2. Preparing the Cash Flow Statement
d. distinguish between the direct and indirect methods of presenting cash from operating activities and describe arguments in favor of each method;
e. describe how the cash flow statement is linked to the income statement and the balance sheet;
f. describe the steps in the preparation of direct and indirect cash flow statements, including how cash flows can be computed using income statement and balance sheet data;
g. convert cash flows from the indirect to direct method;
What the three reasons that net income differs from net operating cash flows?
1. Non-cash expenses, such as depreciation and the amortization of intangible assets
2. Timing differences existing between the recognition of revenue and expense and the occurrence of the underlying cash flows
3. Non-operating gains and losses enter into the determination of net income, but the related cash flows are classified as investing or financing activities, not operating activities.
What is the direct method of reporting operating cash flow?
The direct method discloses operating cash inflows by source (e.g., cash received from customers, cash received from investment income) and operating cash outflows by use (e.g., cash paid to suppliers, cash paid for interest) in the operating activities section of the cash flow statement.
What is the indirect method of reporting operating cash flow?
The indirect method reconciles net income to net cash flow from operating activities by adjusting net income for all non-cash items and the net changes in the operating working capital accounts.
Between the direct and indirect method of reporting operating cash flows, which method is used more frequently? Why?
The indirect method is used more frequently because the direct method reveals more information and companies often want to limit the information they disclose.
What are the three steps to convert cash flows from the indirect to the direct method?
Although the indirect method is most commonly used by companies, the analyst can generally convert it to the direct format by following a simple three-step process.
1. Aggregate all revenue and all expenses.
2. Remove all non-cash items from aggregated revenues and expenses and break out remaining items into relevant cash flow items.
3. Convert accrual amounts to cash flow amounts by adjusting for working capital changes.