Direct method for operating activities
The direct method presents cash flows more straightforwardly than the indirect method: it reports gross cash receipts and gross cash payments directly, instead of reconciling from net income (the approach used by the indirect method, covered in the next chapter).
This method breaks down the operating activity section of the statement of cash flows into the following items as a minimum:
- Receipts of cash from customers, including lessees, licensees, and the like
- Receipts of cash in the form of interests and dividends, except those that are donor restricted for long-term purposes
- Other operating cash receipts or payments, if any
- Cash payments to employees and other suppliers of goods or services
- Cash payments for interest
- Cash payments for taxes
Under US GAAP, interest paid and interest or dividends received are always classified within operating activities. IFRS permits some flexibility here, allowing interest and dividends to be classified as operating, investing, or financing cash flows.
Entities are encouraged to provide a further breakdown of the gross receipts or payments that are considered meaningful and feasible.
Steps in preparing direct method cash flows
The most accurate way of preparing a direct method of cash flows is to track the actual cash movements so they can be easily grouped into cash receipts and disbursements per nature. However, this proves to be too cumbersome in practice.
The following table shows the minimum line items of the direct method cash flows:
In case it is asked in the exam, all the above can be analyzed using the T-accounts.
One example of the cash receipts from customers follows below. The cash collection line is indirectly determined through the T-accounts as follows:
From the above template, we can understand that the beginning balance of accounts receivable plus the revenues during the period is equal to total receivables available for collection. When we remove the ending balance of accounts receivable from this, we are left with the cash collections that we can include in the statement of cash flows. This process can be represented by the formula:
For example, if beginning accounts receivable is , sales during the period are , and ending accounts receivable is , then cash collected from customers is
Another useful example would be for the cash payments to other suppliers of goods or services, which requires two T-accounts, one for inventory and one for accounts payable:
From the above template, we can see that the beginning balance of inventory plus purchases during the period is equal to the cost of sales plus the ending balance of inventory (together, these represent the total inventory available for sale). Rearranging this relationship, the amount of inventory purchased during the period is equal to the cost of sales plus the ending balance of inventory, minus the beginning balance of inventory.
However, since the purchases are not always made in cash, we need to use this amount as an input to another T-account for the trade payables to determine how much of the purchases were paid during the period: beginning accounts payable plus purchases, minus ending accounts payable, equals cash paid to suppliers.
For example, if cost of sales during the period is , beginning inventory is , and ending inventory is , then purchases are . If beginning accounts payable is and ending accounts payable is , then cash paid to suppliers is .
This procedure requires the good availability of information and a proper understanding of the changes in the related balance sheet items.
The schedules above cannot capture all income statement and balance sheet relationships. For example, the changes in allowance for doubtful accounts have to be considered if the accounts receivable are presented at net.
Disclosure considerations
It is always required to present a reconciliation between the net income and the cash flows from operating activities, regardless of the method used (direct or indirect). Under the direct method, that reconciliation is presented in a separate schedule, typically in the notes to the financial statements.