Question

A tutorial question and its suggested solution was:

            Q. There are two methods of calculating ‘cash flow from operating activities’: the direct method (gross flows) and the indirect method (reconciliation).

                        (a) Explain the difference between the two methods.

                        (b) Which method is required by the Australian Accounting Standards?

                        (c) Which method is preferable? Why?

                        Solution:

(a) The direct method or gross flows method shows the cash received and paid for the different operating activities. Typical operating activities include:

• cash received from customers
• cash paid to suppliers and employees
• tax paid
• interest received (if part of day-to-day operations)
• dividends received (if part of day to day operations, could be investing)
• interest paid (if part of day-to-day operations, could be financing).

The indirect or reconciliation method simply shows the net differences between the ‘profit after tax’ and the ‘cash flow from operating activities’.

(b) Both methods are required according to the Australian Accounting Standard (the direct method in the accounts and the indirect method in the notes).

(c)   This is a debatable question; however, the indirect method is possibly more appropriate or informative for the lay reader of reports.

Required:

In your own words, explain the indirect method of presenting operating cash flows and why the format is useful to decision makers.

Answer 1

The indirect method starts with the net income.

The net income is the accounting income. But in accrual accounting system the revenues and expenses incurred during the period without cash flows are also recognized. For example depreciation expense does not involve any cash flow.

To arrive at the operating cash flow, adjustments are made for such non cash revenues and expenses.

Depreciation and amortization expenses are added to the net income. If there is loss on sale of asset ,same is added . If there is a gain on sale of assets , the same is deducted. The total cash received from sale of asset is considered investing activity , not operating activity.

There may be sales without receiving cash. Hence increase in Accounts receivable is deducted. In case of decrease in accounts receivable, it is a source of cash , hence added to Net income.

Increase in inventory consumes cash without affecting Net Income. Hence , the same is deducted. Decrease in inventory is a source of cash and added to the net income.

Increase in other current assets are deducted and decrease is added.

There may be purchase without paying cash. Hence increase in Accounts payable is added. In case of decrease in accounts payable , same is reduced from the income.

Increase in other current liabilities are added and decrease is deducted from the net income.

The format is useful because it pinpoints the reason for change in cash and reconciles the net income and net cash flows

An example of INDIRECT METHOD of presenting operating cash flow is given below:

	CASH FLOW FROM OPERATING ACTIVITIES
a	Net Income for 2011	$760
	Adjustment to reconcile net income
	to net cash provided by operating activities
b	Depreciation expense	$520
	(Increase)/Decrease in current assets
c	Increase in Accounts Receivable	-$50
d	Increase in Inventory	-$50
	Increase/(Decrease) in current liabilities
e	Increase in Accounts Payable	$50
g=a+b+c+d+e	NET CASH PROVIDED BY OPERATING ACTIVITIES	$1,230