Financial Reporting and Analysis
About Lesson
LOS G requires us to:
convert cash flows from the indirect to direct method.
The cash flow from indirect to the direct method can be converted by taking the two major components of the income statement and the cash flow statement (prepared using the indirect method), i.e. cash receipts and cash payments. All we have to do here is to adjust each item of the income statement for its corresponding balance sheet accounts and to eliminate the non-cash and non-operating transactions.
Following steps are followed in conversion:
a. Take the value of net income from the income statement and bifurcate it into two of its major components i.e. cash revenues and expenses.
b. Adjust the total revenues for non-cash revenue items such as gain on sale of assets.
c. Adjust the total expenses for non-cash expenses such as depreciation.
d. Make the adjustment for the corresponding balance sheet figures as follows:
i. subtract the changes in accounts receivable to the adjusted total revenue to calculate the value of cash collected from customers,
ii. add the change in inventory and changes in accounts payable to the cost of goods sold to calculate the cash paid to the suppliers,
iii. add changes in wages payable to the salary expense to calculate cash paid to employees,
iv. add changes in the other operating expenses payable to operating expenses to calculate the cash paid for other operating expenses,
v. add changes in the balance interest payable to the interest expense to calculate the cash paid for interest, and
vi. add the changes in tax payable to tax expense to calculate the cash paid for the tax.
e. This process can be illustrated using the following diagram:
