To start with, we need two successive balance sheets and the operating statement or profit and loss account linking the two balance sheets.
There are two ways in which this statement can be drawn up. The first method is the direct method whereby major classes of gross cash receipts and gross cash payments are disclosed. The second method is known as the short-cut or indirect method. Under this method net profit or loss is taken as the basis and adjusted for the effects of transactions of non-cash nature, changes in current assets and current liabilities and transactions of income or expenses associated with financial cash flows.
Under the direct method, you are basically analysing your cash and bank accounts to identify cash flows during the period. You could use a detailed general ledger report showing all the entries to the cash and bank accounts, or you could use the cash receipts and disbursements journals. You would then determine the offsetting entry for each cash entry in order to determine where each cash movement should be reported on the cash flow statement.
Another way to determine cash flows under the direct method is to prepare a worksheet for each major line item, and eliminate the effects of accrual basis accounting in order to arrive at the net cash effect for that particular line item for the period. Some examples for the operating activities section include:
Cash Receipts from Customers:
• Net sales per the Income Statement • Plus beginning Balance in Accounts Receivable • Minus ending Balance in Accounts Receivable • Equals Cash Receipts from Customers
Cash Payments for Inventory:
• Ending Inventory • Minus Beginning Inventory • Plus Beginning Balance in Accounts Payable to Vendors • Minus Ending Balance in Accounts Payable to Vendors • Equals Cash Payments for Inventory Cash Paid to Employees:
• Salaries and Wages per the Income Statement • Plus Beginning Balance in Salaries and Wages Payable • Minus Ending Balance in salaries and Wages Payable • Equals Cash Paid to Employees
Cash Paid for Operating Expenses:
• Operating Expenses per the Income Statement
Construction and Analysis of Fund Flow and Cash Flow Statements
• Minus Depreciation Expenses • Plus Increase or Minus Decrease in Prepaid Expenses • Plus Decrease or Minus Increase in Accrued Expenses • Equals Cash Paid for Operating Expenses
• Tax Expense per the Income Statement • Plus Beginning Balance in Taxes Payable • Minus Ending Balance in Taxes Payable • Equals Taxes Paid
• Interest Expense per the Income Statement • Plus Beginning Balance in Interest Payable • Minus Ending Balance in Interest Payable • Equals Interest Paid
Under the direct method, for this example, you would then report the following in the cash flows from the operating activities section of the cash flow statement:
• Cash Receipts from Customers • Cash Payments for Inventory • Cash Paid to Employees • Cash Paid for Operating Expenses • Taxes Paid • Interest Paid • Equals Net Cash provided by (used in) Operating Activities.
Similar types of calculations can be made of the balance sheet accounts to eliminate the effects of accrual accounting and determine the cash flows to be reported in the investing activities and financing activities sections of the cash flow statement.
In preparing the cash flows from the operating activities section under the indirect method, you start with net income per the income statement, reverse out entries to income and expense accounts that do not involve a cash movement, and show the change in net working capital. Entries that affect net income but do not represent cash flows could include income you have earned but not yet received, amortisation of prepaid expenses, accrued expenses, and depreciation or amortisation. Under this method you are basically analysing your income and expense accounts, and working capital. The following is an example of how the indirect method would be presented on the cash flow statement:
1) Net Income per the Income Statement 2) Minus Entries to Income Accounts that do not represent Cash Flows 3) Plus Entries to Expense Accounts that do not represent Cash Flows 4) Equals Cash Flows before movements in Working Capital 5) Plus or minus the change in Working Capital, as follows:
• An increase in current assets (excluding cash and cash equivalents) would be shown as a negative figure because cash was spent or converted into other current assets, thereby reducing the cash balance.
• A decrease in current assets would be shown as a positive figure, because other current assets were converted into cash.
Understanding and Analysis of Financial Statements • An increase in current liabilities (excluding short-term debt which would be reported in the financing activities section) would be shown as a positive figure since more liabilities mean that less cash was spent. • A decrease in current liabilities would be shown as a negative figure, because cash was spent in order to reduce liabilities.
The net effect of the above would then be reported as cash provided by (used in) the operating activities. The cash flows from investing activities and financing activities would be presented the same way as under the direct method.