Cash Flow Statement Direct Method Preparation, Format & Example

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Definition

The direct method cash flow, where major classes of gross cash receipts and gross cash payments are disclosed. (IAS 7, Para 18).

Cash flow statement classifies all the business activities into three main categories. These categories are operating, investing and financing activities. Under the direct method cash flow statement, the both investing and financing activities are presented in the same way as presented in indirect method. While activities under the heading of operating activities are presented in a different way as compared to the indirect method.  More precisely we would say that the only difference between direct and indirect methods of cash flow statement is the presentation of Cash flow from operating activities. The remaining portion of cash flow i.e. investing activities and financing activities remain the same and there is no difference occurs whether it is direct method or indirect method of cash flow statement preparation.

Explanation

From the above discussion it is expected that you would have understood the main differences between two methods of cash flow statement. Now this is the time to further explain that what direct method of cash flow statement actually is.

The direct method cash flow presents cash generated from operations as the difference between cash receipts from entity’s customers and cash paid to entity’s suppliers and employees.

Cash receipts from customers

There are two components of Cash receipts from customers. These components are

  1. Cash received from current period’s sales/incomes   and
  2. Cash received from previous year’s sales

The computation is carried out as under

Sales
XXX
Add Decrease / Less Increase in gross accounts receivable
XXX
Payment to suppliers and employees
XXX

Gross accounts receivable means the balance of accounts receivables before deducting allowances for bad debts and before incorporating the effects of write off of receivables during the year, if any.

Cash paid to suppliers & employees

Now let’s understand how this figure is worked out and arrived at.

The word ‘supplier’ would mean and include both supplier for materials and suppliers for services.

Cost of sales
XXX
Add selling & administrative expenses
XXX
Add other expenses
XXX
Add increase (or less decrease) in prepaid expenses
XXX
Add increase (or less decrease) in inventories
XXX
Add decrease (or less increase) in Accounts payables
XXX
Add decrease (or less increase) in accrued expenses
XXX
 Payment to suppliers and employees
XXX

If the cost of sales and other expenses include some non-cash items like deprecation, allowances for bad debts, amortization of deferred cost or other items of non-cash charges, the same would have to be deducted from cost of sales and expenses.

Format

The following receipts and payments list is used in the direct method format

  1. Cash Receipts from Customers
  2. Cash Payments to Suppliers
  3. Cash Payments to Employees
  4. Interest Payments
  5. Income Tax Payments
  6. Cash Payments for Purchase of Prepaid Assets

The above list tells about the receipt are coming and payment are going which is a great source of information for financial statement users. In this method the investors, creditors and company management can have a close look on cash inflows and cash outflows. The FASB recommends this method because it provides information which may be useful in estimating future cash flows. This method provides detail information but it is time consuming and difficult to create.

For example, there is a specific formula for direct method cash flow prepration.

  1. The Cash Receipts from Customers equal to company net sales plus beginning accounts receivable and then minus ending receivables.
  2. Likewise, cash payments to suppliers equal to purchases plus ending inventory minus beginning inventory plus beginning accounts payable minus ending accounts payable.
  3. Likewise, interest payments equal to company beginning interest payable minus ending interest payable plus interest expense.

Example and Preparation

The following are the balance sheets of A Traders as at December 31, 2015 and December 31, 2014 and extracts of Profit and Loss Account for the year ended December 31, 2015. You are required to prepare statement of cash flow under direct method. This example shows students the calculations and format of cash flows.

A Traders
Balance Sheet
 
2015
2014
Cash
7,900
9,700
Receivables
8,300
12,700
Allowances for doubtful debts 
-1,350
-1,200
Inventories 
36,000
40,000
Furniture
80,000
60,000
Accumulated depreciation 
-24,050
-16,000
 
106,800
105,200
Payables 
16,000
20,800
Debentures
  
20,000
 
16,000
40,800
 
 
 
Share capital 
80,000
56,000
Retained earnings
10,800
8,400
 
106,800
105,200

Profit and Loss Account

Net sales  95,000

Cost of goods sold  (44,000)

Gross profit  51,000

Operating expenses (including deprecation)  (28,600)

Net profit   22,400

Dividend declared and paid  20,000

Additional information

During the year furniture costing 10,000 dollars on which 8,000 dollars deprecation was provided, sold for $ 1,500. The loss on disposal is included in selling and administrative expenses.

CASH FLOW FROM OPERATING ACTIVITIES
 $  $
Cash received from customers (N-1)
99400
 
Cash paid to suppliers & employees (N-2)
(56700)
 
Net cash flow from operating activities
 
42700
CASH FLOW FROM INVESTING ACTIVITIES
 
 
Purchase of fixed assets (N-3)
(30000)
 
Sale of furniture 
1500
 
Net cash used in investing activities 
 
28500
CASH FLOW FROM FINANCING ACTIVITIES
 
 
Dividend paid 
(20000)
 
Redemption of debentures 
(20000)
 
Proceed from issuance of shares 
24000
 
Net cash used in financing activities 
 
(16000)
Net decrease in cash & cash equivalents during the year 
 
(1800)
Cash & cash equivalents at the beginning of the year 
 
9700
Cash & cash equivalents at the end of the year 
 
7900

Direct Method Cash Flow Payble Receivable 

Direct method cash flow statement is not used commonly because it does not give much details about operating activities comparing to indirect method. Therefore, almost all the entities like to adopt indirect method of cash flow statement which will be explained in our next topic.