[Anonymous]

Do you have a good strategy on how to remember application of the Direct vs. Indirect method for cash flows?

With all my little brain cells working together looking at my notes, I can mostly figure it out. When confronted by a question I don’t seem to know where to start. Somehow it seems counter-intuitive to me. I’m looking for a method I can apply each time.

[musicamor]

Can you post a sample question? A lot of companies use the indirect method which is essentially backing into your ending cash balance by starting with Net Income; however, the direct method is becoming more common and there have been talks of it being the required method for external reporting.

So, in the indirect method, you will look at your change in balance sheet accounts and use those figures to arrive at your ending cash balance. For example, an operating activity can be a change in A/R or inventory. When using the direct method, you take your A/R balance at 12/31/X1 compared to the balance at 12/31/X2 and take the inverse result into the operating activities section of the SOCF. If I have $10,000 in A/R at 12/31/X1 and $20,000 in A/R at 12/31/X2, my balance increased which is considered a use of cash because you're not collecting if your A/R balance increases; therefore, you would enter ($20,000) on the SOCF, indirectly. Make sense?

Using the above example for the direct method; you would not derive your cash activity by dealing with ending balances, you would pull details directly out of the ledger for input into the SOCF. In this case, you would go to the A/R subledger detail and take the difference between new billings and cash receipts–the resulting number would be entered on the SOCF under the operating activities section. Make sense?

Hopefully I did not confuse you any further. I can help you with specific questions if you would post them. I prepare the SOCF for my company and I LOVE IT!!

Texas CPA - licensed in 2012!!!

[Anonymous]

Thanks for responding 🙂 Here's a question from Wiley:

Lance Corp's SOCF for the year ended 9/30/10 was prepared using the indirect method and included the following:

Net income $60,000

Noncash adjustments:

Deprec expense $9,000

Increase in A/R ($5,000)

Decrease in inventory $40,000

Decrease in A/P ($12,000)

Net cash flows from operating activities $92,000

Lance reported revenues from customers of $75,000 in its 2010 I/S. What amount of cash did Lance receive from its customers during the year ended 9/30/10?

A. $80,000

B. $70,000

C. $65,000

D. $55,000

B is the correct answer. ($75,000 – $5,000 = $70,000) Firstly, I didn't know how to approach it. Secondly, after I saw the answer I was thinking that the $5,000 should be added for some reason. Also, I thought that the indirect approach always started at net income? Their solution implies that they are using the direct method to solve it? Also, why did they say the used the indirect method to prepare the statements? I found it confusing and started the problem as if I had to find the answer starting with net income. What if they had said they had used the direct approach to prepare the statements. Would the answer be the same?

Anyway, I guess I'm looking for an approach. I have a harder time overlooking irrelevant information when I attempt to find the solution to these kind of problems.

[musicamor]

Yeah, the cash flow can be tricky–especially in this fact pattern; as it appears as though one should use the direct method to solve. In solving this problem, you must understand how to account for the change in A/R. If you don't understand how changes in these activities impact underlying items (sales), then it will be really confusing.

To answer your questions in the order they appear:

1. “Secondly, after I saw the answer I was thinking that the $5,000 should be added for some reason.” Whenever A/R increases, you are reporting more income than you are collecting cash; on the cash flow, this is depicted as a (negative), or a USE of cash. So, instead of adding, you subtract this number.

2. “Also, I thought that the indirect approach always started at net income?” You are correct–in looking at the fact pattern, the author correctly started with net income of $60,000.

3. “Also, why did they say the used the indirect method to prepare the statements?” I believe this is just fodder. In solving the question, this statement is irrelevant because one can deduce that the indirect method is in use.

4. “Their solution implies that they are using the direct method to solve it?” Not so. The question is requiring you to “back into” the number of cash collected by netting the change in A/R with the revenue reported in 2010; the direct method is not in use here because the direct method would not incorporate the change in A/R.

5. “What if they had said they had used the direct approach to prepare the statements. Would the answer be the same?” No, the answer (nor the fact pattern) would be the same because, again, the direct method does not deal with changes in balance sheet accounts and other noncash items (depreciation).

In order to solve this problem, you take the $75,000 of revenue that was recognized (given) and subtract the increase in A/R. Why subtract? Because this is a use of cash; since the question is asking for cash receipts, the $5k change in A/R would be a reduction to cash receipts.

Let me know if you need more help.

Texas CPA - licensed in 2012!!!

[Anonymous]

I appreciate your help @musicamor 🙂

[musicamor]

Glad I could help!

Texas CPA - licensed in 2012!!!

[Author]

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