The Direct Method Cash Flow Statement With Reconciliation
Companies need financial statements to gauge and track their financial and operational performance. Financial statements include the income statement, balance sheet and cash flow statement. Due to its relative simplicity, most companies use the indirect method to put together the cash flow statement. However, a few companies use the direct method, even though the information can be difficult to assemble.
Direct Method Description
The direct method presents only those specific items that affect cash flow. This method solely reports cash receipts and cash disbursements in the operating section. Cash receipts include cash received from customers and interests and dividends received. Cash disbursements generally involve cash paid to employees, cash paid to vendors and suppliers, interest paid on debt, federal income taxes paid and cash paid for employee taxes and benefits. The net cash flow equals the difference between these cash receipts and cash disbursements.
Because the direct method solely focuses on cash transactions, the cash flow statement does not have an obvious link to the income statement with this method. Therefore, companies must reconcile the cash flow statement to the income statement through an adjustment and reconciliation process. Under the direct method, reconciliation occurs when a company shows how net income from its income statement translates into the net cash it generated during the same accounting period. After making all the required adjustments, the net income, or net loss, reconciliation must equal the net cash from operating activities shown on the cash flow statement.
Reconciliation How To
To begin the reconciliation process, a company accountant starts with the net income or net loss taken from the income statement and makes certain adjustments to the numbers shown on the income statement or in the short-term assets and liabilities on the balance sheet. She adds back noncash expenses, including any depreciation and amortization shown, provisions for losses that did not actually occur and increases in deferred taxes or taxes payable. Accountants also deduct any gain or add back any loss on the sale of an investment because the investing section already reflects this.
Example -- Cash Flow Statement
A company uses the cash flow method to prepare its statement of cash flows. Its cash flow statement shows $300,000 in cash receipts from customers, $150,000 in cash paid to vendors and suppliers, and $50,000 in cash paid to and on behalf of employees. Subtracting the cash payments from the cash receipts gives the total cash generated by operations of $100,000. The company also paid $20,000 in income taxes. Net cash from operating activities equals $80,000.
Example -- Reconciliation
The company had $70,000 in net income. It made the following adjustments to reconcile net income to net cash from operating activities: added back $5,000 in depreciation; added the increase in accounts payable of $7,000; and recorded a decrease in other short-term liabilities of $2,000. The total adjustments of $10,000 brought the net cash provided by operating activities to $80,000 -- equal to the amount shown on the cash flow statement.
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