income statement directly to a cash basis. Alternatively, the indirect method starts with accrual basis net income and indirectly adjusts net income for items that affected reported net income but did not involve cash.
The direct method converts each item on the income statement to a cash basis. For instance, assume sales are stated at $45,785 on an accrual basis. If accounts receivable decreased by $15, from $1,750 to $1,735, cash collections from customers would have been $45,800, which you could calculate in a T account or in a table as follows:
| Beginning balance | $ 1,750 |
|---|---|
| Accrual basis sales | 45,785 |
| Balance before payments | 47,535 |
| Less: Ending balance | 1,735 |
| Cash payments from customers | $ 45,800 |
Here is a hypothetical example of a statement of cash flows prepared using the direct method:
| Description | Amount | Total |
|---|---|---|
| In millions | ||
| Subcategory, Cash flows from operating activities | ||
| Cash receipts from customers | $ 45,800 | |
| Cash paid to suppliers | (29,800) | |
| Cash paid to employees | (11,200) | |
| Cash generated from operations |
Single Line 4,800 |
|
| Interest paid | (310) | |
| Income taxes paid | (1,700) | |
| Net cash from operating activities | Single Line |
Single Line $2,790 |
| Subcategory, Cash flows from investing activities | ||
| Purchase of property, plant, and equipment | (580) | |
| Proceeds from sale of equipment | 150 | |
| Net cash used in investing activities | Single Line |
Single Line (430) |
| Subcategory, Cash flows from financing activities | ||
| Proceeds from issuance of common stock | 1,000 | |
| Proceeds from issuance of long-term debt | 500 | |
| Dividends paid | (460) | |
| Net cash used in financing activities | Single Line |
Single Line 1,040 |
| Net increase in cash and cash equivalents | 3,400 | |
| Cash and cash equivalents at beginning of period | 1,640 | |
| Cash and cash equivalents at end of period |
Single Line $5,040 Double Line |
|
The indirect method adjusts net income (rather than adjusting individual items in the income statement) for (1) changes in current assets (other than cash) and current liabilities, and (2) items that were included in net income but did not affect cash. We’ll explore this in more detail in a later section.
practice question
