Accounting: The Language of Business - Vol. 1 (Part 99)

You can't make a manager have a coach he doesn't want. I can't make the head of the accounting department work with someone he doesn't want.

Jerry Reinsdorf

 Statement of Cash Flows (Part E)

by

Charles Lamson

Statement of Cash Flows---The Direct Method

As we discussed in a previous post, the manner of reporting cash flows from investing and financing activities is the same under the direct and indirect methods. In addition, the direct method and the indirect method will report the same amount of cash flows from operating activities. However, the methods differ in how the cash flows from operating activities data are obtained, analyzed, and reported.

To illustrate the direct method, we will use the comparative balance sheet and the income statement for Rundell Inc. In this way, we can compare the statement of cash flows under the direct method and the indirect method.

 Exhibit 7 shows the changes in the current asset and liability account balances for Rundell Inc. The income statement in Exhibit 7 shows additional data for Rundell Inc.

EXHIBIT 7 Balance Sheet and Income Statement Data for Direct Method

The direct method reports cash flows from operating activities by major classes of operating cash receipts and operating cash payments. The difference between the major classes of total operating cash receipts and total operating cash payments is the net cash flow from operating activities.

Cash Received from Customers

The $1,180,000 of sales for Rundell Inc. is reported by using the accrual method [revenues and expenses are recorded when they are earned, regardless of when the money is actually received or paid (bench.co)]. To determine the cash received from sales to customers, the $1,180,000 must be adjusted. The adjustment necessary to convert the sales reported on the income statement to the cash received from customers is summarized below.

For Rundell Inc., the cash received from customers is $1,171,000, as shown below.

The additions to accounts receivable for sales on account during the year was $9,000 more than the amount collected from the customers on account. Sales reported on the income statement therefore included $9,000 that did not result in a cash inflow during the year. In other words, the increase of $9,000 in accounts receivable during 2023 indicates that sales on account exceeded cash received from customers by $9,000. Thus, $9,000 is deducted from sales to determine the cash received from customers. The $1,171,000 of cash received from customers is reported in the cash flows from operating activities section of the cash flow statement.

Cash Payments for Merchandise

The $790,000 of cost of merchandise sold is reported on the income statement for Rundell Inc., using the accrual method. The adjustments necessary to convert the cost of merchandise sold to cash payments for merchandise during 2023 are summarized below.

For Rundell Inc., the amount of cash payments for merchandise is $785,200, as shown below:

The $8,000 decrease in inventories indicates that the merchandise sold exceeded the cost of the merchandise purchased by $8,000. The amount reported on the income statement for cost of merchandise sold therefore includes $8,000 that did not require a cash outflow during the year. Thus, $8,000 is deducted from the cost of merchandise sold in determining the cash payments for merchandise.

The $3,200 decrease in accounts payable (merchandise creditors) indicates a cash outflow that is excluded from cost of merchandise sold. In other words, the decrease in accounts payable indicates that cash payments for merchandise were $3,200 more than the purchases on account during 2023. Plus $3,200 is added to the cost of merchandise sold in determining the cash payments for merchandise.  

Cash Payments for Operating Expenses

The $7,000 of depreciation expense reported on the income statement did not require a cash outflow. Thus, under the direct method, it is not reported on the statement of cash flows. The $196,000 reported for other operating expenses is adjusted to reflect the cash payments for operating expenses, as summarized below.

For Rundell Inc., the amount of cash payments for operating expenses is $193,800, determined as follows:

The increase in accrued expenses (operating expenses) indicates that operating expenses include $2,200 for which there was no cash outflow (payment) during the year. In other words, the increase in accrued expenses indicates that the cash payments for operating expenses were $2,200 less than the amount reported as an expense during the year. Thus $2,200 is deducted from the operating expenses on the income statement in determining the cash payments for operating expenses. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 654-657*

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