CFA Program Level I for November 2024 $ & '

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K Home ) # The Direct Method for Cash Flows from Operating Activities 3 4 7 6
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r Practice THE DIRECT METHOD FOR CASH FLOWS FROM OPERATING

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ACTIVITIES

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describe the steps in the preparation of direct and indirect cash flow statements, including how cash
e Discussions
flows can be computed using income statement and balance sheet data
B Search The first step in preparing the cash flow statement is to determine cash flows from operating activities, which
can be presented using the direct or indirect method. The direct method uses the major categories of gross
cash receipts and payments, and the indirect method reconciles net income to net cash flow. Cash flows
from investing activities and from financing activities are identical regardless of whether the direct or indirect
method is used to present operating cash flows.

Companies often disclose only indirect operating cash flow information but understanding how cash flow
information is put together will enable you to take an indirect statement apart and reconfigure it to
approximate a direct cash flow statement, which—while not perfectly accurate—can be useful. This
lesson demonstrates the approximate preparation of a direct cash flow statement using the income
statement and the comparative balance sheets for Acme Corporation (a fictitious retail company) shown
in Exhibit 9 and Exhibit 10.

Exhibit 9: Acme Corporation Income Statement Year Ended 31

December 2018

Revenue (net) USD23,598

Cost of goods sold 11,456
Gross profit 12,142
Salary and wage expense USD4,123
Depreciation expense 1,052
Other operating expenses 3,577
Total operating expenses 8,752
Operating profit 3,390
Other revenues (expenses):
Gain on sale of equipment 205
Interest expense (246) (41)
Income before tax 3,349
Income tax expense 1,139
Net income USD2,210

Exhibit 10: Acme Corporation Comparative Balance Sheets 31 December

2018 and 2017

2018 2017 Net Change

Cash USD1,011 USD1,163 USD(152)
Accounts receivable 1,012 957 55
Inventory 3,984 3,277 707
Prepaid expenses 155 178 (23)
Total current assets 6,162 5,575 587
Land 510 510 —
Buildings 3,680 3,680 —
Equipment* 8,798 8,555 243
Less: accumulated depreciation (3,443) (2,891) (552)
Total long-term assets 9,545 9,854 (309)
Total assets USD15,707 USD15,429 USD278

Accounts payable USD3,588 USD3,325 USD263

Salary and wage payable 85 75 10
Interest payable 62 74 (12)
Income tax payable 55 50 5
Other accrued liabilities 1,126 1,104 22
Total current liabilities 4,916 4,628 288
Long-term debt 3,075 3,575 (500)
Common stock 3,750 4,350 (600)
Retained earnings 3,966 2,876 1,090
Total liabilities and equity USD15,707 USD15,429 USD278
* During 2018, Acme purchased new equipment for a total cost of $1,300. No items impacted retained earnings other than net income and
dividends.

Operating Activities: Direct Method

We first determine how much cash Acme received from its customers (sometimes referred to as “cash
collections”), followed by how much cash was paid to suppliers and to employees, as well as how much
cash was paid for other operating expenses, interest, and income taxes.

Cash Received From Customers

The income statement for Acme reported revenue of USD23,598 for the year ended 31 December 2018. To
determine the approximate cash receipts from its customers, it is necessary to adjust this revenue amount
by the net change in accounts receivable for the year. If accounts receivable increase during the year,
revenue on an accrual basis is higher than cash receipts from customers, and vice versa. For Acme
Corporation, accounts receivable increased by USD55, so cash received from customers was USD23,543,
as shown in Exhibit 11.

Exhibit 11: Cash Received from Customers

Revenue USD23,598
Less: Increase in accounts receivable (USD55)
Cash received from customers USD23,543

Cash received from customers affects the accounts receivable account as shown in Exhibit 12.

Exhibit 12: Effect on Accounts Receivable, 1

Beginning accounts receivable 957

Plus revenue 23,598
Minus cash collected from customers (23,543)
Ending accounts receivable USD1,012

The accounts receivable account information can also be presented as shown in Exhibit 13.

Exhibit 13: Effect on Accounts Receivable, 2

Beginning accounts receivable USD957

Plus revenue 23,598
Minus ending accounts receivable (1,012)
Cash collected from customers USD23,543

Acme did not have any deferred or unearned revenue. If it did, further adjustment would be required to arrive
at cash collected from customers (a decrease in deferred revenue would be a negative adjustment and vice
versa).

EXAMPLE 5

Computing Cash Received from Customers

1. Blue Bayou, a fictitious advertising company, reported revenues of USD50 million, total expenses of
USD35 million, and net income of USD15 million in the most recent year. If accounts receivable
decreased by USD12 million, how much cash did the company receive from customers?

A. USD38 million
B. USD50 million
C. USD62 million

Hide Solution

Solution:

C is correct. Revenues of USD50 million plus the decrease in accounts receivable of USD12
million equals USD62 million cash received from customers. The decrease in accounts
receivable means that the company received more in cash than the amount of revenue it
reported.

Cash Paid to Suppliers

For Acme, the cash paid to suppliers was USD11,900, determined as shown in Exhibit 14.

Exhibit 14: Cash Paid to Suppliers

Cost of goods sold USD11,456

Plus: Increase in inventory 707
Equals purchases from suppliers USD12,163
Less: Increase in accounts payable (263)
Cash paid to suppliers USD11,900

There are two pieces to this calculation: the amount of inventory purchased and the amount paid for it. To
determine purchases from suppliers, cost of goods sold is adjusted for the change in inventory. If inventory
increased during the year, then purchases during the year exceeded cost of goods sold, and vice versa.
Acme reported cost of goods sold of USD11,456 for the year ended 31 December 2018. For Acme
Corporation, inventory increased by USD707, so purchases from suppliers was USD12,163. Purchases from
suppliers affect the inventory account, as shown in Exhibit 15.

Exhibit 15: Effect on Inventory

Beginning inventory USD3,277

Plus purchases 12,163
Minus cost of goods sold (11,456)
Ending inventory USD3,984

Acme purchased USD12,163 of inventory from suppliers in 2018, but is this the amount of cash that Acme
paid to its suppliers during the year? Not necessarily. Acme may not have yet paid for all of these purchases
and may yet owe for some of the purchases made this year. In other words, Acme may have paid less cash
to its suppliers than the amount of this year’s purchases, in which case Acme’s liability (accounts payable)
will have increased by the difference. Alternatively, Acme may have paid even more to its suppliers than the
amount of this year’s purchases, in which case Acme’s accounts payable will have decreased.

Therefore, once purchases have been determined, cash paid to suppliers can be calculated by adjusting
purchases for the change in accounts payable. If the company made all purchases with cash, then accounts
payable would not change and cash outflows would equal purchases. If accounts payable increased during
the year, then purchases on an accrual basis would be higher than they would be on a cash basis, and vice
versa. In this example, Acme made more purchases than it paid in cash, so the balance in accounts payable
increased. For Acme, the cash paid to suppliers was USD11,900, determined as shown in Exhibit 16.

Exhibit 16: Cash Paid to Suppliers

Purchases from suppliers USD12,163

Less: Increase in accounts payable (263)
Cash paid to suppliers USD11,900

The amount of cash paid to suppliers is reflected in the accounts payable account, as shown in Exhibit 17.

Exhibit 17: Cash Paid to Suppliers

Beginning accounts payable USD3,325

Plus purchases 12,163
Minus cash paid to suppliers (11,900)
Ending accounts payable USD3,588

EXAMPLE 6

Computing Cash Paid to Suppliers

1. Orange Beverages Plc., a fictitious manufacturer of tropical drinks, reported cost of goods sold for
the year of USD100 million. Total assets increased by USD55 million, but inventory declined by
USD6 million. Total liabilities increased by USD45 million, but accounts payable decreased by
USD2 million. How much cash did the company pay to its suppliers during the year?

A. USD96 million
B. USD104 million
C. USD108 million

Hide Solution

Solution:

A is correct. Cost of goods sold of USD100 million less the decrease in inventory of USD6
million equals purchases from suppliers of USD94 million. The decrease in accounts payable of
USD2 million means that the company paid USD96 million in cash (USD94 million plus USD2
million).

Cash Paid to Employees

To determine the cash paid to employees, it is necessary to adjust salary and wage expenses by the net
change in salary and wages payable for the year. If salary and wages payable increased during the year,
then salary and wage expenses on an accrual basis would be higher than the amount of cash paid for this
expense, and vice versa. For Acme, salary and wages payable increased by USD10, so cash paid for salary
and wages was USD4,113, as shown in Exhibit 18.

Exhibit 18: Salary and Wages

Salary and wages expense USD4,123

Less: Increase in salary and wages payable (10)
Cash paid to employees USD4,113

The amount of cash paid to employees is reflected in the salary and wages payable account, as shown in
Exhibit 19.

Exhibit 19: Cash Paid to Employees

Beginning salary and wages payable USD75

Plus salary and wages expense 4,123
Minus cash paid to employees (4,113)
Ending salary and wages payable USD85

Cash Paid for Other Operating Expenses

To determine the cash paid for other operating expenses, it is necessary to adjust the other operating
expense amounts on the income statement by the net changes in prepaid expenses and accrued expense
liabilities for the year. If prepaid expenses increased during the year, other operating expenses on a cash
basis would be higher than on an accrual basis, and vice versa. Likewise, if accrued expense liabilities
increased during the year, other operating expenses on a cash basis would be lower than on an accrual
basis, and vice versa. For Acme Corporation, the amount of cash paid for operating expenses in 2018 was
USD3,532, as shown in Exhibit 20.

Exhibit 20: Cash Paid for Operating Expenses

Other operating expenses USD3,577

Plus: Change in prepaid expenses
Less: Decrease in prepaid expenses (23) + (-23)

Less: Increase in other accrued liabilities (22)

Cash paid for other operating expenses USD3,532

EXAMPLE 7

Computing Cash Paid for Other Operating Expenses

1. Black Ice, a fictitious sportswear manufacturer, reported other operating expenses of USD30 million.
Prepaid insurance expense increased by USD4 million, and accrued utilities payable decreased by
USD7 million. Insurance and utilities are the only two components of other operating expenses.
How much cash did the company pay in other operating expenses?

A. USD19 million
B. USD33 million
C. USD41 million

Hide Solution

Solution:

C is correct. Other operating expenses of USD30 million plus the increase in prepaid insurance
expense of USD4 million plus the decrease in accrued utilities payable of USD7 million equals
USD41 million.

Cash Paid for Interest

The cash paid for interest is included in operating cash flows under US GAAP and may be included in
operating or financing cash flows under IFRS. To determine the cash paid for interest, it is necessary to
adjust interest expense by the net change in interest payable for the year. If interest payable increases
during the year, then interest expense on an accrual basis will be higher than the amount of cash paid for
interest, and vice versa. For Acme Corporation, interest payable decreased by USD12, and cash paid for
interest was USD258, as shown in Exhibit 21.

Exhibit 21: Cash Paid for Interest

Interest expense USD246

Less: Changes in interest payable
Plus: Decrease in interest payable 12 - (-12)

Cash paid for interest USD258

Alternatively, cash paid for interest may also be determined by an analysis of the interest payable account,
as shown in Exhibit 22.

Exhibit 22: Interest Payable Account

Beginning interest payable USD74

Plus interest expense 246
Minus cash paid for interest (258)
Ending interest payable USD62

Cash Paid for Income Taxes Rate Your Confidence

To determine the cash paid for income taxes, it is necessary to adjust the income tax expense amount on
High
the income statement by the net changes in taxes receivable, taxes payable, and deferred income taxes for
the year. If taxes receivable or deferred tax assets increase during the year, income taxes on a cash basis Medium
will be higher than on an accrual basis, and vice versa. Likewise, if taxes payable or deferred tax liabilities
increase during the year, income tax expense on a cash basis will be lower than on an accrual basis, and Low
vice versa. For Acme Corporation, the amount of cash paid for income taxes in 2018 was USD1,134, as
shown in Exhibit 23. Continue !

Category
Exhibit 23: Cash Paid for Income Taxes
Analyzing Statements of Cash
Flows I
Income tax expense USD1,139
Less: Increase in income tax payable (5) r Related Questions:
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Cash paid for income taxes USD1,134
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