What items appears first on the statement of cash flows prepared using the direct method?
Managers, investors, and lenders are particularly interested in the availability of cash, where it comes from, and what it is used for in a business. However, the income statement, retained earnings statement, and balance sheet do not directly track or report the flow of cash. Therefore, businesses prepare a fourth financial statement, the statement of cash flows, to clearly provide information about the sources and uses of cash. The statement of cash flows is based on
information from the income statement, retained earnings statement, and balance sheet. Therefore, it is prepared last. All business transactions can be classified as one of three types of activities: operating, investing, or financing. Operating activities are
those involved in the day-to-day running of the business. Accounts used for operating activities include all those on the income statement as well as current assets and current liabilities on the balance sheet. (Current assets and liabilities are those that are expected to be converted to cash within one year.) Most of a business’ transactions are operating activities. Investment activities involve fixed or long-term assets that are found on the balance sheet. These are
assets that are expected to last more than one year. Investment activities include buying and/or selling any of the following: equipment, vehicles, buildings, land, patents, investments in stock, and investments in bonds. Financing activities involve raising funds for a business and may include long-term debt or equity accounts found on the balance sheet. These include transactions involving the following: issuing common or preferred stock, issuingor redeeming bonds
payable, and paying off a mortgage note payable. Buying or selling treasury stock and paying dividends are related to stock and are also financing activities. The statement of cash flows reports cash inflows and/or cash outflows in each of three sections: cash flows from
operating activities, cash flows from investing activities, and cash flows from financing activities. An inflow occurs when cash is paid to a business. An outflow is when a business makes a cash payment. Each of the three sections is summarized by one number, which is the net cash flows amount. If the summary number is positive, it means that more cash was received than was paid out for that activity during the accounting period. If the summary number is negative, more cash was paid out
than was received for that activity during the period. Example You receive and cash your paycheck for the week for $400. This is a cash inflow. On the same day you pay your cell phone bill and car insurance payment for a total of $210. You then go out for dinner and pay $30 cash with tip. These three payments are cash outflows. The net cash inflow on that day is $160; that is, $160 more came in than went out. The following sample journal entries are
reminders of transactions that involve cash. The Cash account is either debited or credited, to indicate a cash inflow or cash outflow, respectively. Example When Cash is debited, there is a cash inflow. Here is an example of an investing activity that results in a cash inflow: selling equipment. Account Debit Credit ▲ Cash 50,000 ▼ Accumulated Depreciation 1,000 ▼ Equipment 48,000 ▲ Gain on Sale of Equipment 3,000 Cash inflow: $50,000. Notice there is a gain on this transaction. Example When Cash is credited, there is a cash outflow. Here is an example of a financing activity that results in a cash outflow: calling bonds. Account Debit Credit ▼ Bonds Payable 100,000 ▲ Loss on Redemption of Bonds 5,000 ▼ Discount on Bonds Payable 3,000 ▼ Cash 102,000 Cash outflow: $102,000. Notice there is a loss on this transaction. Example When Cash is debited, here is a cash inflow. Here is an example of a financing activity that results in a cash inflow: issuing common stock. Account Debit Credit ▲ Cash 180,000 ▲ Common Stock 150,000 ▲ Paid-in Capital in Excess of Par - Common Stock 30,000 Cash inflow: $180,000. Notice there is no gain or loss on this transaction. The operating activities section of the statement of cash flows appears first. It may be prepared in one of two ways, using either the indirect or the direct method. The indirect method begins with net income from the income statement and mathematically backs out non-cash transactions to arrive at cash flows from operating activities.The direct method itemizes all
of the operating cash inflows, or receipts, followed by a list of the operating cash ouflows, or payments. Although information presented in the operating activities section is different, both methods yield the same cash flows from operating activities amount. The indirect method is more popular because the information needed to prepare the section is readily available on the income statement and balance sheet. The choice of methods pertains only to the operating activities section. The
investing and financing section both are prepared using a direct method. The following is a sample statement of cash flows that has been prepared based on the financial statements presented on page 255. The operating activities section uses the indirect method. The following section will show you how to prepare the statement of cash flows (indirect method for operating activities section) on page 259 from the financial statements on page 255. Using the basic shell that includes the heading and formatting captions, complete the statement of cash flows. Operating activities section (indirect method) Most of a business’ transactions are operating activities. Some of these involve cash; some do not. There are too many transactions to make it practical to look at each one individually to determine its impact on cash flow. Therefore, the income statement and comparative
balance sheet numbers will be used to efficiently remove non-cash transactions in order to arrive at the net cash flow from operating activities number. The process is described next. Cash flows from operating activities: Net income $48,000 Adjustments to reconcile net income to net cash flow from operating activities: Depreciation 5,000 Gain on sale of investments (10,000) Loss on sale of equipment 1,000 Comparative Balance Sheet December 31, 2019 and 2018 End 2019 End 2018 Assets Accounts receivable 34,000 58,000 24,000 decrease Merchandise inventory 112,000 80,000 32,000 increase Prepaid insurance 9,000 15,000 6,000 decrease Liabilities Accounts payable 29,000 22,000 7,000 increase Wages payable 14,000 17,000 3,000 decrease To remove non-cash operating transactions, the difference in the amount from one year and the next for each of these accounts is reported in the operating activities section of the statement of cash flows using the following rules: Add the following to net income: Deduct the following from net income:
List these current operating assets and liabilities in the order in which they appear on the balance sheet. Be sure any deductions in the operating activities section are in parenthesis to indicate they are amounts to be subtracted. The final summary amount indicates that $46,000 more “came in” than was paid out during this year for operating activities. (If it were a net cash outflow, use parenthesis on the number to indicate this.) This is the first of six numbers in the right-hand column. Investing Activities SectionThere are relatively few items in the investing activities section, so it is reasonable to look at them one by one to determine if there is a cash inflow or outflow and, if so, its amount. Identify the investing activities on the comparative balance sheet. These are any fixed, long-term, or intangible assets Jonick Company Comparative Balance Sheet December 31, 2019 and 2018
Note
If a fixed asset’s balance increases from one year to the next, it means that more must have been purchased and there was a cash outflow. Similarly, if a fixed asset’s balance decreases from one year to the next, it means that some or all of it was sold and there was a cash inflow. To help determine the amount of cash received or paid, refer to the journal entry for each transaction to see if Cash was debited or credited. IMPORTANT: It is possible for one fixed asset, such as equipment, to have both a sale and a purchase of two different pieces of equipment for cash. This would have to be explained in a separate note in order to properly prepare the statement of cash flows. When a long-term or fixed asset is sold, there may be a gain or loss. This information would be found on the income statement. Jonick Company Income Statement For the Year Ended December 31, 2009
The land cost $100,000 (given on the balance sheet) and there was a loss of $1,000 when it was sold (given on the income statement). That would mean there was a $99,000 cash inflow ($100,000 - $1,000). The investments cost $80,000 (given on the balance sheet) and there was a gain of $10,000 when they were sold (given on the income statement). That would mean there was a $90,000 cash inflow ($80,000 + $10,000). The Equipment balance on the balance sheet at the beginning of the year was $60,000 and at the end of the year was $221,000, an increase of $161,000. Since it was noted that no equipment was sold, this is the amount of the cash outflow for equipment. Each investing activity transaction is listed on its own line on the statement of cash flows. Cash inflows are listed first and each begins with “Cash received from...” Cash outflows follow and each begins with “Cash paid for...” If there is more than one inflow, they are subtotaled in the middle column. The same is true for more than one outflow.
Calculate net cash flows from investing activities amount by deducting cash outflows from cash inflows. This final summary amount indicates that $28,000 more “came in” than was paid out during this year for investing activities. (If it were a net cash outflow, use parenthesis to indicate this.) This is the second of six numbers in the right-hand column. As a different possibility, an asset account such as Equipment may have experienced more than one transaction rather than just a single purchase. Using the same comparative balance sheet information as in the previous example, note that the information to its right in item d. shows that some of the equipment was also sold. Jonick Company Comparative Balance Sheet December 31, 2019 and 2018
Note
This would impact the cash flows from investing activities section since there would be an additional cash receipt.
Additional equipment still had to have been purchased since the overall Equipment balance on the balance sheet increased from year to year. The calculation to determine the amount of the purchase is as follows: $221,000 ending balance - ($60,000 beginning balance - $10,000 cost of equipment sold given) = $171,000 purchased The same information about the equipment that was sold could have been provided in the form of a ledger account, such as the one that follows for Equipment: Equipment
The beginning and ending balances that appear on the comparative balance sheet are the same as those in the Equipment ledger’s debit balance column on January 1 and September 12, respectively. The $10,000 credit entry is the cost of the equipment that was sold on April 3. The $171,000 debit entry in the debit column is the cost of the equipment that was purchased on September 12. The sale results in a cash inflow, and the purchase results in a cash outflow. Financing Activities SectionThere are relatively few items in the financing activities section, so it is reasonable to look at them one by one to determine if there is a cash inflow or outflow and, if so, its amount.
Final Formatting Note for the Investing and Financing SectionsIn the investing and financing sections, there may be cash receipts and/or cash payments. In each section, if there is more than one cash receipt, enter their amounts in the left column and a subtotal in the middle column. If there is only one receipt, enter it directly in the middle column. The same holds true for cash payments. See the examples below. Subtotaling Tips for Investing and Financing Sections
The following is a sample statement of cash flows that has been prepared based on the financial statements presented on page 255. The operating activities section uses the direct method in the operating activities section. Two-step calculation to determine cash paid for inventory First determine the cost of inventory purchases. The determine how much of those purchases was paid in cash.
The following section will show you how to prepare the statement of cash flows (direct method for operating activities section) on page 270 from the financial statements on page 255. 7.2.4 Basic Shell of the Statement of Cash Flows (direct method)Steps in Preparing the Statement of Cash FlowsUsing the basic shell that includes the heading and formatting captions, complete the statement of cash flows. Operating activities section (direct method) The operating activities section using the line items on the income statement that (1) relate to operations and (2) that involve cash transactions. In the sample income statement below, there are six operational accounts: Sales, Cost of Merchandise Sold, and four expense accounts that might possibly be listed on the statement of cash flows if they involve cash. The gain and loss that is listed on the income statement are the result of transactions that do not relate to the normal operations of the business, so they will not appear in the operating activities section on the statement of cash flows when using the direct method. Balance sheet accounts are needed as well to mathematically determine how much of some of the amounts are cash transactions. Jonick Company Income Statement For the Year Ended December 31, 2009
Jonick Company Comparative Balance Sheet (partial) December 31, 2019 and 2018
7.2.5 Comparative Operating Activities Sections – Statement of Cash FlowsIndirect MethodJonick Company Statement of Cash Flows For the Year Ended December 31, 2009
Direct MethodJonick Company Statement of Cash Flows For the Year Ended December 31, 2009
Notice that for both methods, the net cash flow from operating activities amount is the same: $46,000. What is the direct method for cash flow statement?What Is the Direct Method? The direct method is one of two accounting treatments used to generate a cash flow statement. The statement of cash flows direct method uses actual cash inflows and outflows from the company's operations, instead of modifying the operating section from accrual accounting to a cash basis.
Which of the following items would appear in a cash flow statement?The main categories found in a cash flow statement are (1) operating activities, (2) investing activities, and (3) financing activities of a company and are organized respectively.
How the operating cash flow part is prepared using the direct method?The simplest format of the direct method looks something like this:. Cash Flow from Revenue.. - Cash Payments for Expenses.. = Income Before Income Taxes.. - Cash Payment for Income Taxes.. = Net Cash Flow From Operating Activities.. What are the steps to prepare a cash flow statement?How to Create a Cash Flow Statement. Determine the Starting Balance. ... . Calculate Cash Flow from Operating Activities. ... . Calculate Cash Flow from Investing Activities. ... . Calculate Cash Flow from Financing Activity. ... . Determine the Ending Balance.. |