Chapter 23, Problem 2CE

To determine

Compute cash from operating activities under the direct and indirect methods.

Explanation of Solution

Statement of cash flows: This statement reports all the cash transactions which are responsible for inflow and outflow of cash, and result of these transactions is reported as ending balance of cash at the end of reported period. Statement of cash flows includes the changes in cash balance due to operating, investing, and financing activities.

Direct method: Under direct method, cash receipts from customers (cash inflows) and cash payments to suppliers (cash outflows) are reported under the operating activities.

Operating activities: Operating activities include cash inflows and outflows from business operations.

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

Cash flows from operating activities (Direct method)

Add: Cash receipts.

Cash receipt from customer

Dividend received

Interest received

Less: Cash payments:

To supplier for acquisition of inventory

To employees

For interest on loans

Income tax expenses and other operating expenses

Net cash provided from or used by operating activities

Table (1)

Indirect method: Under indirect method, net income is reported first, and then non-cash expenses, losses from fixed assets, and changes in opening balances and ending balances of current assets and current liabilities are adjusted to reconcile the net income balance.

Cash flows from operating activities: Operating activities refer to the normal activities of a company to carry out the business.

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

Cash flows from operating activities (Indirect method)

Net income:

Add: Decrease in current assets

Increase in current liability

Depreciation expense and amortization expense

Loss on sale of plant assets

Deduct: Increase in current assets

Decrease in current liabilities

Gain on sale of plant assets

Net cash provided from or used by operating activities

Table (2)

Compute cash from operating activities under the direct method:

Statement of Cash Flows Direct Method (Partial)
Details	Amount ($)	Amount ($)
Cash flows from operating activities:
Cash receipts:
Cash received from customers	530
Total cash receipts		530
Cash payments:
Cash paid to employees	(350)
Total cash payments		(350)
Net cash provided by operating activities		$180

Table (3)

Working notes:

Calculate the amount of cash received from customers:

$\begin{array}{c}\left(\begin{array}{l}\text{Cash}\text{receipts}\text{from}\\ \text{customers}\end{array}\right)=\left[\text{Sales}\text{revenue }\left(\begin{array}{l}+\text{Decrease in accounts receivable}\\ \text{OR}\\ -\text{Increase in accounts receivable}\end{array}\right)\right]\\ =\left(\text{Sales}\text{revenue + }\text{Decrease in accounts receivable}\right)\\ =\left(\$500+\$30\right)\\ =\$530\end{array}$

Calculate the amount of cash paid to employees:

$\begin{array}{c}\left(\begin{array}{l}\text{Cash}\text{paid to}\\ \text{employees}\end{array}\right)=\left[\text{Wages expense }\left(\begin{array}{l}\text{+Decrease in Wages payable}\\ \text{OR}\\ -\text{Increase in Wages payable}\end{array}\right)\right]\\ =\left(\text{Wages expense + }\text{Decrease in Wages payable}\right)\\ =\left(\$300+\$50\right)\\ =\$350\end{array}$

Compute cash from operating activities under the indirect method:

Statement of Cash Flows - Indirect Method
Details	Amount ($)	Amount ($)
Cash flows from operating activities:
Net Income		200
Adjustment to reconcile net income to net cash provided by operating activities:
Changes in current assets and current liabilities:
Decrease in accounts receivable	30
Decrease in wages payable	(50)	(20)
Net cash provided by operating activities		$180

Table (4)

Working note:

Calculate the amount of net income:

$\begin{array}{c}\text{Net income}=\left(\text{Revenue}-\text{Expense}\right)\\ =\left(\text{Sales}-\text{Wages expense}\right)\\ =\left(\text{\$500}-\text{\$300}\right)\\ =\$200\end{array}$

Conclusion

Therefore, the net cash flows from operating activities under the direct and indirect method are $180.