Overview
This lecture explains how to prepare the operating activities section of the statement of cash flows using the direct method, contrasting it with the indirect method and detailing calculation steps for cash receipts and payments.
Direct vs. Indirect Method
- The statement of cash flows can be prepared using either the direct or indirect method for operating activities.
- The indirect method starts with net income and adjusts for non-cash transactions and changes in working capital.
- The direct method lists actual cash receipts and cash payments from operating activities during the period.
- Although GAAP prefers the direct method, most companies use the indirect method due to simpler calculations.
Cash Receipts Calculation (Direct Method)
- Convert each income statement line item from accrual to cash basis for the statement.
- Cash receipts from customers = Sales revenue + Beginning accounts receivable – Ending accounts receivable.
- Cash receipt of interest = Interest revenue (if no interest receivable exists, all interest is received in cash).
- Cash receipts of dividends = Dividend revenue (if no dividends receivable exists, all dividends are received in cash).
- Total cash receipts from operating activities sum these amounts.
Cash Payments Calculation (Direct Method)
- Cash payments to suppliers include payments for merchandise inventory and operating expenses (excluding employee compensation, interest, and income taxes).
- Cash paid for merchandise inventory = Cost of goods sold – Beginning inventory + Ending inventory + Beginning accounts payable – Ending accounts payable.
- Cash paid for operating expenses = Other operating expenses + Beginning accrued liabilities – Ending accrued liabilities.
- Cash paid to employees = Salaries/wages expense (if no salaries/wages payable exists, all paid in cash).
- Interest and income tax payments use expenses shown if no related payables exist.
Items Excluded from Operating Activities (Direct Method)
- Depreciation expense and gains/losses on disposal of plant assets are excluded as they are non-cash items.
- Cash from disposal of long-term assets appears in investing activities, not operating.
Key Terms & Definitions
- Direct Method — Method reporting cash receipts/payments directly in the operating activities section.
- Indirect Method — Method adjusting net income for non-cash and accrual items to show cash from operations.
- Cash Receipts — Actual cash received during the period from operating activities.
- Cash Payments — Actual cash paid during the period for operating expenses and inventory.
- Accounts Receivable — Amounts customers owe; used to adjust sales revenue to cash.
- Accrued Liabilities — Expenses incurred but not yet paid; affect cash payments calculation.
Action Items / Next Steps
- Review the process for converting accrual basis results to cash basis amounts.
- Practice preparing the operating activities section of the statement of cash flows using the direct method.