PREPARING A STATEMENT OF CASH

FLOWS USING THE DIRECT METHOD

Direct method vs indirect method:
The direct method of making a statement of cash flows is more understandable
than the indirect method because it directly tells you how much cash the business
received from its customers and how much cash it has paid out. This type of information
can’t be found in the indirect method because it only gives you the net income and
adjusts it with depreciation, gains, losses and changes in working capital. Although the
direct method is easier for the external users to read, this method is harder for the
accountant to prepare. This is because you need to compute every line item before you
can find the answer. Unlike in the indirect method where the values are easily found.

Preliminary preparation:
To make a statement of cash flows using the direct method, you will need a
comparative statement of financial position, the statement of profit and loss for the
current period and additional information not listed in the financial statements but has
cash inflows or outflows. The first step is to subtract the current and previous balances
in the SFP to determine the increases or decreases of that account.

The next step is to convert the line items in the statement of profit and loss into its
corresponding line item in the statement of cash flows. Here are the line items for the
statement of cash flows under the direct method. Remember that every problem is
different and not all line items may be used.
1. Cash receipts from customers (Sales under cash basis)
2. Cash receipts from rent income (Rent income under cash basis)
3. Cash receipts from interest income (Interest income under cash basis)
4. Cash paid to suppliers (COGS under cash basis)
5. Salaries paid (Salaries expense under cash basis)
6. Rent paid (Rent expense under cash basis)
7. Insurance paid (Insurance expense under cash basis)
8. Supplies paid (Supplies expense under cash basis)
9. Interest paid (Interest expense under cash basis)
10. Income tax paid (Income tax expense under cash basis)
11. Cash flows from buying or selling trading securities
Direct method line item computation

Cash receipts from customers (Sales under cash basis):

Sales Accounts receivable Unearned revenues
Increases in N/A Minus (-) Add (+)
Decreases in N/A Add (+) Minus (-)

Cash receipts from rent / interest income (Other income under cash basis):
Rent / interest income Rest / interest receivable
Increases in N/A Minus (-)
Decreases in N/A Add (+)

Cash paid to suppliers (COGS under cash basis):

COGS Inventory Accounts payable
Increases in N/A Add (+) Minus (-)
Decreases in N/A Minus (-) Add (+)

Salaries paid, Interest paid, Income tax paid etc. (postpaid expenses under cash basis):
Salaries / interest / tax expense Salaries / interest / tax payable
Increases in N/A Minus (-)
Decreases in N/A Add (+)

Rent paid, Insurance paid, supplies paid etc. (prepaid expenses under cash basis):
Rent/insurance/supplies expense Prepaid rent/ insurance/supplies
Increases in N/A Add (+)
Decreases in N/A Minus (-)

Depreciation expense and gain or loss from selling equipment are not included in
making the cash flows statement under the direct method. No matter what kind of
method you used, you should arrive at the same answer when using the direct or
indirect method. If it is different, then you did something wrong. Cash flows from
investing activities and cash flows from financing activities are the same in the direct
and indirect method. To find out more, check out my notes under the indirect method.