Direct Method of Preparing the Statement of Cash Flows
If the Financial Accounting Standards Board (FASB)/ International Accounting Standards Board (IASB) proposed changes take effect, the direct method for preparing the statement of cash flows will be required, eliminating the choice of using the indirect method. Unfortunately, many students find the direct method more confusing than the indirect.
However, if you keep in mind the primary purpose of the statement of cash flows, which is to give the users of the financial statements relevant data about cash a business brings in and pays out during a financial period, you should be able to stay more focused with the whole preparation procedure.
Here are a few important direct method basics, to build upon the material in your intermediate accounting textbook:
You show cash received and paid, not net income or loss as shown on the income statement. Why? Because the income statement shows both cash and noncash transactions, and the users of the statement of cash flows want to know about only cash transactions. A biggie noncash transaction is depreciation.
To figure cash receipts from customers, you adjust accrual-based sales revenue by the change in accounts receivable (A/R) during the period. If A/R goes up, you decrease sales revenue. If A/R goes down during the period, it’s an addition to sales revenue.
For example, if during July 2013 the company has sales revenue of $200,000 and a $20,000 decrease to accounts receivable, total cash received from customers is $220,000 ($200,000 + $20,000).
To figure cash payments to suppliers during the period, you use the income statement account, the cost of goods sold (COGS), and the balance sheet accounts, inventory and accounts payable (A/P).
This process involves two steps. First, you adjust the COGS by adding an increase or subtracting a decrease in the inventory account balance during the month. The resulting figure is further adjusted by subtracting an increase or adding back a decrease in the accounts payable account balance during the financial period.
For this computation, COGS is $100,000, inventory shows an increase of $10,000, and A/P shows an increase of $5,000 during the financial period.
Using a portion of the very abbreviated financial statement information from the preceding figure, the following one shows the operating section of the statement of cash flows.
Accounting Glossary
accounting equation
The equation Assets = Liabilities + Equity, which demonstrates the two-sided nature of accounting and is useful for explaining the concept of double-entry accounting (or double-entry bookkeeping).
Accounting Glossary
accounting period
The time period for which financial information is being tracked in a business, such as monthly, quarterly, or annually.
Accounting Glossary
accounts receivable
An account that records the amounts that customers owe to a business.
Accounting Glossary
adjusting entry
A correction made to a bookkeeping account that adjusts for accounting errors or other necessary changes at the end of the accounting period.
Accounting Glossary
cash flows
Used to describe the source or sources of cash or how cash is used.
Accounting Glossary
Chart of Accounts
A list of all the accounts used by a business, including what types of transactions go into each account.
Accounting Glossary
debit
An accounting entry that increases an asset or expense account, and decreases a liability or income account.
Accounting Glossary
dividends
A portion of a company’s profits paid by share of common stock on a quarterly or annual basis.
Accounting Glossary
FASB
Financial Accounting Standards Board. FASB is the highest-ranking authority in the private (non-government) sector of the U.S. for making pronouncements on GAAP and for keeping accounting standards up-to-date.
Accounting Glossary
Federal Unemployment Tax
In the U.S., the fund that used to be known simply as Unemployment. Employers contribute to the fund, and states also collect taxes to fill their unemployment fund reserves. (The acronym FUTA means Federal Unemployment Tax Act.)
Accounting Glossary
fidelity bonds
A type of insurance — typically carried by employers for their employees — that helps guard against theft and reduce the risk of loss.
Accounting Glossary
FIFO
First-in, first-out. A method for costs of goods sold in which a business charges out product costs to cost of goods sold expense in the chronological order in which the goods were acquired.
Accounting Glossary
fungible
Describes a product that is interchangeable and virtually indistinguishable from another product.
Accounting Glossary
General Ledger
A summary of all of a business’s accounts and transactions.
Accounting Glossary
IASB
International Accounting Standards Board. The IASB (based in London) is the main authoritative accounting standards setter outside the U.S.
Accounting Glossary
Journals
The location in which bookkeepers keep records (in chronological order) of daily company transactions.
Accounting Glossary
LIFO
Last-in, first-out. A method for costs of goods sold that selects the last item you purchased first, and then works backward until you have the total cost for the total number of units sold during the period.
Accounting Glossary
LLP
Limited liability partnership. A legal structure that state laws offer to qualified professionals in which all the partners have limited liability.
Accounting Glossary
PC
Professional corporation. A legal structure that state laws offer to qualified professionals who otherwise would have to operate as an unlimited partnership liability.
Accounting Glossary
petty cash
A cash account that businesses keep on hand for unexpected expenses.
Accounting Glossary
revenue
Monies that are collected in the process of selling a company’s goods and services.
Accounting Glossary
salvage value
The amount that an asset is worth after it has been fully depreciated.
Accounting Glossary
statement of cash flows
A financial statement that summarizes a business’s cash inflows and outflows during an accounting period.
Accounting Glossary
transactions
Economic exchanges between a business or other entity and the parties with which the entity interacts and makes deals.
Accounting Glossary
worker’s compensation insurance
A type of insurance carried by employers that covers its employees in case they are injured on the job.
