Chapter 16, Problem 1DQ

To determine

Determine the advantage and disadvantage of the direct method of reporting cash flows from operating activities.

Explanation of Solution

Statement of cash flows: It is one of the financial statement that shows the cash and cash equivalents of a company for a particular period. It determines the net changes in cash through reporting the sources and uses of cash due to the operating, investing, and financing activities of a company.

Direct method: This method uses the basis of cash for preparing the cash flows statement.

Cash flows from operating activities: These refer to the cash received or cash paid in day-to-day operating activities of a company.  In this direct method, cash flow from operating activities is computed by using all cash receipts and cash payments during the year.

Cash Receipts: It encompasses all the cash receipts from sale of goods and on account receivable.

Cash Payments: It encompasses all the cash payments that are made to suppliers of goods and all expenses that are paid.

The below table shows the way of calculation of cash flows from operating activities:

Cash flows from operating activities (Direct method)

Add: Cash receipts.

Cash receipt from customer

Less: Cash payments:

To supplier

For operating expenses

Income tax expenses

Net cash provided from or used by operating activities

Advantages:

• The main advantage of direct method presents the operating cash receipts and cash payments to estimate the future cash flows in the statement of cash flows.
• This is similar to the income statement as it is familiar to the users of financial statement.

Disadvantages:

• The main disadvantage is that the cash receipts and cash payments data’s might not be readily available in the accounting records.
• This method (direct method) is not frequently prepared or used in practice.
• The required data to calculate operating activities section will be an expensive one and it is a time –consuming process.