Looking at a Business’s Statement of Cash Flows
A business has its choice between two quite different methods of reporting cash flow from operating activities in its statement of cash flows. Financial reporting standards permit either approach — the direct method (which is the preferred method) or the indirect method.
The direct method for reporting cash flow
What you see in the first section of the statement of cash flows in the following figure is called the direct method for reporting cash flow from operating activities. The term “direct” is probably meant to refer to the cash flows connected with sales and expenses. For example, the business collects $25.55 million from customers during the year, which is the direct result of making sales.
The statement of cash flows — using the direct method for presenting cash flow from operating activities.
When issuing the financial reporting standard for the statement of cash flows, the Financial Accounting Standards Board (FASB) thought that financial report readers would compare cash flow from operating activities with net income, and they would want some sort of explanation for the difference between these two important financial numbers.
Therefore, the FASB decreed that the statement of cash flows should also include a reconciliation schedule to explain the difference between cash flow from operating activities and net income. Or, a business can use the alternative method for reporting cash flow from operating activities.
The indirect method for reporting cash flow
The alternative method for reporting cash flow from operating activities starts with net income, and then makes adjustments in order to reconcile cash flow from operating activities with net income. This method is called the indirect method, shown in the next figure.
The statement of cash flows — using the indirect method for presenting cash flow from operating activities.
The indirect method for reporting cash flow from operating activities focuses on the changes during the year in the assets and liabilities that are connected with sales and expenses.
While there are obvious differences in the first section of the statement of cash flows between the two methods for reporting cash flow from operating activities, the other two sections of the statement (cash flow from investing activities and cash flow from financing activities) are the same.
The level of detail disclosed in these two sections varies from business to business. For example, some companies report one aggregate amount for all capital expenditures (investments in new long-term operating assets), whereas others give a more detailed breakdown.
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.
