Direct method of statement of cash flows with examples

Definition

The direct method is one of two accounting treatments used to generate a cash flow statement. The direct method uses actual cash inflows and outflows from the company’s operations.

The direct method is also known as the income statement method.

Cash Flow Statement Direct Method Format:

The main difference between direct and indirect method of cash flows lies in the operating activities section.

Cash flow from Operating activities:

Net cash flows from operating activities are determined by combining certain cash inflows and subtracting  certain cash outflows.

The inflows are cash received from customers and interest and dividends received. The outflows are cash paid to suppliers and employees, interest paid and income tax paid.

In conclusion, the total cash outflows are then subtracted from the cash inflows to compute the net cash flow from operating activities.

Those inflows and outflows are as follow:

  1. Cash received from Customers
  2. Cash Paid to Suppliers
  3. Cash Payment for Expenses
  4. Cash payment for interest
  5. Cash payment for Taxes

Cash Received from Customers:

Cash received from customers = Net Sales {+ Decrease in accounts receivable}

or

                   {- Increase in accounts receivable}

For instance: In Kamran’s corporation, if accounts receivable increases by 30,000 during the year and net sales by 900,000. Consequently, the  cash received from customers will be:

Net sales (Accrual basis)                                                          900,000

Less: Increase in accounts receivable                                   (300,000)

Cash received from customers                                                870,000

In order to calculate the cash received from customers, the following account will be prepared.

         Debtors account  
OPENING                                             XXX  
  CASH AND BANK XXX (BAL)                     
SALES (CASH+ CREDIT) XXX                
  CLOSING                          XXX

Cash Paid to Suppliers:

It includes cash payment for both purchase of merchandise and for operating expenses.

For Example, Kamran’s corporation paid 269,000 as operating expenses and 495,000 for purchase of merchandise. Given these points, its cash payments to suppliers will be:

Cash payments for purchase of Merchandise                                        495,000

Cash payments for operating expenses                                                   269,000

Cash payments to suppliers                                                                        764,000

In order to calculate the cash paid to suppliers, the following account will be prepared:

Creditors account  
  OPENING                                       XXX
CASH AND BANK (BAL)    XXX PURCHASES (CASH+CREDIT) XXX
CLOSING                                   XXX  
   

Cash Payments for Expenses

Expenses represent the cost of goods and services used during the period. However, the amount given for expenses may differ from cash payments. For example, depreciation, amortization, unfunded portion of post retirement benefits may not require cash outlays.

For Instance, Kamran’s corporation operating expenses are 300,000 with a depreciation of 40,000. It’s increase in short term pre-payments is 3000, while decrease in accrued liabilities is 6000.

Operating expenses                                                                                300,000

Less: Non-cash expenses (Depreciation)                                             (40,000)     

Subtotal                                                                                   260,000          

Add: Increase in short term prepayments                   3000

         Decrease in accrued liabilities                               6000               9000

Cash payments for operating expenses                                               269,000  

In order to calculate the cash payments for expenses, the following account will be prepared:

EXPENSE ACCOUNT  
B/D PREPAYMENTS               XXX B/D ACCRUALS                          XXX
B/D OFFICE SUPPLIES           XXX  
   
CASH AND BANK (BAL) XXX P/L (1.1)
   
  C/D PREPAYMENTS              XXX
C/D ACCRUALS                 XXX C/D OFFICE SUPPLIES            XXX
   

Cash payment for Interest   

Interest expense may be converted into cash payments exactly the same as we convert operating expenses.

For example, Kamran corporation’s income statement shows interest expense of 35,000. Their liability for unpaid interest has been increased by 7000 over the year.  In order to find out interest expense, we subtract the increase in liability from the total expense.

Interest expense                                                                                                35,000

Less: Increase in related accrued liability                                                      (7000)

Interest paid                                                                                                        28000

As an illustration, for calculating the cash paid, the following account shall be prepared for interest expense:

interest expense  
  OPENING PAYABLE                XXX
CASH AND BANK (BAL)             XXX  
  P/L (EXPENSE FOR THE YEAR) XXX
CLOSING BALANCE               XXX  

Cash payment for Taxes

Similarly the income taxes are calculated by using the accrual- based income tax expense from income statement i-e 36,000 from Kamran’s corporation. The corporation reduced its liability for tax payment by 2000. In order to find the total income tax paid, we add the income tax expense and reduction in liability.

Income tax expense                                                               36,000

Add: Decrease in related accrued liability                             2000

Income tax paid                                                                       38,000

The investing and financing activities are the same as indirect method.

Why use direct method cash flow statement:

The listing of above payments gives the financial statement user a great deal of information as to where receipts are coming from and where payments are going to.

This is one of the main advantages of the direct method compared with the indirect method. Investors, creditors, and management can actually see where the company is collecting funds from and whom it is paying funds to

This method looks directly at the source of the cash flows and reports it on the statement.

Drawbacks of the Method:

The problem with this method is it’s difficult and time consuming to create. Most companies don’t record and store accounting and transactional information by customer, supplier, or vendor.

In addition, the direct method also requires a reconciliation report be created to check the accuracy of the operating activities.

Example:

Kamran’s corporation

Statement of cash flows

For the year ended December 31, 2018          

Cash flows from operating activities     
Cash receipts from customers                870,000  
Interest and dividend received 10,000  
Cash paid to suppliers (700,000)  
Cash paid to employees (64,000)  
Cash generated from operations   116,000
Interest paid            (28,000)  
Income taxes paid  (38,000)  
Net cash from operating activities   50,000
Cash flows from investing activities      
Purchase of marketable securities (65,000)  
Proceeds from sale of marketable securities 40,000  
Loans made to burrowers (17,000)  
Collections on loans 12,000  
Cash paid to acquire plant assets (Supp: B) (160,000)  
Proceeds from sale of plant assets 75,000  
Net cash used in investing activities   (115,000)
Cash flows from financing activities    
Proceeds from issuance of capital stock 50,000  
Proceeds from issuance of long-term debt 45,000  
Payment to settle short term debt (55,000)  
Proceeds from issuing bonds payable 100,000  
Dividends paid (40,000)  
Net cash used in financing activities   100,000
Net increase/decrease in cash and cash equivalents   35,000
Cash and cash equivalents at beginning of period              20,000
            Cash and cash equivalents at end of period   55,000
     

Supplementary schedule A: Net cash provided by operating activities:

Net income    65,000
Adjustments to reconcile net income to net cash provided by operating activities:              
Add: Depreciation and amortization   40,000
Decrease in accrued interest receivable   1,000
Increase in accounts payable   15,000
Increase in accrued liabilities   7,000
Non-operating loss on sale of marketable securities   4,000
Subtotal   132,000
Less: Increase in accounts receivable 30,000  
Increase in inventory 10,000  
Increase in prepaid expenses 3,000  
Decrease in accrued liabilities 8,000  
Non-operating gain on sale of plant assets 31,000  
Net cash provided by operating activities   50,000

Supplementary schedule B: Non-cash Investing and Financing Activities

Purchase of plant asset   200,000
Less: Portion financed through issuance of long-term debt   40,000
Cash paid to acquire plant assets   160,000

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