A company can present its net cash flow from operating activities by using either a direct method or an indirect method approach in the statement of cash flows. The direct method presents the specific amounts of cash received and cash paid for each significant item and the resulting net cash flow arising from operating activities. By contrast, the indirect method shows only the net effect of items which caused net income and net operating cash flows to differ.

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You may wonder why I post about cash flow statement from the operating activities only (not the whole activities). From my personal experience (when I was a junior accountant about 13 years ago), direct and indirect method of the ‘cash flow from operating activities’ was the hardest part of the cash flow statement topic, and I didn’t know why. I thought it was because of I am kind of slow learner. But, as the time gone by and run cash flow statement process more and more, I found the real answer. It is because of the data source—which is about equal to running another income statements plus a half of the balance sheet.

Obviously this post is dedicated to those whose find the same experience as I did—not to those whose been a cash flow statement master. I am going to explain and provide examples to illustrate these concepts through this post. But before that, let me do a flash overview of accrual versus cash basis accounting—particularly in the income statements and cash flow statements. 

 

Accrual Basis Versus Cash Basis Accounting

If you compare income statement results of a company with its operating activities section of the statement of cash flows, you will find some similarities and some differences. The income statement and the operating activities section of the statement of cash flows are similar in that both present information about the primary business activities: the income earned and cash flows from providing services or selling goods.

However, the income statement and the cash flow statement differ in that the income statement shows revenues earned, expenses incurred, and the resulting net income or loss without regard to cash flows, using the accrual basis concept.

Preparing the operating activities section of the statement of cash flows is much like preparing the income statement, but using the cash basis of accounting. Although cash basis information is important and valuable, an income statement prepared on the cash basis generally is not considered the best measure of a company’s operating performance.

 

Which Method to Use: Direct or Indirect?

The accounting profession encourages the use of the direct method, with additional disclosure using the indirect method in a supplemental schedule that is referred to as the schedule reconciling net income to net cash flows from operating activities.

However, it is permissible to use only the indirect method in the statement of cash flows. In fact, and perhaps unfortunately, the indirect method is used more widely in published financial statements. Although the indirect method does make sense and provides valuable information, it is not as straightforward or easily understood as the direct method.

To discuss basic concepts and illustrate how operating cash flows are reported using both the direct and indirect approaches. I use a condensed income statement for Lie Dharma Company as shown below:

Sales Revenue                                                             $800,000
Cost of Goods Sold and Operating Expenses    (696,000)
Operating Income                                                         104,000

Interest Income                                                                  1,000
Interest Expense                                                              (5,000)
Net Income                                                                  $100,000

 

Using Direct Method

If Lie Dharma Company uses the direct method, net operating cash flows will be based on the specific amounts of cash received and paid for all significant (material) income statement items, as shown below:

Cash Receipts from Operating Activities
Cash collections from customers                                  $782,000
Interest earned on investments                                             1,000
Total                                                                                          $783,000
Cash Payments for Operating Activities
Merchandise purchases and operating expenses     733,000
Interest on notes payable                                                        5,000
Total                                                                                          (738,000)

Net Cash Flows from Operating Activities                  $45,000 (=$783,000 – 738,000)

The detailed cash-flow information presented in the direct method approach is useful in assessing differences between revenues and related cash receipts and between expenses and related cash payments.

The information provided can be understood readily by persons with little background in accounting and is useful to managers in evaluating budgeted and actual cash flows. For example, you can see that Lie Dharma Company earned $800,000 sales revenue, but only $782,000 was received in cash this year. It had cost of goods sold and operating expenses of $696,000 but its cash payments for these items was $733,000 during the year. We will discuss the reasons for these differences in later using more comprehensive examples.

 

Using Indirect Method

If Lie Dharma Company uses the indirect method, net operating cash flows will be determined by using the differences between net income and cash flows for particular items. For example, the difference between revenues and actual cash collections is related to the increase or decrease in customer receivables. Similarly, the difference between expenses and cash payments is related to prepayments and expenses payable.

Net Income                                                                   $100,000

Differences between net income and
net cash flows from operating activities:

Revenues earned this period which were
not received in cash                                                     (18,000)
Cash payments for expenses of
previous or future time periods                             (37,000)
Net Cash Flows from Operating Activities         $45,000

The income statement I presented above is not exactly what one would see in an actual financial statement, but it illustrates the concept of the indirect method, which I am going to discuss and illustrate in more detail in more comprehensive example.

As you can see, both methods arrived at net cash flows from operating activities of $45,000. The direct method shows the specific amounts of actual cash receipts and payments, while the indirect method shows the differences between revenues earned and cash received and the differences between expenses incurred and actual cash payments for those expenses.

[Info_Box]Although most revenues earned and expenses incurred will also be received or paid in the same financial statement period, some cash flows may occur before the revenues are earned or the expenses incurred and some cash flows may occur in a later period.[/Info_Box]

 

Cash Flow From Operating Activities (A Comprehensive Examples)

Let’s expand the discussion of operating cash flows using more specific information and more detailed version of Lie Dharma Company’s income statement presented below:

Cash Flow From Operating Activities

Next, I am going to illustrate each item in the above income statement with a set of extensive case examples (I am going to try to make it as close as it is in a real transaction)

Item-1: Sales Revenue versus Cash Receipts from Customers – 

Lie Dharma Company started the year with $13,000 of accounts receivable from the prior year’s sales, all of which were collected in cash this year. It earned $800,000 of sales revenue this year, all from credit sales. Of that amount, $769,000 was collected in cash and the remaining $31,000 is in year-end accounts receivable.

Below figure shows how this information might appear in the financial statements.

INCOME STATEMENT
Sales Revenue Earned                                      $800,000
STATEMENT OF CASH FLOWS

From Operating Activities, Direct Method
Cash receipts from customers                     $782,000

OR

From Operating Activities: Indirect Method
Net Income                                                         $100,000
Less: Increase in Accounts Receivable      (18,000)

The income statement reports the $800,000 of sales revenue earned during the year in accordance with the revenue recognition principle. In the statement of cash flows, the direct method shows the amount actually collected in cash of $782,000, which includes the beginning accounts receivable of $13,000 and $769,000 of the current year’s credit sales.

By contrast, the indirect method shows only the $18,000 difference between sales revenue ($800,000) and actual cash receipts ($782,000) as a deduction from net income due to the increase in accounts receivable. An increase in accounts receivable means that not all of this year’s revenue earned from credit sales were collected in cash; thus, operating cash flows were $18,000 less than net income. If receivables had decreased, rather than increased, this amount would be added to net income signifying that cash collections were greater than the amount of sales revenue earned.

 

Item-2: Cost of Goods Purchased versus Cash Paid to Merchandise Suppliers

Lie Dharma Company started the year with $36,000 of accounts payable from the prior year’s purchases of merchandise, all of which were paid in cash this year. It purchased $525,000 this year, all on credit. Of this amount, $509,000 was paid in cash and the remainder of $16,000 is in year-end accounts payable.

Below figure shows how this information might appear in the financial statements.

INCOME STATEMENT

Cost of Goods Sold:
Inventory, January 1                               $xxx,xxx
Add: Purchases                                             525,000
Cost of Goods Available for Sale             xxx,xxx
Less: Inventory, December 31                 (xx,xxx)
Cost of Goods Sold                                    ($xxx,xxx)

STATEMENT OF CASH FLOWS
Operating Activities: Direct Method
Cash paid to suppliers                            ($545,000)

OR

Operating Activities: Indirect Method
Net Income                                                    $100,000
Less: Decrease in accounts payable       (20,000)

Recall that the cost of inventory purchased is not an expense in the income statement until the inventory has been sold. As will be discussed in the example to follow, the amount reported as cost of goods sold is based on not only the $525,000 of inventory purchased, but also the amounts of inventory on hand at the beginning and end of the year.

The direct method shows the cash payments to suppliers of $545,000 as an operating cash outflow; this amount includes the payment of the $36,000 accounts payable owed at the beginning of the year and $509,000 cash payments for some, but not all, of the inventory purchased on credit during the year.

The indirect method shows only the $20,000 difference between the amount of inventory purchased on credit ($525,000) and the cash payments to suppliers ($545,000) as a deduction from net income. A decrease in accounts payable means that the company paid more cash to suppliers than the amount of inventory it purchased during the year. If accounts payable instead had increased, it would signify that cash payments to suppliers were less than the amount of credit purchases, and this difference would be added to net income.
Item- 3: Cost of Goods Purchased versus Cost of Goods Sold

The previous items (on the previous page) focused on the difference between cash payments to suppliers and inventory purchased on credit during the year, but any difference between the amount of inventory purchased versus the amount sold also must be considered. As you may have known that inventory costs are expenses when the inventory is sold and matched with the sales revenue reported in the income statement for that period, and not as expenses in the period when purchased.

So, continuing on with the previous example, the difference between the amount of inventory purchased versus the amount sold is also considered and illustrated below.

Lie Dharma Company started the year with $40,000 of merchandise inventory which it purchased during the previous year and had $525,000 of additional credit purchases of inventory this year; thus, during the year a total of $565,000 of inventory was on hand and available for sale. Of this amount, goods which cost $500,000 were sold and the remaining $65,000 were still on hand and included in year-end inventory.

Below figure shows the financial statement effects for cost of goods sold and cash payments to suppliers, taking into consideration the differences between credit purchases versus cash payments to suppliers, as well as the additional effects of the difference between the amounts purchased versus the amount of inventory sold that was discussed above.

INCOME STATEMENT
Cost of Goods Sold:
Inventory, January 1                                    $40,000
Add: Purchases                                                 525,000
Cost of Goods Available for Sale                565,000
Less: Inventory, December 31                    (65,000)
Cost of Goods Sold                                      $(500,000)

STATEMENT OF CASH FLOWS
Operating Activities: Direct Method
Cash paid to suppliers                                $(545,000)

OR

Operating Activities: Indirect Method
Net Income                                                             $ 100,000
Less: Decrease in Accounts Payable                (20,000)
Less: Increase in Merchandise Inventory     (25,000)

The $45,000 difference between cost of goods sold of $500,000 (treated as an expense in the income statement) and the $545,000 cash paid to suppliers (treated as an operating cash outflow in the statement of cash flows) arose for two reasons:

  • First, Lie Dharma Company’s cash payments to suppliers on account were $20,000 more the cost of the inventory it purchased on credit, which resulted in a $20,000 decrease in accounts payable by year-end.
  • Second, Lie Dharma Company purchased $25,000 more inventory than it sold during the year, which resulted in a $25,000 increase in merchandise inventory by year-end.

When reported operating cash flows are based on the direct method, the specific amount of cash paid to suppliers of $545,000 is shown. By contrast, if Lie Dharma Company reports operating cash flows based on the indirect method, the adjustments to net income reveal that: (1) cash payments to suppliers exceeded the amount purchased on credit – accounts payable decreased; and (2) inventory purchased on credit exceeded the amount sold – inventory increased.

 

Item-4: Depreciation Expense

Depreciation expense is a bit different from most other types of operating expenses reported in the income statement and is also handled in a different manner in the statement of cash flows.

You may recall that depreciation, depletion, and amortization allocate a portion of the cost of an asset as an expense during each period of use according to the matching principle and that these do not represent operating expenses that will require the payment of cash. Any cash paid at the time of purchase is considered an investing and not an operating cash flow, and if the purchase was financed with borrowed funds, the principal amounts repaid are considered financing, not operating activities.

Depreciation expense is used in determining net income, but as a noncash expense it is either omitted from operating activities in the direct method approach or added to net income as a noncash item in the indirect method approach, as shown below.

INCOME STATEMENT
Depreciation Expense                                        $(10,000)

STATEMENT OF CASH FLOWS
From Operating Activities: Direct Method
(not applicable, no cash paid)

OR

From Operating Activities: Indirect Method
Net Income                                                             $100,000
Add: Depreciation Expense                                    10,000

Concepts similar to those discussed in the examples above also apply to most other types of revenues and expenses. Visual representations and financial statement results for Lie Dharma Company’s other revenues and expenses are presented and briefly discussed in the items which follow.

 

Item-5: Salaries and Wages Expense versus Cash Payments to Employees

Lie Dharma Company incurred salary and wage expenses of $130,000, of which $125,000 was paid in cash and the remaining $5,000 is owed to employees and included in year-end salaries and wages payable. It also paid the $4,000 of salaries it owed to employees at the end of the prior year. The $1,000 increase in salaries and wages payable represents the difference between the current year’s salary and wages expense ($130,000) and the cash payments made to employees ($129,000).

Below figure shows how this information might appear in the financial statements.

INCOME STATEMENT
Salaries and Wages Expense                                  $(130,000)

STATEMENT OF CASH FLOWS
From Operating Activities: Direct Method
Cash paid to employees                                           $(129,000)

OR

From Operating Activities: Indirect Method
Net Income                                                                      $100,000
Add: Increase in Salaries and Wages Payable            1,000

 

Item-6: Supplies and Postage Expense versus Cash Payments for Supplies Purchased

Lie Dharma Company used $7,000 of supplies during the year but purchased and paid for only $6,000 of supplies; thus, its supplies inventory decreased by $1,000. It used the $2,000 of supplies on hand at the beginning of the year and $5,000 of the $6,000 of the supplies purchased and has $1,000 of supplies on hand at year-end.

Below figure shows how this information might appear in the financial statements.

INCOME STATEMENT
Supplies and Postage Expense                                     $ (7,000)

STATEMENT OF CASH FLOWS
From Operating Activities: Direct Method
Cash paid to purchase supplies and postage           $ (6,000)

OR
From Operating Activities: Indirect Method
Net Income                                                                          $100,000
Add: Decrease in Supplies and Postage on Hand          1,000

 

Item-7: Insurance Expense versus Cash Payments for Insurance

Lie Dharma Company purchased $11,000 of insurance during the year, but only $9,000 was an expense of this year; thus, its year-end prepaid insurance increased by $2,000. The prepaid insurance at the beginning of the year was used, but only $6,000 of the additional insurance purchased during the year was used, and so year-end prepaid insurance is $5,000.

Below figure shows how this information might appear in the financial statements.

INCOME STATEMENT
Insurance Expense                                                        $ (9,000)

STATEMENT OF CASH FLOWS
From Operating Activities: Direct Method
Cash paid to purchase insurance                            $(11,000)

OR
From Operating Activities: Indirect Method
Net Income                                                                     $100,000
Less: Increase in Prepaid Insurance                         (2,000)

 

Item-8: Property Tax Expense versus Cash Payments for Property Taxes

Lie Dharma Company incurred property tax expense of $5,000, paid $4,000 of this amount in cash and the remaining $1,000 is in year-end property taxes payable. Property tax payments totaled $7,000, which included the payment of $4,000 of the current year’s property tax expense and the $3,000 it owed from the prior year. The $2,000 decrease in property tax payable signifies that the cash payments ($7,000) were greater than the current year’s property tax expense ($5,000).

Below figure shows how this information might appear in the financial statements.

INCOME STATEMENT
Property Tax Expense                                                 $ (5,000)

STATEMENT OF CASH FLOWS
From Operating Activities: Direct Method
Cash paid for property taxes $                                    (7,000)

OR
From Operating Activities: Indirect Method
Net Income                                                                     $100,000
Less: Decrease in Property Taxes Payable              (2,000)

 

Item- 9: Revenues Earned and Received and Expenses Incurred and Paid in the Same Period

Other revenues and expenses in Lie Dharma Company’s income statement were received or paid in cash during the same year, such as the $1,000 of interest income, the $5,000 of interest expense, and the $20,000 for advertising and $15,000 for telephone and utility expenses. The specific amounts of cash received or paid for these revenues and expenses are presented as operating cash flows when using the direct method approach.

If operating cash flows are reported using the indirect method approach, there is no need to show adjustments to net income because the amounts reported as revenues and expenses under the accrual basis of accounting are identical to the amounts of the cash received or paid during the same time period.

 

Item-10: Nonoperating Gains and Losses

In addition to the net income and net operating cash flow differences discussed and illustrated earlier, there is one more concept you may encounter when reviewing a company’s statement of cash flows: the treatment of nonoperating gains and losses.

Although Lie Dharma Company did report interest income and interest expense separately from the revenues and expenses arising from its routine and ongoing operations, it did not have any gains or losses to report this year, and so I am going to use  different and unrelated example to explain how nonoperating gains and losses are treated in the statement of cash flows.

As you probably know that when a company sells a plant asset or an investment it owns, the difference between the selling price and the book value of the asset or investment is reported as a gain or as a loss in its income statement. While, purchases and sales of assets used by the business or investments it owns are considered to be investing activities, and not operating activities; thus, the cash received from the sale of such an asset or investment is classified as an investing activity cash flow and does not appear in the operating cash flows when the direct method approach is used.

However, when the indirect method approach is used to report operating cash flows, any nonoperating gains that are included in the amount of net income reported in the income statement should be deducted, and any nonoperating losses should be added to net income. The cash received from the sale of an asset or investment, whether sold at a gain or at a loss, is classified as an investing cash inflow.

For example, assume both accounting income and operating cash flows were $100,000, excluding any effects from the sale of equipment. If equipment with a book value of $20,000 was sold for $25,000, a $5,000 gain from the sale would be included in the amount of net income reported in the income statement.

In the statement of cash flows, the sale of equipment is considered an investing activity, and the $25,000 cash proceeds from the sale should be reported as an investing cash inflow. If the indirect method is used to report operating cash flows, the $5,000 nonoperating gain must be deducted from net income as it did not produce an operating cash flow.

The financial statements would include the information shown below:

INCOME STATEMENT
Operating Income                                                  $100,000
Other Income and Expense:
Gain on sale of equipment                                           5,000
Net Income                                                                $105,000

STATEMENT OF CASH FLOWS
Operating Activities: Direct Method
(cash received from equipment sale is an
investing, not an operating cash flow)            $100,000

OR
Operating Activities: Indirect Method
Net Income                                                                 $105,000
Less: Gain on sale of equipment                               (5,000)
Net cash fl ows from operating activities      $100,000

Investing Activities
Cash received from sale of equipment              $ 25,000

Notice that the net operating cash flow of $100,000 was not affected by the equipment sale; the $25,000 cash received from the equipment sale was an investing activity cash flow, not an operating cash flow.

If instead the equipment had been sold for $18,000, a $2,000 loss from the sale would have been deducted in arriving at the amount of net income reported in the income statement.

Similar to the previous example, the $18,000 cash proceeds from the sale should be reported in the statement of cash flows as an investing activity. If the indirect method is used to report operating cash flows, the $2,000 nonoperating loss which reduced net income but did not result in a cash outflow must be added back to net income to arrive at the proper amount of operating cash flows. The financial statements would include the information shown below:

INCOME STATEMENT
Operating Income                                                   $100,000
Other Income and Expense
Loss on sale of equipment                                          (2,000)
Net Income                                                                  $  98,000

STATEMENT OF CASH FLOWS
Operating Activities: Direct Method
(cash received from equipment sale is an
investing, not an operating cash flow)            $100,000

OR
Operating Activities: Indirect Method
Net Income                                                                  $ 98,000
Add: Loss on sale of equipment                                 2,000
Net cash flows from operating activities       $100,000

Investing Activities
Cash received from sale of equipment              $ 18,000

As in the previous item, the net operating cash flows of $100,000 has not changed; the equipment sale generated an $18,000 investing activity cash flow and did not affect operating cash flows.

All those items above illustrated and explained why the amount of a specific revenue or expense that was reported in the income statement may differ from the amount of the related cash receipt or cash payment during the same time period. And, putting all the items altogether, here how the operating activity section of Lie Dharma Company’s statement of cash flows using direct and indirect methods.

Cash Flow Direct and Indirect Methods

In the next post, I probably discuss investing and financing activities as well, and the way they are reported in the statement of cash flows, also the concept of cash equivalents.