Accounting: The Language of Business - Vol. 2 (Intermediate: Part 82)

There is no other proposition in economics that has more solid empirical evidence supporting it than the Efficient Market Hypothesis... In the literature of finance, accounting, and the economics of uncertainty, the EMH is accepted as a fact of life.

Michael Jensen

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

by

Charles Lamson

Reporting Cash Flows from Operating Activities: Direct Method

Under the direct method, companies report actual cash inflows and outflows in the operating section of the statement of cash flows by converting each income statement line item from the accrual basis to the cash basis.

Cash Collected from Customers

To compute cash collected from customers, examine the activity in accounts receivable, which increases with sales revenue and decreases with collections.

This approach focuses on the change in the receivables balance. An increase in accounts receivable indicates that the firm has recorded more revenue than the amount of cash it received. 

Cash Paid for Merchandise

The computation of cash paid for merchandise requires two steps. First, determine the purchases on an accrual basis. Second, determine how much cash the firm spent on these purchases.

Next, review the activity in accounts payable because purchases are usually made on account. Use the purchases computed above to obtain cash paid for merchandise.

                                                 

The beginning and ending balances are obtained from the balance sheet [For more on the balance sheet, see Accounting: The Language of Business - Vol. 2 (Intermediate: Part 64)], and cost of goods sold is reported on the income statement [For more on the income statement, see Accounting: The Language of Business (Part 8)].

Again, we focus on the changes in the balance sheet accounts to determine the cash flow related to acquiring merchandise. If inventory increases, purchases are higher than cost of goods sold. If inventory decreases, purchases are lower than cost of goods sold. In other words, a decrease in inventory indicates that some of the units sold this year were purchased and possibly paid for in prior years.

An increase in accounts payable represents invoices for inventory not paid in the current year. A decrease in accounts payable represents invoices for inventory paid for in the current year but not purchased in the current year.

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 302-303*

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