Accounting Principles II: Preparing the Statement

There are two acceptable methods for reporting a statement of cash flows: the direct and the indirect methods. The difference between the two methods is seen in the operating section of the statement of cash flows. Although the total cash provided (used by) operating activities will be the same, the line items used to report the cash flows will be different.

Direct Method

Using the direct method requires cash related to day-to-day business operations to be identified by type of activity. For example, cash collected from customers, cash paid to employees, cash paid to suppliers (or paid for merchandise), cash paid for building operations, cash paid for interest, and cash paid for taxes. These types of labels make it easy for the reader to understand where cash came from and what it was spent on.

Indirect Method

Although the Financial Accounting Standards Board favors the direct method for preparing the statement of cash flows, most companies do not use the direct method, opting instead for the indirect method because it is easier to prepare and provides less detailed information to competitors. The indirect method begins with the assumption that net income equals cash and adjusts net income for significant non-cash income statement items such as depreciation, amortization, and gains and losses from sales, and for net changes in current asset, current liability, and income tax accounts. Table 1 shows the operating activities section prepared using each method

TABLE 1

Computation of Net Cash Flow Provided by Operating Activities

Direct Method		Indirect Method
Operating Activities		Operating Activities
Collections from customers	$129,663	Net income	$6,300
Payments to suppliers	(71,976)	Adjustments to reconcile cash
Payments for operating expenses	(29,317)	Depreciation expense	14,400
Payments for income taxes	(4,200)	Loss on sale of equipment	3,000
Payments	(1,950)	Changes in Current Accounts
		Decrease in accounts receivable	663
		Increase in inventory	(107)
		Increase in prepaid expenses	(142)
		Decrease in accounts payble	(919)
		Increase in salaries payable	320
		Decrease in accrued expenses	(1,295)
Cash provided by operating activities	$22,220	Cash provided by operating activities	$22,220

The information in the 20X1 and 20X0 balance sheets and the 20X1 income statement for the Brothers' Quintet, Inc. will be used to illustrate the preparation of the statement of cash flows using the direct and indirect methods. Additional information regarding the Brothers' Quintet, Inc., include:

All sales are made on credit. The company has no bad debts.
Accounts payable represents amounts owed suppliers for merchandise. All purchases of merchandise are made on account.
Equipment with a cost of $15,000 and accumulated depreciation of $5,000 was sold for $7,000.
1,000 additional shares of common stock were sold for $10 each.
Dividends totaling $600 were declared and paid in the current year.
No amounts are accrued for interest or income taxes.

Brothers' Quintet, Inc. Balance Sheet As of December 31, 20X1 and 20X0

	20X1	20X0	Increase (Decrease)
ASSETS
Current Assets
Cash	$ 16,950	$ 6,330	$10,620
Accounts Receivable	18,567	19,230	(663)
Inventory	12,309	12,202	107
Prepaid Expenses	712	570	142
Total Assets	48,538	38,332	10,206
Property, Plant and Equipment
Land	10,500	10,500	0
Building	50,000	50,000	0
Equipment	35,000	30,000	5,000
Less: Accumulated deprecitation, equipment	(10,000)	(5,000)	(5,000)
Accumulated depreciation, equipment	(11,000)	(6,600)	(4,400)
Total property, plant and equipment	74,500	78,900	(4,400)
Other assets	1,500	1,500	0
Total Assets	$124,538	$118,732	$5,806
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities
Accounts payable	$ 15,730	$ 16,649	$ (919)
Wages payable	9,995	9,675	320
Accrued expenses	2,390	3,685	(1,295)
Total current liabilities	28,115	30,009	(1,894)
Long-term debt	15,000	23,000	(8,000)
Stockholders' Equity
Common stock	30,000	20,000	10,000
Retained earnings	51,423	45,723	5,700
Total stockholders' equity	81,423	65,723	15,700
Total liabilities and stockholders'equity	$124,538	$118,732	$5,806

Brothers' Quintet, Inc. Income Statement For the Year Ended December 31, 20X1

Sales, net	$129,000
Cost of goods sold	70,950
Gross profit	58,050
Operating expenses, includes depreciation expense of $14,400	42,600
Operating income	15,450
Interest expense	1,950
Loss on sale of equipment	3,000
Income before taxes	10,500
Income tax expense	4,200
Net income	$6,300