When a company uses the direct method to prepare the information for its statement of cash flows, it may use either the visual inspection method or the worksheet method.
This depends on the complexity of its accounting information. The information is obtained, however, in a slightly different manner. Normally, under the direct method, a company obtains the information for its statement of cash flows from the following working papers:
1. Post-closing trial balance (or balance sheet) from previous period.Recall from Chapter 3 that a post-closing trial balance contains the debit and credit balances of all the permanentaccounts in a company’s general ledger. In other words, a post- closing trial balance of the previous period contains the same information as the ending balance sheetof the previous period.
2. Adjusted trial balance of current period.Recall from Chapter 3 that an adjusted trial balance contains the debit and credit balances (after adjustments but before closing) of all the temporary and permanent accounts in a company’s general ledger. In other words, an adjusted trial balance of the current period contains the balance sheet,income statement, and retained earnings statementinformation for the current period.
In addition, the company needs other information to explain the changes in its balance sheet (permanent) accounts (other than cash). This information is obtained from its accounting records. In complex situations, use of the post-closing trial balance of the prior period and the adjusted trial balance of the current period is the most efficient way to prepare the statement of cash flows. In simpler situations, however, the statement may be developed based on the information contained in the beginning and ending balance sheets, the income statement, and the retained earnings statement of the current year.
Visual Inspection Method
Under the visual inspection approach, the steps to complete the statement of cash flows using the direct method for operating activities are similar to those for the indirect method, except that the information for the cash flows from operating activities section is computed as follows:
• Make adjustments to the applicable revenues for the period (e.g., to sales rev- enue for change in accounts receivable and deferred revenues) to determine the amounts of collections from customers, interest and dividends collected, and other operating receipts.
• Make adjustments to the applicable expenses for the period (e.g., to cost of goods sold for changes in inventory and accounts payable) to determine the amounts of payments to suppliers, payments to employees, other operating payments, payments of interest, and payments of income taxes.
Exhibit 22-5 is helpful for making these adjustments. Once the operating activities sec- tion is completed, the investing activities section and the financing activities section are completed by analyzing the changes in the other balance sheet accounts in the same way as we discussed for the indirect method.
9 Compute the operating cash flows under the direct method.
Example: Visual Inspection Method
Assume that the following income statement items were taken from the adjusted trial bal- ance of the Betha Company at the end of 2007:
Debit Credit
Sales revenue $94,000
Interest revenue 5,400
Cost of goods sold $43,000 Salaries expense 18,500 Depreciation expense 11,000
Other expenses 4,700
Interest expense 9,200
Income tax expense 3,900
Also assume that a comparison of the post-closing trial balance for 2006 with the adjusted trial balance for 2007 shows the following changesin selected balance sheet accounts:
Accounts receivable $ 8,200 credit (decrease)
Interest receivable 1,200 debit (increase)
Inventory 6,300 debit (increase)
Prepaid expenses 600 debit (increase)
Accumulated depreciation 11,000 credit (increase)
Accounts payable 4,800 credit (increase)
Salaries payable 500 debit (decrease)
Discount on bonds payable 200 credit (decrease)
Income taxes payable 300 credit (increase)
Deferred tax liability 400 credit (increase)
Based on the preceding information, Betha Company prepares Example 22-8 to deter- mine each of the operating cash inflows and outflows.
Operating Cash Inflows The $94,000 of sales revenue is increased by the $8,200 decrease in accounts receivable to determine the $102,200 collections from customers.
This is because the company’s cash collections exceeded its sales during the year. The
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Procedures for Statement Preparation
Income Statement Amounts Adjustments Operating Cash Flows
Sales revenue $ 94,000 + Decrease in accounts receivable of $ 8,200 = $ 102,200 Collections from customers Interest revenue 5,400 – Increase in interest receivable of 1,200 = 4,200 Interest collected
$106,400 Operating cash inflows Cost of goods sold $ (43,000) + Increase in inventory of 6,300
= $ (44,500) Payments to suppliers – Increase in accounts payable of 4,800
Salaries expense (18,500) + Decrease in salaries payable of 500 = (19,000) Payments to employees Other expenses (4,700) + Increase in prepaid expenses of 600 = (5,300) Other operating payments Interest expense (9,200) – Decrease in discount on bonds
payable (amortization) of 200 = (9,000) Payments of interest – Increase in income taxes payable of 300
– Increase in deferred tax liability of 400 EXAMPLE 22-8 Schedule to Compute Cash Flows
Income tax expense (3,900) = (3,200) Payments of income taxes
$ (81,000) Operating cash outflows
$ 25,400 Net cash provided by operating activities
$5,400 interest revenue is decreased by the $1,200 increase in interest receivable to deter- mine the $4,200 interest collected because the company received less cash than it recorded as interest revenue. The total operating cash inflows were $106,400 in 2007.
Operating Cash Outflows The $43,000 cost of goods sold is adjusted for two items. It is increased for the $6,300 increase in inventory because the company’s purchases exceeded its cost of goods sold. It is decreased by the $4,800 increase in accounts payable because the company’s cash payments were less than its purchases. Thus, payments to suppliers totaled $44,500 in 2007. The $18,500 of salaries expense is increased by the
$500 decrease in salaries payable to determine the $19,000 paid to employees, because salaries paid exceeded salaries expense. The $4,700 of other expenses are increased by the
$600 increase in prepaid expenses to determine the $5,300 other operating payments, because the company’s cash payments for prepaid items exceeded its expenses. Note that the $11,000 depreciation expense is the same as the $11,000 credit to accumulated depre- ciation. Because this is a “noncash” income statement item and is listed separately from other operating expenses, no adjustment is made for operating cash flows.
The decrease in the discount on bonds payable resulted from the amortization of the discount. Recall that the amortization of the discount on bonds payable increases interest expense to an amount greater than the cash the company paid for interest.
Therefore, the $200 decrease in the discount on bonds payable is subtracted from the
$9,200 interest expense to determine the $9,000 interest paid. The $3,900 income tax expense is decreased by the $300 increase in income taxes payable and the $400 increase in the deferred tax liability to determine the $3,200 payments of income taxes, because the company paid less taxes currently than it recorded as an expense. The total operating cash outflows were $81,000 in 2007, so that $25,400 net cash was provided by operating activities during 2007 as we show at the bottom of Example 22-8.
Example 22-9 shows the cash flows from operating activities section of the Betha Company’s statement of cash flows, under the direct method. The company includes cash flows from investing activities and the cash flows from financing activities in the usual manner to complete the statement of cash flows.
BETHA COMPANY
Statement of Cash Flows (Partial) For Year Ended December 31, 2007 Cash Flows From Operating Activities
Cash Inflows:
Collections from customers $102,200
Interest collected 4,200
Cash inflows from operating activities $106,400 Cash Outflows:
Payments to suppliers $(44,500)
Payments to employees (19,000)
Other operating payments (5,300)
Payments of interest (9,000)
Payments of income taxes (3,200)
Cash outflows for operating activities (81,000) Net cash provided by operating activities $ 25,400 EXAMPLE 22-9 Operating Cash Flows (Direct Method)
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Worksheet Method
Under the worksheet approach, the steps completed using the direct method are very simi- lar to those of the indirect method. There are enough slight differences, however, that we list all of the steps using the direct method in Exhibit 22-6, after which we present an example.