Preparing the statement of cash flows using the direct method would be a simple task if all companies maintained extremely detailed cash account records that could be easily summarized like this cash account:
Most companies record an extremely large number of transactions in their cash account and do not record enough detail for the information to be summarized. Therefore, the statement of cash flows is prepared by analyzing all accounts except the cash accounts. Remember that in accounting, all transactions affect at least two accounts. If cash increases or decreases, at least one other account also changes. If cash increases, that increase may also decrease another asset account, such as accounts receivable [payment from customer on account] or equipment [sale of equipment], or increase the sales account [cash sales]. Similarly, if cash decreases, there may be an increase in another asset account, such as inventory [purchase of inventory] or equipment [purchase of equipment], a decrease in a liability account, such as accounts payable [payment to creditor] or notes payable [payment on loan], or an increase in an expense account [payment to vendor]. Table summarizes many cash activities and the related financial statement accounts used to analyze each listed activity .
Operating activities
To prepare the operating activities section, certain accounts found in the current assets and current liabilities section of the balance sheet are used to help identify the cash flows received and incurred in generating net income.
Cash collections from customers This consists of sales made for cash [cash sales] and cash collected from credit customers. The activity in the accounts receivable and sales accounts is used to determine the cash collections from customers. Accounts receivable decreased by $663 because the company received more cash from its customers than credit sales made by the company. The $663 decrease is added to sales per the income statement of $129,000 to determine the cash collections from customers reported in the cash flow statement of $129,663. If the accounts receivable balance had increased, the cash collected from customers would be determined by subtracting the increase in the accounts receivable balance from the sales balance because an increase in accounts receivable means your customers owe you the cash for their purchases [your sales].
Cash payments to suppliers. This represents the amount paid by the company for merchandise it plans to sell to its customers. It takes a two‐step calculation to determine the cash payments to suppliers of $71,976. First, the $107 increase in the inventory account is added to the amount of cost of goods sold—found on the income statement—of $70,950 to get $71,057 as the cost of goods purchased. An increase in inventory means a company purchased more than it sold. Because the amount paid for merchandise includes what was sold as well as what still remains on hand in inventory to be sold, the change in inventory effects the cash payments to suppliers. To determine the amount that has actually been paid for the merchandise purchased, a second step is needed. The decrease in accounts payable of $919 is then added to the amount of the purchases of $71,057 to calculate the cash paid to suppliers of $71,976. The decrease in accounts payable is added to the amount of the purchases because a decrease in the accounts payable balance means more cash was paid out than merchandise was purchased on credit.
If the inventory account balance had decreased, the decrease would be subtracted from the cost of goods sold to calculate the cost of goods purchased because the decrease indicates less merchandise was purchased than was sold during the period. If the accounts payable balance had increased, the amount of the increase would have been subtracted from the cost of goods purchased to determine cash payments to suppliers because the accounts payable increase means you have a loan from your suppliers and have not yet paid cash for your purchases.
Cash payments for operating expenses. This includes wages and other operating costs. To calculate the cash payments for operating expenses, two steps are required. First, the amount of total operating expenses in the income statement of $42,600 is reduced by $14,400 depreciation expense because depreciation is a non‐cash expense. Second, the balance is adjusted for changes in the balances of related balance sheet accounts. For Brothers' Quintet, Inc., the related balance sheet accounts and the changes in these account balances are: increase of $142 in prepaid expenses; increase of $320 in wages payable; and $1,295 decrease in accrued expenses. The operating expenses before depreciation expense total $28,200. To this total the increase of $142 in prepaid expenses is added, the increase of $320 in wages payable is subtracted, and the decrease of $1,295 in accrued expenses is added to get cash payments to suppliers of $29,317. As with the prior calculations, the calculation changes with the direction of the change in the balances of the related balance sheet accounts. The operating expenses excluding depreciation expense would be decreased by a decrease in the prepaid expenses account's balance, increased by a decrease in the balance of the wages payable account, and decreased by an increase in the balance of the accrued expenses account.
Cash payments for income taxes. This represents amounts paid by the company for income taxes. The amount is calculated by taking income tax expense and increasing it by the amount of any decrease in the balance of the income taxes payable account or decreasing it by the amount of any increase in the balance of the income taxes payable account. In this case, there are no accrued taxes so the income tax expense is the same as cash paid for income taxes.
Cash paid for interest. This represents amounts paid by the company for interest. The amount is calculated by taking interest expense and increasing it by the amount of any decrease in the balance of the interest payable account or decreasing it by the amount of an increase in the balance of the interest payable account. In this case, there is no balance in the accrued interest account at the end of the period so the cash paid for interest is the same as the interest expense.
Investing activities
To identify the investing activities, the long‐term asset accounts must be analyzed.
Purchase of equipment This includes the amount of cash paid for equipment. If a note had been taken in exchange for a portion of or all of the purchase price of the equipment, only the cash actually paid would be reported as a payment on the statement of cash flows. The portion of the purchase price represented by the note would be separately disclosed if it were a material amount.
Proceeds from sale of equipment [or any other long‐term asset]. The cash received from the sale is reported here. The proceeds are not adjusted for any gain or loss that may also have been recorded on the sale because only the proceeds represent cash, the gain or loss represents the difference between the book value of the assets and the value received. For the Brothers' Quintet, Inc., the book value is $10,000 [$15,000 cost – $5,000 accumulated depreciation]. The loss is $3,000, calculated by subtracting the $10,000 book value from the proceeds of $7,000, and is reported in the income statement. The proceeds of $7,000 represent the actual cash received from the sale and is the amount reported in the statement of cash flows. The analysis of long‐term asset accounts includes the following:
Financing activities
To identify the financing activities, the long‐term liability accounts and the stockholders' equity accounts must be analyzed.
Proceeds for bank loan. Proceeds for bank loan of $4,000 represents additional borrowings during the year. Borrowings are not shown net of repayments. Each is treated as a separate activity to be reported on the statement of cash flows.
Payment on loan. Payment on loan of $12,000 equals the cash repayments made to the bank during the year.
Proceeds from sale of stock. This represents the cash received from the issuance of new shares to investors.
Cash payments of dividends. This is the amount of dividends paid during the year. As the statement of cash flows includes only cash activity, the declaration of a dividend does not result in any reporting on the statement, it is only when the dividends are paid that they are included in the statement cash flows. In analyzing the retained earnings account, the other activity is the net income. The cash activities related to generating net income are included in the operating activities section of the statement of cash flows, and therefore, are not included in the financing activities section.
Reconciliation of net income to cash provided by [used by] operating activities
If the direct method of preparing the statement of cash flows is used, the Financial Accounting Standards Board requires companies to disclose the reconciliation of net income to the net cash provided by [used by] operating activities that would have been reported if the indirect method had been used to prepare the statement.