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.