8 Statement of Cash Flow
Exploring Sources and Uses of Cash
Dr. Jacqueline Gagnon
Direct Versus Indirect Method
Tell Me More
Cost of Goods Sold is usually abbreviated COGS. I will use COGS in this chapter and moving forward, and it’s okay for you to use this shorthand in your work.
There are two methods to prepare the operating activities section: direct and indirect. These methods only affect the operating activities section. The investing and financing activities sections are unchanged.
Direct Method
This method follows the income statement order of items. The operating activities section under the direct methodDirect Method:
Presents the operating section of the cash flow statement by sources and uses of cash. Examples include cash from customers, cash paid to suppliers, and cash paid to employees. This method presents more useful information than the indirect method and is therefore preferred by accounting standard setters and financial statement users. looks like this:
| Operating Activities | Calculation of Amount |
|---|---|
| Cash Received from Customers | = Net Sales + A/R, beginning – A/R, ending – Unearned Revenue, beginning + Unearned Revenue, ending |
| Cash Paid to Suppliers | = – Cost of Goods Sold + Inventory, beginning – Inventory, ending – A/P, beginning + A/P, ending |
| Cash Paid to, or on Behalf of, Employees | = – Salaries and Wages Expense – Salaries Payable, beginning + Salaries Payable, ending |
| Cash Paid for Operating Expenses | = – Operating Expenses – Depreciation + Prepaid Expenses, beginning – Prepaid Expenses, ending |
| Cash Paid for Interest | = – Interest Expense – Interest Payable, beginning + Interest Payable, ending |
| Cash Received from Interest | = Interest Income + Interest Receivable, beginning – Interest Receivable, ending |
| Cash Paid for Income Taxes | = – Income Tax Expense – Income Tax Payable, beginning + Income Tax Payable, ending |
| Cash Provided by (Used in) Operating Activities | = Total of all operating activities listed above |
Hmmm. Let’s pause here to explore how beginning and ending balances affect cash. In the template above we see that the beginning balance of A/R increase cash. Why is that? Let’s look at each of the Statement of Financial Position account adjustment to find clarity on why we add (+) or subtract (-) balances in the operating section of the Statement of Cash Flow. We will start with current assets and move on to current liabilities.
Explanation of adjustments of Statement of Financial Position accounts in the operating section:
| Accounts Receivable (A/R) | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Adjustment for Beginning Balance | Adjustment for Ending Balance | |||||||||||
| Direction | Increase ( + ) | Decrease ( – ) | ||||||||||
| Explanation | A/R owing at the beginning of the year should have been paid off by customers during the year. Like this:
So the change to cash from collecting opening A/R is an increase to cash. |
Notice that we added all sales during the year to cash from customers. But we know that not all these sales were cash sales. Some of these sales were made on account and will not be received until next year.
How much do we expect to receive next year from sales we made this year? We can find that amount in the A/R ending balance. We’ll subtract the A/R ending balance to correct the sales amount recorded by reversing credit sales. |
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| Inventory | ||
|---|---|---|
| Adjustment for Beginning Balance | Adjustment for Ending Balance | |
| Direction | Increase ( + ) | Decrease ( – ) |
| Explanation | COGS doesn’t include all cash spent on inventory during the year—only cash spent on the inventory that was sold, regardless of when the inventory was purchased. Inventory is cash paid for goods that are sold.
The beginning inventory was purchased last year but sold this year. So the decrease in cash actually happened last year. We need to reverse last year’s purchase of inventory from cost of goods sold to get the cost of goods purchased and sold this year. Otherwise we will double count inventory purchases: we already reduced cash for inventory purchased last year! |
COGS doesn’t include all cash spent on inventory during the year—only cash spent on the inventory that was sold, regardless of when the inventory was purchased. Inventory is cash paid for goods that are sold.
Ending inventory is goods purchased in the year, a decrease in cash, that have not been sold yet. Because the cash was spent in the current year, we need to record this reduction in cash in the current year. |
| Prepaid Expenses | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Adjustment for Beginning Balance | Adjustment for Ending Balance | |||||||||||||||||||||
| Direction | Increase ( + ) | Decrease ( – ) | ||||||||||||||||||||
| Explanation | The prepaid expense account is cash the company paid in advance for products or services. Prepaid expenses is a current account, meaning that the product or service will be used within the year. When it is used up, it will be expensed. For rent, this journal entry looks like:
See the problem? We assumed that all operating expenses were paid in cash during the year. But some of these expenses were paid last year! So to calculate the amount of cash actually paid for operating expenses during the year, we need to reverse beginning prepaid expenses by adding it back to cash paid for operating expenses. Otherwise it will be double counted—last year and this year. |
Ending prepaid expenses is cash paid for products and services that we haven’t used yet. The journal entry looks like this:
In this case, we have a reduction in cash for operating expenses next year. Because cash was paid this year, it needs to be included in cash paid for operating expenses. So we’ll subtract ending prepaid expenses. |
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| Interest Receivable | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Adjustment for Beginning Balance | Adjustment for Ending Balance | |||||||||||||||||||||
| Direction | Increase ( + ) | Decrease ( – ) | ||||||||||||||||||||
| Explanation | Interest receivable is recognized with this journal entry:
Interest receivable from last year will be received in cash this year:
This is an increase in cash! |
We have to make an adjustment here because we included all of interest income as cash received for interest. But some of it hasn’t been collected yet. |
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| Accounts Payable (A/P) | ||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Adjustment for Beginning Balance | Adjustment for Ending Balance | |||||||||||
| Direction | Decrease ( – ) | Increase ( + ) | ||||||||||
| Explanation | Accounts payable is amounts owing to suppliers. The beginning balance of A/P will have been paid during the year. After all, our suppliers usually require payment within 30 days. When the invoice is paid, it is recorded as:
Cash goes down during the year! Another way of thinking about this is as an adjustment for cost of goods sold. Before our adjustment for A/P, Cash paid to suppliers is the entire amount of inventory purchased during the year. But this isn’t the whole truth because we also paid cash for some inventory that was purchased last year: the beginning balance of A/P. |
The ending balance of A/P is amounts owing to suppliers that have not been paid yet. Before our adjustment for A/P ending, all inventory purchased is recorded as a decrease to cash. But not all our inventory has been paid for! So we need to make a correction in the Statement of Cash Flows for the amount owing for to suppliers for purchases in the year that won’t be paid until next year. This adjustment is an increase to cash. | ||||||||||
| Unearned Revenue | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Adjustment for Beginning Balance | Adjustment for Ending Balance | |||||||||||||||||||||
| Direction | Decrease ( – ) | Increase ( + ) | ||||||||||||||||||||
| Explanation | Unearned revenue is cash received as a deposit for products or services the company owes its customers. The journal entry goes like this:
We have to make an adjustment to cash so we don’t double count. Afterall, we recorded the increase to cash last year, but recorded the sales revenue this year as:
The entire amount of sales revenue has been recorded as an increase to cash, but that’s not true. The beginning balance of unearned revenue increased sales revenue this year, but the cash was received last year. We will reduce cash received from customers for the opening balance of unearned revenue to reflect that this cash doesn’t affect this year’s cash. It was collected and recorded in the Statement of Cash Flows last year. |
Unearned revenue is cash collected for sales, but it does not affect sales revenue until the next year when products or services are delivered to the customer. Because the cash is collected from customers, an increase to cash, we will increase cash received from customers by the ending balance of unearned revenue. | ||||||||||||||||||||
| Interest Payable | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Adjustment for Beginning Balance | Adjustment for Ending Balance | |||||||||||||||||||||
| Direction | Decrease ( – ) | Increase ( + ) | ||||||||||||||||||||
| Explanation | Interest payable is recognized with this journal entry:
Interest receivable from last year will be received in cash this year:
This is a decrease in cash! |
We have to make an adjustment here because we included all of interest expense as cash paid for interest. But some of it hasn’t been paid yet. It is still owing. | ||||||||||||||||||||
| Salaries Payable | ||
|---|---|---|
| Adjustment for Beginning Balance | Adjustment for Ending Balance | |
| Direction | Decrease ( – ) | Increase ( + ) |
| Explanation | ||
| Income Tax Payable | ||||||||||||||||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Adjustment for Beginning Balance | Adjustment for Ending Balance | |||||||||||||||||||||
| Direction | Decrease ( – ) | Increase ( + ) | ||||||||||||||||||||
| Explanation | Last year’s income taxes owing were paid this year, and so will decrease cash…
|
This year’s income tax payable hasn’t been paid yet. A company doesn’t even know how much they owe in income taxes until after their year end. Taxes will be paid next year. But we deducted income tax expense in cash paid for income tax…
Uh-oh! Year end income taxes don’t affect cash, they affect income tax payable. We need to add income taxes payable back because the cash effect doesn’t happen until next year. |
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The good news is that, because of the fundamental accounting equationAssets = Liabilities + Equity, the beginning balance of asset accounts will always increase cash. And the ending asset balance will always reduce cash. Don’t take my word for it! Look back to the tables in this section to see that this is true.
On the liability side, the opposite is true. Beginning balances decrease cash, and ending balances increase cash. Again, look at the tables above to see that this is true!
Ok, let’s put numbers to this method.
- My Turn:
- The following information is for Dexter’s Dog Supplies including Statement of Financial Position and Income Statement information.
-
20X2 20X1 Current Assets A/R 50,000 42,000 Inventory 30,000 39,000 Prepaid Insurance 10,000 — Trading Investments 7,000 5,000 Current Liabilities A/P 20,000 32,000 Unearned Revenue — 15,000 Salaries Payable 35,000 26,000 Interest Payable 2,000 3,000 Income Tax Payable 19,000 12,000 Working capital 21,000 -2,000 - 20X2 Income Statement Information: Sales were $620,000, COGSCOGS:
Cost of Goods Sold $370,000, salaries expense $80,000, other operating expenses $50,000, depreciation $18,000, interest expense $10,000, gain on sale of equipment $5,000, income tax expense $19,000. Net income was $78,000. - Required:
- Prepare the operating activities section of Dexter’s Statement of Cash Flows using the direct method.
| Dexter’s Dog Supplies Statement of Cash Flows (Excerpt) (Direct Method) For the Year Ended 31 December 20X2 |
|||
|---|---|---|---|
| Operating Activities: | |||
| Cash Received from Customers | 597,000 | Cash Received from Customers: 620,000 (Sales) + 42,000 (A/R, beg.) – 50,000 (A/R, end.) – 15,000 (Unearned Revenue, beg.) + 0 (Unearned Revenue, end.) |
|
| Cash Paid to Suppliers | (373,000) | Cash Paid to Suppliers: -370,000 + 39,000 (Inventory, beg.) – 30,000 (Inventory, end.) – 32,000 (A/P, beg.) + 20,000 (A/P, end.) |
|
| Cash Paid to Employees | (71,000) | Cash Paid to Employees: -80,000 (Salaries Exp.) – 26,000 (Salaries Payable, beg.) + 35,000 (Salaries Payable, end.) |
|
| Cash Paid for Operating Expenses | (60,000) | Cash Paid for Operating Expenses: -50,000 (Operating Exp.) + 0 (Prepaid Insurance, beg.) – 10,000 (Prepaid Insurance, end.) |
|
| Cash Paid for Trading Investments | (2,000) | Cash Paid for Trading Investments: 5,000 (Trading Inv., beg.) – 7,000 (Trading Inv., end.) |
|
| Cash Paid for Interest | (11,000) | Cash Paid for Interest: -10,000 – 3,000 (Interest Payable, beg.) + 2,000 (Interest Payable, end.) |
|
| Cash Paid for Income Taxes | (12,000) | Cash Paid for Income Taxes: -19,000 (Income Tax Exp.) – 12,000 (Income Tax Payable, beg.) + 19,000 (Income Tax Payable, end.) |
|
| Net Cash Provided by (Used in) Operating Activities | 68,000 | ||
Now it’s your turn to prepare the operating activities section. You’ve got this!
Good work! The way you just prepared Pete’s Paper Inc’s operating activities section was excellent. Now that you’ve completed the operating activities section, let’s try a full Statement of Cash Flows in good form. I’ll do the first one to illustrate, then you do the second.
- My Turn:
- Ansul’s Army Supply published the following financial statements for the fiscal year ended 31 December 20X2. They have asked you to prepare a Statement of Cash Flow, but are unsure whether the company uses the direct or indirect methodIndirect Method:
Presents the operating section of the cash flow statement as an equation, starting with net income and followed by a series of adjustments for non-cash items and changes in working capital accounts. The indirect method can be contrasted with the direct method, which is preferred by accounting standard setters and financial statement users. for operating activities. Therefore, your job is to prepare the Statement of Cash Flows using the direct method. -
Ansul’s Army Supply
Comparative Statement of Financial Position
As at 31 December 20X2Assets 20X2 20X1 Current Assets: Cash 94,000 55,000 Accounts Receivable 80,000 50,000 Inventory 86,000 60,000 Trading Investments 12,000 20,000 Total Current Assets 272,000 185,000 Non-Current Assets: PP&E: Land 280,000 150,000 Buildings (cost) 150,000 260,000 Accumulated Depreciation — Building (40,000) (70,000) Building, net 110,000 190,000 Total PP&E 390,000 340,000 Long-Term Investments 100,000 45,000 Total Non-Current Assets 490,000 385,000 Total Assets 762,000 570,000 Liabilities & Equity 20X2 20X1 Liabilities: Current Liabilities: Accounts Payable 61,000 44,000 Salaries Payable 15,000 26,000 Interest Payable 3,000 5,000 Income Tax Payable 138,000 200,000 Total Current Liabilities 217,000 275,000 Non-Current Liabilities: Long-Term Debt (net) 80,000 195,000 Total Liabilities 297,000 470,000 Equity: Common Shares 75,000 50,000 Retained Earnings 390,000 50,000 Total Equity 465,000 100,000 Total Liabilities & Equity 762,000 570,000 -
Ansul’s Army Supply
Income Statement
For the Year Ended 31 December 20X2Sales 2,854,500 Cost of Goods Sold (1,570,000) Gross Profit 1,284,000 Operating Expenses: Depreciation Expense (12,000) Office & Insurance Expense (76,000) Salaries Expense (445,000) Other Operating Expenses (68,000) (601,000) Operating Income 683,000 Other Income/Expenses; Gains and Losses: Interest Income 10,000 Gain on Sale of Equipment 4,500 Interest Expense (7,500) 7,000 Income Before Income Taxes 690,000 Income Tax Expense (138,000) Net Income 552,000 - Additional Information:
-
- The company purchased land during the year and sold a small building,
- dividends were declared and paid during the year,
- the company issued shares during the year,
- trading investments were sold during 20X2, and
- interest income was received on non-current investments.
- Required:
- Prepare the Statement of Cash Flows using the direct method.
| Ansul’s Army Supply Statement of Cash Flows (Direct Method) For the Year Ended 31 December 20X2 |
|||
|---|---|---|---|
| Operating Activities: | |||
| Cash Received from Customers | 2,824,000 | Cash Received from Customers: 2,854,000 (Sales) + 50,000 (A/R, beg.) – 80,000 (A/R, end.) |
|
| Cash Paid to Suppliers | (1,579,000) | Cash Paid to Suppliers: -1,570,000 (COGS) + 60,000 (Inventory, beg.) – 86,000 (Inventory, end.) – 44,000 (A/P, beg.) + 61,000 (A/P, end.) |
|
| Cash Paid to Employees | (456,000) | Cash Paid to Employees: -445,000 (Salaries Exp.) – 26,000 (Salaries Payable, beg.) + 15,000 (Salaries Payable, end.) |
|
| Cash Paid for Operating Expenses | (144,000) | Cash Paid for Operating Expenses: -68,000 (Other Operating Exp.) – 76,000 (Office and Insurance Exp.) |
|
| Cash Received for Trading Investments | 8,000 | Cash Received for Trading Investments: 20,000 (Trading Inv., beg.) – 12,000 (Trading Inv., end.) |
|
| Cash Paid for Interest | (9,500) | Cash Paid for Interest: -7,500 (Interest Exp.) – 5,000 (Interest Payable, beg.) + 3,000 (Interest Payable, end.) |
|
| Cash Paid for Income Taxes | (200,000) | Cash Paid for Income Taxes: -138,000 (Income Tax Exp.) – 200,000 (Income Tax Payable, beg.) + 138,000 (Income Tax Payable, end.) |
|
| Net Cash Provided by (Used in) Operating Activities | 68,000 | ||
| Investing Activities: | |||
| Cash Paid for Land | (130,000) | Cash Paid for Land: 150,000 (Land, beg.) – 280,000 (Land, end.) |
|
| Cash Received from Sale of Building | 72,500 | Cash Received from Sale of Building: Proceeds from sale of building can be calculated as the gain on sale of $ 4,500 plus the change in the building’s net book value—190,000 – (110,000 + 12,000)*. *NBV before depreciation expense. |
|
| Cash Received from Investment Interest | 10,000 | ||
| Cash Paid for Long-Term Investments | (55,000) | Cash Paid for Long-Term Investments: 45,000 (Long-Term Inv., beg.) – 100,000 (Long-Term Inv., end.) |
|
| Net Cash Provided by (Used in) Investing Activities | (102,500) | ||
| Financing Activities: | |||
| Cash Received for Common Shares | 25,000 | Cash Received for Common Shares: 75,000 (Common Shares, end.) – 50,000 (Common Shares, beg.) |
|
| Cash Paid for Dividends | (212,000) | Cash Paid for Dividends: 390,000 (RE, end.) – [50,000 (RE, beg.) + 552,000 (Net Income)] |
|
| Cash Paid for Repayment of Debt Principal | (115,000) | Cash Paid for Repayment of Debt Principal: 80,000 (Debt, end.) – 195,000 (Debt, beg.) |
|
| Net Cash Provided by (Used in) Financing Activities | (302,000) | ||
| Net Change in Cash | 39,000 | ||
| Cash and Equivalents, 01 January 20X2 | 55,000 | ||
| Cash and Equivalents, 31 December 20X2 | 94,000 | ||
Here’s the last problem, and it’s for you. I know you can do this!
Excellent! That was a lot of work, but the Statement of Cash Flow is so important to management and other financial statement users, so I’m glad you stuck with it!!
Before we end this section, let’s review the importance of operating cash flows:
- Helps management plan, monitor, and evaluate their cash management strategy to make sure the company is generating enough cash to continue operating.
- Gives information that helps external users, like investors, to verify whether operating income is sustainable. Cash provided by (used in) operating activities is just Operating Income without any accruals, so they are very much linked!
Congratulations: you’ve now learned all four financial accounting statements:
- Statement of Financial Position,
- Income Statement,
- Statement of Retained Earnings, and
- Statement of Cash Flows.
What an achievement! Now you can choose your adventure: a detour to the appendix to this chapter which discusses an alternative method for preparing the operating section of the Statement of Cash Flows, or the next chapter. In the next chapter we’ll continue our journey down the Statement of Financial Position and take a look at Accounts Receivable. Either way, I look forward to seeing you soon.