LOS F requires us to:

describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data.

1.         Steps in Preparing Cash Flow Statement Using Direct Method

As per the direct method, all the cash inflows and outflows are presented.  In this method, all the items from the other financial statements i.e. income statement and balance sheet are taken and adjusted for cash. Cash flow statements prepared using the direct method are usually considered more informative from the analyst’s perspective.

 Following steps should be followed in the preparation of cash flow statement using the direct method:

a.  For calculating the cash from operations, all the line items from the income statements are picked up and adjusted for the non-cash components. For example:

     i.  We start with the sales revenue and since the change in accounts receivable represents the value of the non-cash component in the same, the sales revenue are adjusted for the change in the value of accounts receivable.

        For example, say the revenue of a company during the year was $ 150,000 and the balances in the accounts payable account were:

        Now the change in accounts receivable during the year was $ 3,000 ($28,000 – $25,000). Since there was an increase in the value of accounts receivable, and any increase in the value of the asset is considered as outflow; it should be reduced from the value of revenue to arrive at the figure of cash from the sales. Thus cash from the sales would be $ 147,000 (i.e. $ 150,000 – $ 3,000).

    ii.  Then we move to the cost of sales. It includes the cost of purchase of input goods and services, the labor cost, the other overheads, etc. These are adjusted for the change in the value of accounts payable and change in the value of inventory.

         For example, say the purchase of raw material by a company during the year was $ 100,000. The balances in the accounts payable were:

        The balances in the value of inventory were:

        Now the change in accounts receivable during the year was $ 4,000 ($ 21,000 – $ 17,000). Since there was an increase in the value of accounts payable, and any increase in the value of the liability is considered as an inflow or sources of cash; it should be added to the value of expense to arrive at the figure of cash from the sales. Also, there is a decrease in the value of inventory for $ 2,000 (i.e. $ 20,000 – $ 18,000), which should be considered as an inflow of cash or source of cash. Thus cash from the sales would be $ 105,000 (i.e. $ 100,000 + $ 3,000 + $ 2,000).

   iii.  Similarly, we also pick up the other items of the income statement, except the non-cash items (such as depreciation, amortization, etc.), and adjust the same for the value of changes in their respective affecting accounts in the balance sheet. For example, the wages and salary expenses are adjusted for the change in wages payable, other operating expenses are adjusted for the changes in the prepaid expense account in the balance sheet and the changes in accrued liabilities, etc.

   iv.  Putting it together, we can calculate the cash from operation by deducting all the cash payments to the suppliers, the employees, for the interest, taxes, etc. from the cash received from the sales.

b.  Cash from investing activities is calculated by examining the changes in the assets account and adjusting the same for the changes in non-cash accounts such as depreciation, amortization, etc. In other words, the cash from investing activities is calculated by reducing the sale of assets from the purchases; any non-cash adjustment in the assets account is ignored.

c.  Cash from financing activities is calculated by determining the flow of cash between the reporting entity and the supplies of its capital. It includes the issue of shares, debentures, bonds, etc., and the value of payment for the buy-back of shares, repayment of the principal portion of the debt, etc is reduced.

Kindly note, that the interest and other such payment is a part of the cash from operations.

2.         Steps in Preparing Cash Flow Statement Using Indirect Method

Under the indirect method, the steps in calculation and presentation of cash from operating activities differ. The presentation of cash from investing and financing activities, however, remains the same. For calculating the cash from operations, we begin with the net income and make the adjustment for the difference between the accounting items and actual cash receipts.

The steps in preparing the cash flow statements using the indirect method are:

a.  Start with the figure of net income.

b.  Subtract the losses and add the gains from the disposal of financing and investing assets and liabilities.

c.  Add all the non-cash charges to income, such as depreciation, amortization, etc., and subtract all the non-cash components of revenue, such as barter sales, etc.

d.  Add or subtract the changes in working capital – operating accounts in the balance sheet, as follows:

     i.  Increase in current assets during the year are subtracted as they are considered as outflow or uses of cash

    ii.  Decrease in current liabilities should be added as they are considered as inflow or sources of cash

   iii.  Increase in current liabilities during the year are subtracted as they are considered as outflow or uses of cash

   iv.  Decrease in current assets should be added as they are considered as inflow or sources of cash

e.  For calculating the cash from financing and investing activities the steps similar to that of the direct method are followed.

Example for calculating the Cash from Investing Activity

f.  To sum up, we can compile the calculations for cash from operating, investing, and financing activities to prepare the cash flow statement. (The format of the cash flow statement is given above). Resultantly, we will obtain the value of change in cash balances.