Cash Flow Statement Example-Direct and Indirect Method:
Unlike the major financial statements, cash flow statement is not
prepared from the adjusted trial balance. The information to prepare this
statement usually comes from three sources:
- Comparative balance sheets provide the amount of the changes
in assets, liabilities, and equities from the beginning to the end of the
period.
- Current income statement data help the reader determine the
amount of cash provided by or used by operations during the period.
- Selected transaction data from the general ledger provide
additional detailed information needed to determine how cash was provided or
used during the period
Preparing the statement of cash flows from the data sources above involves
three major steps: Step 1. Determine the change in cash:
This procedure is straight forward because the difference between the
beginning and the ending cash balance can be easily computed from an
examination of the comparative balance sheet.
Step 2. Determine the net
cash flow from operating activities:
This procedure is complex. It involves analyzing not only the current year's
income statement but also comparative balance sheets and selected
transitions data. Step 3. Determine net cash flows from investing and
financing activities:
All other changes in the balance sheet accounts must be analyzed to
determine their effects on cash.
Cash Flow Statement Example:
A Comprehensive illustration
To illustrate a statement of cash flows we will use the first year of
operations for Tax Consultants Inc. The company started on January 1, 2003, when
it issued 60,000 shares of $1 par value common stock for $60,000 cash. The
company rented its office space and furniture and equipment, and it performed
tax consulting services throughout the first year. The comparative balance
sheets at the beginning and at the end of the year 2003 appear as follows.
|
Assets
Cash
Accounts receivable
Total
Liabilities and Stockholder's Equity
Accounts payable
Common stock
Retained earnings
Total
|
Dec. 31, 2003
$49,000
$36,000
-----------
$85,000
======
$ 5,000
$60,000
$20,000
---------
$85,000
======= |
Jan. 1, 2003
$-0-
$-0-
---------
$-0-
=====
$-0-
$-0-
$-0-
-------
$-0-
===== |
Change Increase/Decrease
$49,000 increase
$36,000 increase
$ 5,000 increase
$60,000 increase
$20,000 increase
|
The income statement and additional information for Tax Consultation Inc. are
as follows.
Tax Consultants Inc.
Income Statement
For the year ended December 31, 2003
Revenue
Operating expensesIncome before income taxes
Income tax expenses
Net income |
$125,000
$ 85,000
---------
$ 40,000
$ 6,000
----------
$ 34,000
======= |
Step 1: Determine the Change in Cash:
To prepare a statement of cash flows, the first step―determining
the change in cash―is a simple computation. The company has no cash on hand at
the beginning of the year 2003, but $49,000 at the end of 2003. Thus the change
in cash for 2003 was an increase of $49,000
Step 2: Determine Net
Cash Flow from Operating Activities:
A usual starting point in determining net cash flow from operating activities is
to understand why net income must be converted. Under generally accepted
accounting principles, most companies must use the accrual basis of accounting,
requiring revenues be reported when earned and that expenses be recorded when
incurred. Net income may include credit sales that have not been collected in
cash and expenses incurred that may not have been paid in cash. Thus, under the
accrual basis of accounting, net income will not indicate the net cash flow from
operating activities.
To arrive at net cash flow from operating activities, it is necessary to
report revenue and expenses on cash basis. This is done by eliminating the
effects of statement transactions that did not result in a corresponding
increase or decrease in cash.
The conversion of net income into net cash flow from operating activities may
be done through either a direct method or an
indirect method as explained in the
following discussion.
(also called the income statement method) reports cash
receipts and cash disbursements from operating activities. The difference
between these two amounts in the net cash flow from operating activates. In
other words, the direct method deducts from operating cash receipts the
operating cash disbursements. The direct method results in the presentation of a
condensed cash receipts and cash disbursements statement.
As directed from the accrual based income statement, Tax consultants Inc.
reported revenues of $125,000. However, because the company's accounts
receivable increased during 2003 by $36,000, only $89,000 ($125,000 − $36,000) in cash collected on these
revenues. Similarly, company reported operating expenses of $85,000, but
accounts payable increased during the period by $5,000. Assuming that payable
related to operating expenses, cash operating expenses were $80,000 ($85,000 − $5,000). Because no taxes payable exist at
the end of the year, the$6,000 income tax expense for 2003 must have been paid
in cash during the year. Then the computation of net cash flow from operating
activities is as follows:
Cash collected from revenues
Cash payment for expenses
Income before income taxes
Cash payments for income taxes
Net cash provided by operating activities |
$89,000
$80,000
---------
$ 9,000
$ 6,000
---------
$ 3,000
====== |
"Net cash provided by operating activities" is equivalent of cash-basis net
income. ("Net cash used by operating activities" would be equivalent to
cash-basis net loss)
(or reconciliation method) starts with net income
and converts it to net cash flow from operating activities. In other words,
the Indirect method adjusts net income for items that affected reported net
income but didn't affected cash. To compute net cash flows from operating
activities, noncash changes in the income statement are added back to net
income, and net cash credits are deducted. Explanations for the two adjustments
to net income in this example―namely, the accounts
receivable and accounts payable―are as follows.
Increase in Accounts Receivable―Indirect
Method:
When accounts receivable increase during the year, revenues on an accrual
basis are higher than on a cash basis because goods sold on account are reported
as revenues. In other words, operations for the period led to increased
revenues, but not all of these revenues resulted in an increase in cash. Some of
the increase in revenues resulted in an increase in accounts receivable. To
convert net income to net cash flow from operating activities, the increase of
$36,000 in accounts payable must be deducted from net income.
Increase in Accounts Payable―Indirect Method:
When accounts payable increase during the period, expenses on an accrual
basis are higher than they are on a cash basis because expenses are incurred for
which payment has not taken place. To convert net income to net cash flow from
operating activities, the increase of $5,000 in accounts payable must be added
back to net income.
As a result of the accounts receivable and accounts payable adjustments, net
cash provided by operating activities is determined to be $3,000 for the year
2003. This calculation is shown as follows.
Net income
Adjustments to reconcile net income to net cash provided by operating
activities:
Increase in accounts receivable
Increase in accounts payableNet cash provided by operating activities |
$(36,000)
$ 5,000 |
$34,000
($31,000)
----------
$ 3,000
=======
|
Note that net cash provided by operating activities is the same whether the
direct or indirect method is used.
Step 3: Determine Net Cash Flows from Investing and Financing
Activities:
Once the net cash flows from operating activities is computed, the next step
is to determine whether any other changes in balance sheet accounts caused an
increase or decrease in cash.
For example, an examination of the remaining balance sheet accounts for Tax
Consultants Inc. shows that both common and retained earnings have increased.
The common stock increase of $60,000 resulted from the issuance of common stock
for cash. The issuance of common stock is a receipt of cash from a financing
activity and is reported as such in the statement of cash flows. The retained
earnings increase of $20,000 is caused by two items:
- Net income of $34,000 increased retained earnings
- Dividend declared of $4,000 decreased retained earnings.
Net income has been converted into net cash flows from operating activities,
as explained earlier. The additional data indicates that the dividend was paid.
Thus, the dividend payment on common stock is reported as cash outflow,
classified as financing activity.
We are now ready to prepare the statement of cash flows. The statement starts
with the operating activities section. Either the direct or indirect method may
be used to report net cash flow from operating activates.
The statement of cash flows under indirect method for Tax Consultation Inc.
is as follows.
Tax
Consultants Inc.
cash flow statement-Indirect Method
For the year ended December 31, 2003
| Cash Flows From Operating Activities:
Net income
Adjustments to reconcile net income to net cash provided by operating
activities:
Increase in accounts receivable
Increase in accounts payable
Net cash provided by operating activities
Cash Flows From
Financing Activities:
Issuance of common stock
Payment of cash dividend
Net cash provided by financing activities
Net
increase in cash
Cash, January 1, 2003
Cash, December 31, 2003 |
$(36,000)
$ 5,000
---------------
$60,000
$(14,000)
----------
|
$34,000
($31,000)
-------------
$ 3,000
$46,000
-----------
49,000
-0-
----------
$49,000
======= |
As indicated, the $60,000 increase in common stock results in a cash inflow
from a financing activity. The payment of $14,000 in cash dividends is
classified as a use of cash from a financing activity. The $49,000 increase in
cash reported in the statement of cash flows agrees with the increase of $49,000
shown as the change in the cash account in the comparative balance sheet.
|
