Direct and Indirect Methods for Preparing a Statement of Cash Flows

Cash flows from operating activities

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 Statement of Financial Accounting Standards No. 95 encourages use of the direct method but permits use of the indirect method. Whenever given a choice between the indirect and direct methods in similar situations, accountants choose the indirect method almost exclusively. The American Institute of Certified Public Accountants reports that approximately 98% of all companies choose the indirect method of cash flows.

The direct method converts each item on the income statement to a cash basis. For instance, assume that sales are stated at $100,000 on an accrual basis. If accounts receivable increased by $5,000, cash collections from customers would be $95,000, calculated as $100,000 – $5,000. The direct method also converts all remaining items on the income statement to a cash basis.

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.

The most common example of an operating expense that does not affect cash is depreciation expense. The journal entry to record depreciation debits an expense account and credits an accumulated depreciation account. This transaction has no effect on cash and, therefore, should not be included when measuring cash from operations. Because accountants deduct depreciation in computing net income, net income understates cash from operations. Under the indirect method, since net income is a starting point in measuring cash flows from operating activities, depreciation expense must be added back to net income.

Consider the following example. Company A had net income for the year of $20,000 after deducting depreciation of $10,000, yielding $30,000 of positive cash flows. Thus, Company A had $30,000 of positive cash flows from operating activities. Company B had a net loss for the year of $4,000  but after deducting $10,000 of depreciation, it had $6,000 of positive cash flows from operating activities, as shown here:

  Company A Company B
Net income (loss) $20,000 $(4,000)
Add depreciation expense (which did not require use of cash) 10,000 10,000
Positive cash flows from operating activities $30,000 $ 6,000
Companies may add other expenses and losses back to net income because they do not actually use company cash in addition to depreciation.  The items added back include amounts of depletion that were expensed, amortization of intangible assets such as patents and goodwill, and losses from disposals of long term assets or retirement of debt.

To illustrate the add back of losses from disposals of noncurrent assets, assume that Quick Company sold a piece of equipment for $6,000. The equipment had cost $10,000 and had accumulated depreciation of $3,000.   The book value of the equipment is $7,000 and we received $6,000 cash for the equipment.  The cash would be reported in the investing section since equipment is a long term asset.  The difference between our book value $7,000 and the cash received $6,000 is the loss of $1,000 which represents receiving less than it is worth but does not equal cash.  The journal entry to record the sale is:

 

Cash
Debit

6,000
 Credit

 
Accumulated depreciation 3,000
Loss on sale of equipment 1,000
  Equipment 10,000
 To record disposal of equipment at a loss.
Although Quick deducted the loss of $1,000 in calculating net income, it recognized the total $ 6,000 effect on cash (which reflects the $1,000 loss) as resulting from an investing activity. Thus, Quick must add the loss back to net income in converting net income to cash flows from operating activities to avoid double-counting the loss.

The same process would apply to gains on sales of long term assets or retirement of debt since the cash will be accounted for in later cash flow sections we want to remove the effect from net income so any gains will be subtracted from net income.

To illustrate why we deduct the gain on the disposal of a noncurrent asset from net income, assume that Quick sold the equipment just mentioned for $9,000. The journal entry to record the sale is:

Cash 9,000
Accumulated depreciation 3,000
  Equipment 10,000
  Gain on sale of equipment (9,000cash - 7,000 book value) 2,000
 To record disposal of equipment at a gain.
Quick shows the $9,000 inflow from the sale of the equipment on its statement of cash flows as a cash inflow from investing activities. Thus, it has already recognized the total $9,000 effect on cash (including the $2,000 gain) as resulting from an investing activity. Since the $2,000 gain is also included in calculating net income, Quick must deduct the gain in converting net income to cash flows from operating activities to avoid double-counting the gain.

As a general rule, an increase in a current asset (other than cash) decreases cash inflow or increases cash outflow. Thus, when accounts receivable increases, sales revenue on a cash basis decreases (some customers who bought merchandise have not yet paid for it). When inventory increases, cost of goods sold on a cash basis increases (increasing cash outflow). When a prepaid expense increases, the related operating expense on a cash basis increases. (For example, a company not only paid for insurance expense but also paid cash to increase prepaid insurance.) The effect on cash flows is just the opposite for decreases in these other current assets.  Why do we not include cash?  The purpose of our cash flow is to reconcile cash so we will use the figure later.

An increase in a current liability increases cash inflow or decreases cash outflow. Thus, when accounts payable increases, cost of goods sold on a cash basis decreases (instead of paying cash, the purchase was made on credit). When an accrued liability (such as salaries payable) increases, the related operating expense (salaries expense) on a cash basis decreases. (For example, the company incurred more salaries than it paid.) Decreases in current liabilities have just the opposite effect on cash flows.  A short term notes payable from a bank would be treated as a financing activity and not an operating activity.

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To summarize, the indirect method for calculating the operating activities of a statement of cash flows includes:

Cash Flows from Operating Activities:

Net Income
+ Depreciation Expense (from income statement)
+ Losses (from income statement)
- Gains (from income statement)
+ Amortization, depletion (from income statement)
+ DECREASE in Current Assets (other than cash)
- INCREASE in Current Assets (other than cash)
+ Increase in Current Liabilities
- Decrease in Current Liabilities
Net cash provided by Operating Activities
 

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