As we have discussed, the operating section of the statement of cash flows can be shown using either the direct method or the indirect method. With either method, the investing and financing sections are identical; the only difference is in the operating section. The direct method shows the major classes of gross cash receipts and gross cash payments. As a result, D&A are expenses that allocate the cost of an asset over its useful life. Depreciation involves tangible assets such as buildings, machinery, and equipment, whereas amortization involves intangible assets such as patents, copyrights, goodwill, and software.
The use of T-accounts for this type of analysis provides a useful visual tool to help understand whether the changes that occurred in the account are cash inflows or outflows, as shown below. (Figure)Use the following excerpts from Nutmeg Company’s financial records to determine net cash flows from operating activities and net cash flows from investing activities. (Figure)Use the following excerpts from Grenada Company’s financial records to determine net cash flows from operating activities and net cash flows from investing activities. Assume that you are the chief financial officer of a companythat provides accounting services to small businesses.
Prepare the Operating Activities Section of the Statement of Cash Flows Using the Indirect Method
The following lines will show increases and decreases in asset and liability accounts, and these items will be added to or subtracted from net income based on the cash impact of the item. The indirect method is one of two accounting treatments used to generate a cash flow statement. The indirect method uses increases and decreases in balance sheet line items to modify the operating section of the cash flow statement from the accrual method to the cash method of accounting. With accrual accounting, revenue is recorded when it is earned rather than when it is received—i.e., when a sale takes place, not when the money reaches the bank account. If a landscaping company that charges $30 per hour bills a client for four hours of work, under the accrual method, it would record $120 in revenue before any money changed hands. This method allows the company to account for all cash and credit sales, providing a clearer picture of the business’s financial health.
An increase in accounts payable signifies that Home Store, Inc., recorded more as an expense on the income statement (accrual basis) than the company paid in cash (cash basis). Since expenses are lower using the cash basis, net income must be increased by $1,000. Cash flows from investing activities always relate to long-termasset transactions and may involve increases or decreases in cashrelating to these transactions. The most common of these activitiesinvolve purchase or sale of property, plant, and equipment, butother activities, such as those cash flow statement format indirect method involving investment assets andnotes receivable, also represent cash flows from investing. Changesin long-term assets for the period can be identified in theNoncurrent Assets section of the company’s comparative balancesheet, combined with any related gain or loss that is included onthe income statement. Increases in current liabilities indicate an increase in cash,since these liabilities generally represent (1) expenses that havebeen accrued, but not yet paid, or (2) deferred revenues that havebeen collected, but not yet recorded as revenue.
Cash Flow from Investing Activities
Since expenses are $2,000 lower using the cash basis, net income must be increased by $2,000. Under the indirect method, the calculation of cash flows from operating activities begins with net income, which is then adjusted for changes in balance sheet accounts to arrive at the amount of cash generated or lost by operating activities. Under the direct method, actual cash flows are presented for items that affect cash flow. Examples of the items that are usually presented under this approach are cash collected from customers, interest and dividends received, cash paid to employees, cash paid to suppliers, interest paid, and income taxes paid. The difference between these methods lies in the presentation of information within the cash flows from operating activities section of the statement.