Accounting: The Language of Business - Vol. 2 (Intermediate: Part 73)

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Even before he came to power in 1997, Gordon Brown promised to change the accounts to parliament from simple litanies of cash in and cash out, to a more commercial system that took notice of the public property the departments were using. This system is known as resource accounting.

James Buchan

Statements of Financial Position and Cash Flows and the Annual Report (Part K)

by

Charles Lamson

EXAMPLE 6.1  Operating Cash Flows: and Direct Method

PROBLEM: Walker Welding Company provided you with the following information for the current year:

Compute net cash flow from operating activities for Walker Welding under the indirect reporting format.

SOLUTION: The indirect method requires applying a series of adjustments to net income to arrive at net cash flow from operating activities. We first add back depreciation expense because it is a noncash expense. That is, depreciation is an expense deducted on the income statement reducing net income, but it does not use cash. 

Because accounts receivable increased by $6,000 during the year, Walker Welding did not collect all of its sales. As a result, we subtract the increase in accounts receivable from net income to determine the cash collected from customers.

Accrual-basis expense is recognized at the same time that the accounts payable is recognized. However, if accounts payable increase, this indicates that Walker Welding has not yet paid the balance. Therefore, less cash is paid for expenses than reported under the accrual basis on the income statement. So, we add the increase in accounts payable back to net income to reflect the cash paid for these expenses.

The accrual-basis income tax expense is recognized at the same time that the income taxes payable is reported. Because the payable balance decreased, Walker Welding actually paid more for income taxes than it recorded as expense this year. In other words, the company paid all of this year's taxes and the remaining liability from last year. Thus, its cash-basis tax expense was higher than its accrual-basis tax expense, and we deduct the decrease in income tax payable from net income to arrive at operating cash flow.

 Walker's operating activities section of the statement of cash flows follows.

Indirect Method: International Financial Reporting Standards (IFRS). Under IFRS a company can begin its reconciliation to operating cash flows with other income numbers, such as income before taxes or operating income. 

Direct Method of Reporting Cash Flows from Operating Activities. Under the direct method (also referred to as the income statement format) for reporting cash flows from operating activities, companies report actual cash inflows and outflows in the operating section of the statement of cash flows. That is, instead of presenting a reconciliation between net income and net operating cash flows, a company converts each individual income statement line item from the actual to the cash basis.

The FASB prefers the direct method because the cash receipts and cash payments approach is easy to understand.

EXAMPLE 6.2 Operating Cash Flows: Direct Method 

PROBLEM: Using the information provided by Walker Welding Company, compute net cash flow from operating activities using the direct reporting format.

SOLUTION: The direct method uses the same adjustments as the indirect method but applies the adjustments to each income statement line item, as Illustrated in the following computations.

We are now able to prepare the operating activities section under the direct method.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 251-252*

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