Definition and Explanation:
Normally, two methods are used to prepare statement
of cash flows. One is the direct method and other is the
indirect method. On this page we are going to
explain direct method. This method is also known as
income statement method. This method reports cash
receipts and cash disbursements from operating
activities. The difference between theses two
amounts is the net cash flow from operating
activities. In other words, the direct method
deducts from operating cash receipts the operating
cash disbursements. This method results in the
presentation of condensed cash receipts and cash
disbursements statement.
The
direct and indirect methods are different only to
the extent of calculation of cash flows from
operating activities. The cash flow from investing
activities and financing activities are calculated
in the same way under both the methods.
Example:
To
illustrate direct method of statement of cash flows, we
will use the first year of operation for Tax
Consultants Inc. The company started on 1st January
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 end of the year 2003 appear as
follows:
|
Tax
Consultants Inc.
Comparative Balance Sheets
|
Assets |
Dec. 31, 2003 |
Jan. 1, 2003 |
Change (Increase/Decrease) |
|
Cash |
$49,000 |
$-0- |
$49,000 Increase |
|
Accounts receivable |
36,000 |
-0- |
36,000 Increase |
| |
|
|
|
|
Total |
$85,000 |
-0- |
|
| |
|
|
|
|
Liabilities and Stockholders'
Equity |
|
|
|
|
Accounts payable |
$5,000 |
$-0- |
$5,000 Increase |
|
Common stock ($1 par) |
60,000 |
-0- |
60,000 Increase |
|
Retained earnings |
20,000 |
-0- |
20,000 Increase |
| |
|
|
|
|
Total |
$85,000 |
$-0- |
|
| |
|
|
|
|
The income
statement and additional information for tax consultants Inc.
are as follows:
|
Tax
Consultants Inc.
Income Statement
For the year ended Dec. 31, 2003
|
Revenues |
$125000 |
|
Operating expenses |
85000 |
| |
|
|
Income before income taxes |
40,000 |
|
Income tax expenses |
6,000 |
| |
|
|
Net income |
$34,000 |
| |
|
Additional Information:
Examination of selected data
indicates that a dividend of $14,000 was
paid during the year.
|
Read the following 3 steps for
the preparation of statement of cash flows of Tax consultant Inc.
carefully:
Step 1: Determine the Change in
Cash:
To prepare a statement of cash
flows, the first step is to determine the
change in cash. This is a simple step. Tax
Consultants Inc. had no cash on hand at the
beginning of the year 2003, but $49000 was on hand
at the end of the year 2003. Thus the change in cash
for 2003 was an increase of $49,000.
Step2: Determine
Net Cash Flow From Operating Activities:
Under generally
accepted accounting principles, most companies use
the accrual basis of accounting, requiring that
revenue 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 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 revenues and expenses on a cash basis.
This is done by eliminating the effects of income
statement transactions that did not result in a
corresponding increase or decrease in cash. The
relationship between net income and net cash flow
from operating activities is graphically depicted as
follow:
Net
income versus Net cash Flow From Operating
Activities
The conversion of
net income to net cash flow from operating
activities may be done through either a direct or
indirect method. But on this page we will discuss
only direct method.
As indicated from
the accrual basis 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 ($125000 -
$36,000) in cash was collected on these revenues.
Similarly, Tax Consultants Inc. reported operating
expenses of $85,000, but accounts payable increased
during the period by $5,000. Assuming that these
payables 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 expenses for 2003 must
have been paid in cash during the year. Then the
computation of net cash flow from operating
activities is as follows:
|
Cash collected from revenues |
$89,000 |
|
Cash payment for expenses |
80,000 |
| |
|
|
Income before income taxes |
9,000 |
|
Cash payments for income taxes |
6,000 |
| |
|
|
Net cash provided by operating
activities |
$3,000 |
| |
|
| |
|
|
"Net cash provided by operating
activities" is the equivalent of
cash-basis net income. |
|
"Net cash used by
operating activities" is equivalent to
cash-basis net loss |
|
Step 3: Determine Net Cash Flows from Investing
and Financing Activities:
Once the net cash
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 Consultation Inc. shows that both common
stock 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:
- Net income of
$34000 increased earnings.
- Dividends
declared of $14,000 decreased retained earnings.
Net income has been
converted into net cash flow from operating
activities, as explained earlier. The additional
data indicate that the dividend was paid. Thus, the
dividend payment on common stock is reported as a
cash outflow, classified as a financing activity.
The statement of cash flows of Tax Consultants Inc. is as follows:
Tax Consultants INC.
Statement of Cash Flows
For the year ended December 31, 2003
| Cash Flows from
Operating Activities |
|
|
| Cash collected
from revenues |
|
$89,000 |
| Cash payment for
expenses |
|
80,000 |
| |
|
|
|
Income before income taxes |
|
40,000 |
|
Income tax expenses |
|
6,000 |
| |
|
|
| Net cash provided
by operating activities |
|
$3,000 |
| Cash Flows from
Investing Activities |
|
|
| Issuance of common stock |
60,000 |
|
| Payment of cash
dividends |
(14,000) |
|
| |
|
|
| Net cash provided
by financing activities |
|
46,000 |
| |
|
|
| Net increase in
cash |
|
49,000 |
| Cash, January 1
2003 |
|
-0- |
| |
|
|
| Cash, December 31,
2003 |
|
$49,000 |
| |
|
|
|
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 $49000 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. There were no investing activity
effecting cash during the year.
Advantages of Direct Method:
The principle
advantage of direct method is that it shows
operating cash receipts and payments. That is, it is more
consistent with objective of a statement of cash flows - to
provide information about cash receipts and cash payments -
than the
indirect method,
which does not report operating cash receipts and payments.
Supporters of the direct method contend that knowledge of
the specific source of operating cash receipts and the
purpose for which operating cash payments were made in past
periods is useful in estimating future operating cash flows.
Furthermore, information about amounts of major classes of
operating cash receipts and payments is more useful than
information only about their arithmetic sum (the net cash
flow from operating activities). Such information is more
revealing of an enterprise's ability to:
-
generate
sufficient cash from operating activities to pay its
debts.
-
reinvest
in its operations.
-
to make
distributions to its owners.
Many companies
indicate that they do not currently collect information in a
manner that allows them to determine amounts such as cash
received from customers or cash paid to suppliers directly
from their accounting system. But supporters of the direct
method contend that the incremental cost of assimilating
such cash receipts and payments data is not significant.
|
