7. Preparing the Statement of Cash Flows, Direct and Indirect Methods

Preparing the Statement of Cash Flows

• Author: S. Levkoff, PhD, CAP®Affiliation: UC San Diego Department of Economics & Rady School of Management

Two Methods

• Direct Method

• Indirect Method

Direct Method

• Description:

  • Lists cash receipts and disbursements by source/use of funds.

• Use:

  • Commonly used for the investing and financing activities sections of the cash flow statement.

  • Rarely used for operating activities, as GAAP requires the indirect method for this section.

• Practice:

  • Firms may still have to use the indirect method as a check, resulting in potentially redundant work.

Indirect Method

• Application:

  • Limited to cash flows associated with operating activities.

• Objective:

  • Reconcile net income with operating cash flows.

  • Adjustments include:

    • Removing noncash items (e.g., depreciation, amortization).

    • Including additional cash flows not reflected in net income (changes in accounts receivable, inventory, accounts payable).

• Popularity:

  • Most widely used for preparing the operating activities portion of the cash flow statement.

Indirect Method Preparation

1. Start:

   • Begin with Net Income from the income statement.

2. Adjust for Noncash Items:

   • Add back matched but unpaid expenses and subtract uncollected revenues.

   • Adjust for depreciation and amortization.

   • Adjust for gains and losses on the sale of property, plant, and equipment (PP&E) or investments.

3. Working Capital Adjustments:

   • Adjust for changes in asset/liability accounts tied to operating activities, using the balance sheet identity.

Example 1 - Direct vs. Indirect Method: Cash Transactions Only

• Sales: $100 cash

• COGS: $60 (cash inventory)

• Net Income:

  • Income Statement:

    • $100 - $60 = $40

Direct Statement of Cash Flows (SCF)

• Collections from Customers: $100

• Payments to Suppliers: ($60)

• Operating Cash Flow (CF): $40

Indirect Statement of Cash Flows (SCF)

• Net Income: $40

• Adjustments:

  • Collections from Customers: $100

  • Payments to Suppliers: ($60)

  • Operating CF: $40

Example 2 - Direct vs. Indirect Method: Depreciation Expense

• Sales: $100 cash

• COGS: $60 cash

• Depreciation: $10

• Net Income:

  • Income Statement:

    • $100 - $60 - $10 = $30

Direct SCF

• Collections from Customers: $100

• Payments to Suppliers: ($60)

• Adjust for Depreciation: ($10)

• Operating CF: $30

Indirect SCF

• Net Income: $30

• Adjust for Depreciation: +$10

• Operating CF: $40

Example 3 - Direct vs. Indirect Method: Accounts Receivable

• Sales: $80 cash, $20 Accounts Receivable

• COGS: $60 cash

• Depreciation: $10

• Net Income:

  • Income Statement:

    • $100 - $60 - $10 = $30

Direct SCF

• Collections from Customers: $80

• Payments to Suppliers: ($60)

• Operating CF: $30

Indirect SCF

• Net Income: $30

• Adjust for Depreciation: +$10

• Adjust for Increase in Accounts Receivable: -$20

• Operating CF: $20

Example 4 - Direct vs. Indirect Method: Inventory

• Sales: $80 cash, $20 Accounts Receivable

• COGS: $60 incurred, $75 inventory purchased, $50 paid in cash

• Depreciation: $10

• Net Income:

  • Income Statement:

    • $100 - $60 - $10 = $30

Direct SCF

• Collections from Customers: $80

• Payments to Suppliers: ($50)

• Operating CF: $30

Indirect SCF

• Net Income: $30

• Adjustments for Depreciation: +$10

• Adjust Increase in A/R: -$20

• Adjust Increase in Inventory: -$15

• Adjust Increase in A/P: +$25

• Operating CF: $30

Example 5 - Direct vs. Indirect Method: Sale of PP&E

• Sale of PP&E: Sold for $75 cash; gain of $5 on income statement.

Direct SCF

• Collections from Customers: $100

• Payments to Suppliers: ($60)

• Operating CF: $40

• Proceeds from Sale: $75

• Investing CF: $75

Indirect SCF

• Net Income: $35 (includes the gain on sale)

• Adjust for Gain on Sale of PP&E: -$5

• Operating CF: $40

• Proceeds from Sale: $75

• Investing CF: $75