Intermediate Accounting — Preparing the Statement of Cash Flows: Direct Method and Account Analysis

Principles of Accounting chapter 11 covered the structure of the cash flow statement and the indirect method. This chapter shows how to work back cash flows when there is no transaction ledger and only the financial statements are available — the technique used most often in exams and practical analysis. The key is to convert income statement items to a cash basis by attaching the changes in the related balance sheet accounts.

1. Deriving direct-method operating cash flows

Converting income statement items into cash flows
Cash flow	Starting point (profit or loss)	Adjustment (statement of financial position)
Receipts from customers	Revenue	− increase in receivables + increase in advances received − write-offs
Payments to suppliers	Cost of sales	+ increase in inventory − increase in payables
Payments to employees	Salaries	− increase in salaries payable
Interest paid	Interest expense	− increase in interest payable − amortization of bond discount
Income taxes paid	Income tax expense	− increase in current tax payable − increase in deferred tax liability + increase in deferred tax asset

Non-cash elements such as depreciation or amortization of a bond discount must be removed from the relevant item. Bond discount amortization is included in interest expense but did not leave in cash.

2. Worked example

Company SS’s figures for 20X1 (unit: ₩10,000):

Income statement: revenue 5,000, cost of sales 3,000, salaries 600, depreciation 700, interest expense 200 (including bond discount amortization of 30), gain on disposal of PP&E 50, income tax expense 150, profit 400
Changes in the statement of financial position: receivables +300, inventory −100, payables +120, salaries payable −20, interest payable +10, current tax payable +40, deferred tax liability +10

Direct-method operating cash flows (unit: ₩10,000)
Item	Working	Amount
Receipts from customers	5,000 − 300	4,700
Payments to suppliers	3,000 − 100 − 120	(2,780)
Payments to employees	600 + 20	(620)
Interest paid	200 − 10 − 30	(160)
Income taxes paid	150 − 40 − 10	(100)
Net cash from operating activities		1,040

Checking with the indirect method: $400 + 700 + 30 - 50 - 300 + 100 + 120 - 20 + 10 + 40 + 10 = 1{,}040$ , the same. The discount amortization of 30 is a non-cash expense and is added back; the gain on disposal of 50 relates to investing and is deducted.

3. Investing activities: working back through account analysis

Cash spent on and received from PP&E cannot be seen from balance sheet changes alone. The accounts are reconstructed from opening and closing balances and income statement information.

Information on PP&E (unit: ₩10,000)
Account	Opening	Closing	Additional information
PP&E (cost)	5,000	5,600	Cost of equipment disposed of: 800
Accumulated depreciation	2,000	2,300	Depreciation for the year: 700

Account analysis

\begin{aligned}\text{Acquisitions} &= \text{Closing cost} - \text{Opening cost} + \text{Cost of disposals} = 5{,}600 - 5{,}000 + 800 = 1{,}400 \\ \text{Accumulated depreciation on disposals} &= \text{Opening} + \text{Depreciation} - \text{Closing} = 2{,}000 + 700 - 2{,}300 = 400 \\ \text{Disposal proceeds} &= (800 - 400) + \text{Gain } 50 = 450\end{aligned}

Acquisitions of 1,400 are an investing outflow and disposal proceeds of 450 an investing inflow (unit: ₩10,000). Any part involving no cash, such as purchases on credit or leases, is excluded and disclosed in the notes as a non-cash transaction.

Borrowings, bonds and equity accounts are analysed the same way to find the financing cash flows from borrowing and repayment, share issues and dividends. Dividends paid equal opening retained earnings + profit − closing retained earnings (when there are no other movements), adjusted for the change in dividends payable.

4. Non-cash investing and financing activities

Significant investing and financing activities that involve no cash are excluded from the body of the cash flow statement and disclosed in the notes. Conversion of convertible bonds into shares, acquisition of right-of-use assets under leases, and acquisitions of assets by assuming liabilities are typical. A reconciliation of opening and closing liabilities arising from financing activities, split into cash and non-cash changes (exchange rates, fair value, new leases), is also required.

Check your understanding

Company TT’s revenue for the year is ₩80 million, and its receivables (net) rose from ₩12 million at the start of the year to ₩15 million at the end. An impairment loss of ₩500,000 from the loss allowance is included in selling and administrative expenses, and ₩300,000 of receivables were written off. Cost of sales is ₩50 million, inventory fell by ₩4 million and payables fell by ₩1.5 million. What are receipts from customers and payments to suppliers?

Net receivables increased by ₩3 million. That net increase is mixed with the effect of the ₩500,000 impairment loss, which increased the allowance and reduced the net amount, so when working on a net basis the impairment loss is deducted from revenue. Receipts from customers are $8{,}000 - 50 - 300 = 7{,}650$ (₩10,000), i.e. ₩76.5 million; working on a gross basis gives the same result. The ₩300,000 write-off reduces both the allowance and gross receivables and has no effect on the net amount. Payments to suppliers are $5{,}000 - 400 + 150 = 4{,}750$ , i.e. ₩47.5 million.

References

Korea Accounting Standards Board, K-IFRS 1007 Statement of Cash Flows (including disclosure of changes in liabilities from financing activities)
Donald Kieso, Jerry Weygandt and Terry Warfield, Intermediate Accounting: IFRS Edition, ch. 23
IASB, IAS 7 Statement of Cash Flows