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Learning Objectives:
-
What is the difference between direct and
indirect method of cash flow statement?
-
Calculate net cash provided or used by operating
activities using direct and indirect method.
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If
you are really serious about learning cash flows
from operating activities then read this page
very carefully. You will find significant
improvement in your understandings. |
Two
different methods available to adjust income from
operations on an accrual basis to net cash flow from
operating activities are the
indirect
(reconciliation) method and the
direct (income
statement) method.
Indirect Method or Reconciliation
Method:
Indirect method is the most widely used method for
the calculation of net cash flow from operating
activities. Under this method, net cash provided or
used by operating activities is determined by adding
back or deducting from net income those items that
do not effect on cash. The following are the common
types of adjustments that are made to net income to
arrive at net cash flow from operating activities.
Adjustments Needed to Determine Net Cash Flow from
Operating Activities Using Indirect Method
|
Net
Income |
|
Additions |
Deductions |
|
Depreciation expense |
Amortization of bond premium |
|
Importance of intangibles and
deferred charges |
Decrease in deferred income tax
liabilities |
|
Amortization of bond discount |
Income
on investment in common stock using
equity method |
|
Increase in deferred income tax
liability |
Gain
on sale of plant assets |
|
Loss
on investment in common stock using
equity method |
Increase in receivables |
|
Loss
on sale of plant assets |
Increase in inventories |
|
Loss
on written down of assets |
Increase in prepaid expenses |
|
Decrease in receivables |
Decrease in accounts payable |
|
Decrease in inventories |
Decrease in accrued liabilities |
|
Decrease in prepaid expenses |
|
|
Increase in accounts payable |
|
|
Increase in accrued liabilities |
|
|
The
additions and deductions listed above reconcile net
income to net cash flow from operating activities,
illustrating the reason for referring to the
indirect method as reconciliation method.
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Note:
Direct and indirect methods are different
only to the extent of the calculation of
cash flows from operating activities, cash
flows from investing and financing
activities are calculated in the same
manner. |
Example:
|
Cash
flow from operating activities: |
|
|
|
Net
income |
|
117000 |
|
Adjustments to reconcile net income
to net cash used/provided by
operating by activities: |
|
|
|
Depreciation expenses |
14,800 |
|
|
Amortization of trade mark |
2,400 |
|
|
Amortization of bond premium |
(1,000) |
|
|
Equity in earnings of Porter Co. |
(3,500) |
|
|
Gain on condemnation of land |
(8,000) |
|
|
Loss on sale of equipment |
1,500 |
|
|
Increase in deferred tax liabilities |
3,000 |
|
|
Increase in accounts receivable
(net) |
(53,000) |
|
|
Increase in inventories |
(152,000) |
|
|
Decrease in prepaid expenses |
500 |
|
|
Increase in accounts payable |
1,000 |
|
|
Increase in accrued liabilities |
4,000 |
|
|
Decrease in income tax payable |
(13,000) |
203,500 |
| |
|
|
|
Net cash
used by operating activities |
|
(86,500) |
|
|
|
|
|
Direct Method or Income Statement
Method:
Under
the direct method the statement of cash flows
reports net cash flow from operating activities as
major classes of operating cash receipts (e.g., cash
collected from customers and cash received from
interest and dividends) and cash disbursements
(e.g., cash paid to suppliers for goods, to
employees for services, to creditors for interest,
and to government authorities for taxes).
The
direct method is explained on
cash
flow statement direct method page. This method
is illustrated here in more detail to help you
understand the difference between accrual based
income and net cash flow from operating activities
and to illustrate the data needed to apply the
direct method.
Suppose a company which began business on January 1,
2005, has the following balance sheet information:
| |
December 31 |
|
|
2005 |
2004 |
|
Cash |
$159,000 |
0 |
|
Accounts receivable |
15,000 |
0 |
|
Inventory |
160,000 |
0 |
|
Prepaid expenses |
8,000 |
0 |
|
Property, plant, and equipment (net) |
90,000 |
0 |
|
Accounts payable |
60,000 |
0 |
|
Accrued expenses payable |
20,000 |
0 |
|
Company's December 31, 2005, income statement and
additional information are:
|
Revenues from sales |
|
$780,000 |
|
Cost
of goods sold |
|
450,000 |
|
|
|
|
|
Gross
profit |
|
330,000 |
|
Operating expenses |
$160,000 |
|
|
Depreciation |
10,000 |
170,000 |
|
|
|
|
|
Income
before income taxes |
|
160,000 |
|
Income
tax expenses |
|
48,000 |
|
|
|
|
|
Net
income |
|
$112,000 |
|
|
|
|
Additional Information:
(a). Dividends of $70,000 were declared
and paid in cash.
(b). The accounts payable increase resulted
from the purchases of merchandise.
(c). Prepaid expenses and accrued expenses
payable relate to operating
expenses. |
Under
the direct method, net cash provided by operating
activities is computed by adjusting each in the
income statement from the accrual basis to the cash
basis. To simplify and condense the operating
activities section, only major classes of operating
cash receipts and cash payments are reported. The
difference between these major classes of cash
receipts and cash payments is the net cash provided
by operating activities as show below:
Net
Cash Provided by Operating Activities
An
efficient way to apply the direct method is to
analyze the revenues and expenses reported in the
income statement in the order in which they are
listed. Cash receipts and cash payments related to
these revenues and expenses should then be
determined. The direct method adjustments for the
company in 2005 to determine net cash provided by
operating activities are presented in the following
sections.
Cash
Receipts from Customers:
The
income statement of the company reported revenues
from customers of $780,000. To determine cash
receipts from customers, it is necessary to consider
the change in accounts receivables during the year.
When accounts receivable increase during the year,
revenues on an accrual basis are higher than cash
receipts from customers. In other words, operations
led to increased revenues but not all of these
revenues resulted in cash receipts. To determine the
amount of increase in cash receipts, deduct the
amount of the increase in accounts receivable from
the total sales revenue. Conversely, a decrease in
accounts receivable is added to sales revenues,
because cash receipts from customers then exceed
sales revenue. In our example, accounts receivable
increased by $15,000. Thus, cash receipts from
customers were $765,000, computed as follows:
|
Revenues from sales |
$780,000 |
|
Deduct: Increase in accounts
receivable |
15,000 |
|
|
|
|
Cash
receipts from customers |
$765,000 |
|
|
|
|
Cash
receipts from customers may also be determined from
an analysis of the accounts receivable account as
shown below:
Accounts Receivable
1/1/05
Balance
-0-
Revenue from sales
780,000 |
Receipts from customers
765,000 |
|
12/31/05
Balance
15,000 |
|
The
relationship between cash receipts from customers,
revenues from sales, and changes in accounts
receivable are shown below:
Formula to
compute cash receipt from customers
|
Cash
receipts from customers |
= |
Revenues from sales |
{ |
+
Decrease in accounts receivable
or
- Increase in accounts receivable |
|
Cash Payments to Suppliers:
In our
example, company reported
cost of
goods sold on its
income
statement of $450,000. To determine cash payment to
suppliers, it is first necessary to fine for the year.
To find purchases, cost of goods sold is adjusted for
the change in inventory. When inventory increases during
the year, it means that purchases this year exceed cost
of goods sold. As a result, the increase in inventory is
added to cost of goods sold to arrive at purchases.
In 2005
the company's inventory increased $160,000. Purchases,
therefore, are computed as follows:
|
Cost
of goods sold |
$450,000 |
|
Add:
Increase in inventory |
160,000 |
|
|
|
|
Purchases |
$610,000 |
|
|
|
|
After
purchases are computed, cash payments to suppliers
are determined by adjusting purchases for the change
in accounts payable. When accounts payable increase
during the year, purchases on an accrual basis are
higher than they are on a cash basis. As a result,
an increase in accounts payable is deducted from
purchases to arrive at cash payments to suppliers.
Conversely, a decrease in accounts payable is added
to purchases because cash payments o suppliers
exceed purchases. Cash payment to suppliers are
$550,000 computed as follows:
|
Purchases |
$610,000 |
|
Deduct: Increase in accounts payable |
60,000 |
|
|
|
|
Cash
payments to suppliers |
$550,000 |
|
|
|
|
Cash
payments to suppliers may also be determined from an
analysis of the accounts payable account as shown
below:
Accounts Payable
|
Revenue from sales
550,000 |
1/1/05
Balance
-0-
Revenue from sales
610,000 |
| |
12/31/05
Balance
60,000 |
The
relationships between cash payments to customers, cost
of goods sold, changes in inventory, and changes in
accounts payable are shown below:
Formula to
compute cash payments to suppliers
|
Cash
payments to suppliers |
= |
Cost
of goods sold |
{ |
+
Increase in inventory
or
- Decrease in inventory |
{ |
+
Decrease in accounts payable
or
- Increase in accounts payable |
|
Cash
Payments for Operating Expenses:
In our
example, the operating expenses of $160,000 are reported
on the income statement of the company. To determine the
cash paid for operating expenses, this amount must be
adjusted for any changes in prepaid expenses and accrued
expenses payable. For example, when prepaid expenses
increased $8,000 during the year, cash paid for
operating expenses was $8,000 higher than operating
expenses reported on the income statement. To convert
operating expenses to cash payments for operating
expenses, the increase of $8,000 must be added to
operating expenses. Conversely if prepaid expenses
decrease during the year, the decrease must be deducted
from operating expenses
Operating
expenses must also be adjusted for changes in accrued
expenses payable. When accrued expenses payable increase
during the year, operating expenses on an accrual basis
are higher than they are on a cash basis. As a result,
an increase in accrued expenses payable is deducted from
operating expenses to arrive at cash payments for
operating expenses. Conversely, a decrease in accrued
expenses payable is added to operating expenses because
cash payments exceed operating expenses. The cash
payments for operating expense of the company in our
example is $148,000 computed as below:
|
Operating expenses |
$160,000 |
|
Add:
Increase in prepaid expenses |
8,000 |
|
Deduct: Increase in accrued expenses
payable |
(20,000) |
|
|
|
|
Cash
payments to suppliers |
$148,000 |
|
|
|
|
The
relationships among cash payments for operating
expenses, changes in prepaid expenses, and changes
in accrued expenses payable are shown below:
Formula to
compute cash payments for operating expenses
|
Cash
payments for operating expenses |
= |
Operating expenses |
{ |
+
Increase in prepaid exp.
or
- Decrease in prepaid exp. |
{ |
+
Decrease in accrued exp. payable
or
- Increase in accrued exp. payable |
|
Depreciation expense has not been considered,
because depreciation is a non-cash expense.
Cash
Payments for Income Taxes:
The income
statement of the company in our example shows income tax
expenses $48,000. This amount equals the cash paid
because the comparative balance sheet indicates no
income tax payable at either the beginning or end of the
year.
Summary of Net Cash Flows from
Operating Activities - Direct method:
The
computations illustrated above are summarized in the
following schedule:
Accrual
Basis to Cash Basis
|
Accrual Basis |
|
Adjustments |
Add
(Subtract) |
Cash
Basis |
|
Revenue from sales |
$780,000 |
- |
Increase in accounts receivable |
$(15,000) |
$765,000 |
|
Cost
of goods sold |
450,000 |
+ |
Increase in inventory |
160,000 |
|
| |
|
- |
Increase in accounts payable |
(60,000) |
550,000 |
|
Operating expenses |
160,000 |
+ |
Increase in prepaid expenses |
8,000 |
|
| |
|
- |
Increase in accrued expenses |
(20,000) |
148,000 |
|
Depreciation expenses |
10,000 |
- |
Depreciation expenses |
(10,000) |
-0- |
|
Income
tax expenses |
48,000 |
|
|
|
48,000 |
| |
|
|
|
|
|
|
Total
expenses |
668,000 |
|
|
|
746,000 |
| |
|
|
|
|
|
|
Net
income |
$112,000 |
|
Net
cash provided by operating
activities |
$19,000 |
| |
|
|
|
|
|
|
Presentation of the direct method for reporting net
cash flow from operating activities takes the
following form:
|
Cash
received from operating activities: |
|
|
|
Cash
received from customers |
|
$765,000 |
|
Cash
payments: |
|
|
|
To
suppliers |
$
550,000 |
|
|
For
operating expenses |
148,000 |
|
|
For
income taxes |
48,000 |
746,000 |
|
|
|
|
|
Net
cash provided by operating
activities |
|
$19,000 |
|
|
|
|
|
If the
company uses the direct method to present the net
cash flows from operating activities, it will
provide a separate schedule of the reconciliation of
net income to net cash provided by operating
activities. The reconciliation assumes the identical
form and content of the indirect method of
presentation as shown below:
|
Cash
flow from operating activities: |
|
|
|
Net
income |
|
$112,000 |
|
Adjustments to reconcile net income
to net cash used by
operating by activities: |
|
|
|
Depreciation expenses |
10,000 |
|
|
Increase in accounts receivable
|
(15,000) |
|
|
Increase in inventories |
(160,000) |
|
|
Increase in prepaid expenses |
(8,000) |
|
|
Increase in accounts payable |
60,000 |
|
|
Increase in accrued expenses payable |
20,000 |
$(93,000) |
| |
|
|
|
Net cash
provided by operating activities |
|
$19,000 |
|
|
|
|
|
The reconciliation
may be presented at the bottom of the statement of
cash flows when the direct method is used or in a
separate schedule.
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