Indirect method vs. Direct method. Statement of Cash Flows - Essay Example

? ACCT CASE 5: ment of Cash Flows October 14, Indirect method vs. Direct method. Indirect method of ment of cash inflows. The indirect method shows that increases in current assets are classified as decreases in cash inflows. Likewise, decreases in the current assets are recorded as increases in the company’s cash inflows. On the other hand, the indirect method shows that increases in current liabilities are classified as increases in cash inflows. Likewise, decreases in the current liabilities are recorded as decreases in the company’s cash inflows. In addition, the indirect method begins with the income statement’s net income data. Further, noncash deductions are added back to the net income to arrive at the correct cash inflow (Stickney, 2009). For example, the income statement shows a deduction for depreciation expense. Since the indirect methods starts with the net income, the depreciation expense reduced the company’s net income amount. Consequently, the proper process is to add back the depreciation expense to the net income. The reason is very obvious. All company expenses have a correspondent credit to cash or cash equivalents. However, there was no cash outflow or payment made when the company debited depreciation expense. To arrive at the amount of cash that flowed into the company’s coffers, the next step is to add back the cash-absent depreciation expense. The same process is applied to the amortization expense. Amortization expense is debited but there is no corresponding credit to cash or cash equivalents. Direct method statement of cash inflows. The method includes using the T Account to arrive at the cash inflow. The method does not start with the net income figure, unlike the indirect method of arriving at the statement of cash inflows balance figure. The method focuses on the cash payments journal to generate the statement of account outflows figure. The method uses the cash receipts journal to arrive at the statement of cash inflows balance figure. Using the T account method, the amount that balances the debit and credit amounts is classified as the cash inflow or cash outflow figure (Stickney, 2009). Distinguishing between cash flows from operating activities and cash flows from investing activities. There is a big difference between the cash inflows from operating activities and the cash inflows from investing activities. The cash inflows from operating activities represent the cash inflows that come from the normal day to day business operations. For example, the company is engaged in the selling of television sets. Cash inflow figure comes from the day to day selling of the televisions sets. In terms of the company’s cash outflows come from the purchase of the television sets from the television store’s suppliers. If the company is a barber shop, the company’s cash inflows come from the customers who pay for their haircuts. The company’s cash outflows include the amounts paid for the electricity that is used to light the barbershop (Stickney, 2009). The cash inflows from investing activities represent just what account states. The amount represents cash inflows and cash outflows from non-operating activities. For example, the grocery company buys store inventory. The amount paid for the store inventory is part of cash inflows from operating activities. The company buys the inventory in order to sell the inventories to their current and prospective customers. On the other hand, the company buys the adjacent building. The amount paid for the building is classified as cash outflows from investing activities. The company is investing in the building because the company wants to expand the grocery business. When the company sells its old grocery building at a discounted price, the amount collected is classified as cash inflows from investing activities. The company decides to sell the old grocery building, which was originally recorded as cash outflows from investing activities, when the old grocery building was purchased. In the same manner, the grocery store’s purchase of land is classified as cash outflows from investing activities. After several years, the company decides to sell the land at 20 percent markup or profit. The company records the sale of the land as cash inflows from investing activities (Stickney, 2009). •Comparing the statement of cash flows with income statement using terms of net income and cash at end of the year. There is a big difference between the statement of cash inflows and the income. In the accrual type of business organization, the net income includes both cash sales and credit sales. In cash sales transactions, the company debits cash to record the amount of cash that the company receives from the customers on the day of the sale. In addition, some companies offer credit terms to increase sales. The credit sales transaction occurs when the customer is allowed to pay the amount of their purchase at a latter date. When this occurs, the company debits accounts receivable or notes receivable for the sold items or services. The company credits sales or revenues for the items bought by the customers or services rendered by the company. Consequently, the company’s net income includes sales where there is no cash inflow (Stickney, 2009). The statement of cash inflows operate differently. The statement of cash inflows explains the difference between the company’s current year cash balance and the prior year’s cash balance. Consequently, the statement only includes cash flow deductions for transactions where cash flowed out of the company’s coffers. Likewise, the company only records cash additions only if cash is seen flowing into the company’s coffers. • Explaining which of the two financial statements is the better one. The income statement is better than the statement of cash inflows. The main purpose of business is to determine if the company was able to make the bottom line. Making the bottom line means generating a net income figure. By deducting the company’s operating expenses and cost of sales amounts from the net revenues, the company will know if the company generated a net profit. If the company generated a net profit, then the company generates a food financial image. On the other hand, a net loss income statement amount discourages the current and prospective investors from funneling their investments into the net loss-tainted company. The statement of cash flows only came out as an additional financial stamen report in later years to back up or supplement the income statement’s financial information. The statement of cash inflows may not necessarily show that company has a financially profitable picture. Who knows, the company’s net cash inflow may come from investments. Who knows, the cash inflows may come from money that is borrowed from the bank. Just because the company generated a cash inflow, it does not automatically mean the company generated a net profit (Stickney, 2009). REFERENCE: Stickney, C. (2009). Financial Accounting. New York: Cengage Learning Press. Read More