 Oh, and welcome to the session. This is Professor Farhat in which we would look at the direct method, preparing the operating section of the statement of cash flows. In the prior session, we looked at what goes into each section of the statement of cash flows. And we work an example, and we look at the operating section, and we use the indirect method. In this session, we would prepare the operating section using the direct method. There are two methods, either indirect or direct. Also, we looked at the financing and investing section. Now, financing and investing section, there's only one method, so we don't have two methods for those. Now, how do we prepare the operating section using the direct method? So what is the direct method, basically? Well, the direct method is taking the income statement and converting each line of the income statement to a cash figure. And this is very helpful. Why is this very helpful? The direct method is very helpful in explaining, converting from cash to a cruel or a cruel from cash, because this is exactly what we are doing. We are taking the numbers that are a cruel on the income statement and preparing a net income on the cash basis. And that's basically what the direct method versus the indirect method. The indirect method is a reconciliation. The indirect method, we started with net income and we work backward to get to cash net income. Both give you the same answer, just two different method. So in this method, we're going to take line by line. This is the direct method. It's directly looking at each number and converting each number. Now, to convert the figures, you have to have related balance sheet accounts. So notice on this side here, I also have a two-year balance sheet, year X1 and year X2. So you need to have a comparative balance sheet, as well as the income statement. And sometime you might need additional information. But this is what we're going to be working with. Now, if you're not a subscriber, take a picture of this or a copy of it. Otherwise, you can download it from my website. So this way, you can work with it. Now, here are the formulas that we're going to be using. So first thing is don't panic yet. So I'm going to explain basically all these formulas and they follow the same concept. Once you understand how to use one, it's all the same. But it's very important that you understand how to use them. So I'm going to be using those formulas and I will show them to you one by one as we are examining each account separately. Now, the best way to illustrate the direct method is to actually dive into that example and start to convert each number from sales to from sales, sales revenue to how much cash we actually received from what we paid to this, what's cost of goods sold to how much we paid to the suppliers. What was our operating expenses and how much cash we paid for operating expenses? What was our salaries expenses? How much we actually paid for the employees? So on and so forth, line by line. Before we do so, I would like to remind you whether you are an accounting student or a CPA candidate and most likely that's who you are. If you're watching this, this is how you end up on my YouTube. If that's the case, that's great. Go a step further, farhatlectures.com, where I provide additional resources, multiple choice, lectures, true, false exercises that's going to help you do better in your accounting courses, as well as the CPA exam. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation like this recording. If you're watching, it doesn't cost you anything. You can help me and help other by liking the recording. Connect with me on Instagram, Facebook, Twitter, and Reddit. So let's take a look at this example and start with the first number on the income statement, sales. So our job is to take sales, which is in a cruel figure and convert sales into how much cash did we actually receive. Now, what is related to sales on the balance sheet? Well, in other words, what account is related to sales? Well, hopefully, you know, it's a count receivable. That's not the only one, but I'm going to analyze a count receivable. So to convert sales to cash receipts from customers, we're going to take sales revenue, add any decrease in account payable, subtract any increase in account payable. Now you can try to memorize the formulas. I don't recommend that at all. So what I'm going to do, I'm going to explain the formula in front of you now. I'm going to explain the formula and show you how to arrive to it. If you want to memorize it, I don't recommend once again. So here's what you do. You want to analyze the change in account receivable. What is the, what does it mean? Well, you're going to take beginning account receivable, which is 42,000. This is year X1. This is year X2. Ending receivable was 60,000. So notice overall, account receivable went up by 18,000. Now, what does that mean? How do we interpret this? Well, account receivable went up. Our sales was 620. If our sales were 620, initially we're going to assume we're going to sell stuff on account. So when we sell, when we sell on account, we're going to debit account receivable credit sales. So simply put, we're going to add the 620 as a debit to receivable and credit the sales. So if we started with 420, if this is what we started with, we have, we recorded additional sales of 620 for that period and we end up with $60,000 in account receivable. Well, what does that mean? It means you have to find the credit to find out how much cash you received from customers. Simply put, 42 plus 60 plus 620 minus which number to get you to 60. It means what you received from customers is 602,000. What does that mean? It means on the income statement, you recorded $620,000 in accrual sales. However, in reality of this amount, only 602 was cash payment. So if 602 was cash, the remaining 18,000 must have been on account. And take a look at this. What is the difference between 42 and 60? Notice account receivable went up by 18,000. It means part of the 620, 18,000 was sales on account. And sales on account are not cash receipts. We're going to be receiving them later. Therefore, you will take your cash. So notice, let's go back to the formula here. You will take your cash and you will deduct any increase in receivable. And this is basically what we did. All we did is we took 620 minus 18,000 equal to 602. That's all what we did. So we took sales minus the increase in receivable because receivable went up. Now, if receivable went down, let me change the color. So, you know, I'm talking about the different scenario. If receivable went down, we'll take 620 plus any decrease in receivable to get the cash. Why? Because if receivable went down, it means customers are paying their balance. And when customers are paying their balance, it means you have more cash receipts. That's what it means. So I showed it to you in a T account. And I showed you also basically the logic behind it. If a count receivable goes up, you are selling on account. If you're selling on account, you're not receiving cash. So you will deduct the difference from sales. On the other hand, if your receivable went down, it means customers are paying their bills. Bills means their account receivable. It means in addition to your sales that you recorded, you receive additional cash, which considered cash receipts from customers. Now, is this the only account on the balance sheet that could affect revenue? And the answer is no. And the answer is no. What other account on the balance sheet could affect sales? And the answer is unearned revenues. So I don't have an unearned revenue for you in this example, but I am going to make up some numbers. Unearned revenue is a liability. And let's assume for X1 unearned revenue was 10,000. And for year two, unearned revenue was make it six. So unearned revenue from 10 to six, it means there was a decrease of 4,000. Decrease of 4,000. How we would interpret this decrease of 4,000? How do we interpret it? Well, if our sales was 620 and our unearned revenue went down. So what happened when we bring down unearned revenue? It means we debit, we debit, you are unearned revenue for, we debited unearned revenue for 4,000. And we credited revenue 4,000 sales or sales revenue, sales revenue. Okay, sales revenue. What does that mean? It means this 4,000 was included in the 620. And this 4,000 is not cash revenue because we debited unearned revenue. So what do we have to do? If unearned revenue went down, so unearned revenue, which is a liability went down, we will deduct that amount from sales revenue. Well, let's change the, let's change the scenario. Let's assume the opposite happened. That's, I'm going to use a different color to kind of indicate changing the scenario. Let's assume your unearned revenue went from 6,000 to 10,000. Hold on unearned revenue went up now. There was an increase, increase of 4,000. When would your unearned revenue increase? Unearned revenue increases when you debit cash and credit unearned revenue. So overall, you debited cash 4,000. Overall, you credited unearned revenue 4,000. What does that mean? It means from a revenue perspective, from a revenue perspective on a cash basis, you have an additional 4,000 of revenue, which you did not include in your sales. What does that mean? It means if unearned revenue goes up, you add that to your sales. Because from a cash flow perspective, from a cash accounting perspective, you earned the revenue because it's cash revenue. That's why we are converting to cash. Therefore, this is the other formula to convert sales into cash sales. Two accounts, a count receivable, which I showed it to you separately. Then I showed you the liability, the unearned revenue. So let's take a look now. So we're done with sales revenue. And remember, based on our example, cash receipt from customers is 6.02. I'm not going to include the unearned revenue just because for simplicity, although I showed you how to use it. So copy this number down, cash receipts from customers 6.02. We're done with sales. Let's examine cost of goods sold. Now for cost of goods sold, you have to examine two accounts. So you want to convert cost of goods sold to how much you paid the suppliers. And you're going to analyze inventory, which is right here, and you're going to analyze account spable. First, you analyze inventory. You want to find out how much you had additional purchases, or you did not make any purchases. And when you made those purchases, whether you paid for them in cash or you paid for them on account. So let's start to analyze inventory first. Inventory, the beginning inventory is 72. The ending inventory is 86. Well, what does that mean? It means inventory overall went up. Inventory overall went up. That's fine. What happened to inventory? Inventory is expensed. Inventory is expensed to cost of goods sold. So we expensed 320,000. So if we started with 72, we reduced the account 320, and we end up with 86. It means somehow here we made some purchases, right? Because it has to add up. Well, just solve for x, solve for this. And when we solve for this, we find out that the purchases is equal to 334. Just in case you're wondering how we did this, 720 minus 320 plus x equal to 86. So it says this minus this plus this was the unknown in black equal to 86,000. And you find you solve for x and it's 334. So that's fine. We find out that we purchased 334,000 of goods. That's fine. But did we pay for those goods in cash or did we buy them on account? Here's where it comes. You have to analyze another account, which is called accounts payable, not accounts receivable, accounts payable. So let's take a look at accounts payable here. We have the beginning balance. This is a liability 42. The ending balance is 37 overall went down by five. And we know that we purchased 334. So every time we made a purchase, we assume it's on credit. So 42 plus 334. So we must have paid some amount. We must have paid some amount. Okay, what's that amount? Well, if we solve the formula, it's 339. It means cash paid, cash paid to suppliers is 339. So notice cost of goods sold was 320. This is what we expensed. But it appears we purchased inventory. And we didn't only purchase additional inventory because our inventory went up, we purchased additional inventory and our accounts payable went down. So overall, we made payment to suppliers of 339. So from a cash perspective, we paid the suppliers 339. So we're done with this. Again, this is the number that we're looking for. Cash paid to suppliers 339, write it down. Let's examine wages and other operating expenses. Now wages and other operating expenses, as it suggests, other operating expenses, you could have many expenses. So I'm going to solve how you would approach this, then it applies to many other operating expenses. The formula is this, you will take your operating expenses starting with 218, you add any increase in prepaid, reduce any decrease in prepaid, add any decrease in accrued liabilities, deduct any increase in accrued liability. For simplicity, I'm going to keep the liabilities out, but you guys can follow. So operating expenses, we starting with 218 and let's analyze prepaid. What happened to our prepaid account? Right here. Our prepaid is right here. We had a beginning balance of six and ending balance of eight. Well, overall, what would you say? It went up by two. All what I have to do now is just take 218 plus two, that's it, equal to 220. And this is how much I paid for operating expenses. But let me show you from a T account. From a T account, we expense 218, it means we paid in cash 220. So if we started with six and we end up with eight and we know from prepaid expenses, we expense. So we credited prepaid expenses 218, it means overall we paid 220. And as I told you, if we take 218 plus prepaid went up by two, very easy. Prepaid went up, you add the two, it means we paid for operating expenses 220. Now, if we have a related liability, we also add any decrease in accrued liabilities. So if we have liabilities and those liabilities went down, it means we are paying off our liabilities. It means there's more cash outflow. That's why it's a plus to the operating expenses. It means plus, but it's increasing like it's increasing the 218, it's increasing our expense. If our liabilities went up, it means we are operating our expenses. When will your liabilities goes up when you debit an expense credit a liability? When that's the case, you are recording an expense, no cash payment. It means you deduct this, you deduct this from your accrued expense. Again, for any expense, you follow the same concept. You could have an asset and the liability to analyze at the same time. Let's take a look at this. So we're done with this, we're done with this, we're done with this, let's take a look at interest expense. Interest expense is 9,000. And the formula says add any decrease in interest payable, subtract any increase, subtract any increase in interest payable. Okay. Well, let's take a look at interest payable. Interest payable is right here. Interest payable went from five to four, liability went down. When your liability went down, when does your liability go down? It's when you pay them. Well, if I reported 9,000 and my liabilities goes down, it means from a cash perspective, I paid 10,000 for interest expense. Because notice, I recorded 9,000 on the balance, on the income statement, notice I recorded 9,000 debited interest expense, credited interest payable. So if I started with five, credited interest payable for the interest expense 9,000 and end up with four, it means I must have paid 10. So that's my answer. Cash paid for interest 10. And I showed you, you'll take your interest expense plus 1000. Now sometime, again, I'm going to go even a little bit further, sometime you might have a prepaid interest. So it's a prepaid interest specifically for interest. Then you have to analyze the prepaid interest. If your prepaid interest went up, that's an additional payment means you are prepaying your interest. Therefore, you will add to your payment. If your prepaid interest went down overall, then you deduct from your cash payment to interest because now you are expensing your prepaid interest for this period. So we are done with interest depreciation expense. What do we do with the depreciation expense? Not applicable. Why not? Because remember what we are doing, we are taking each line and converting each line to cash accounting. Well, that's fine. If we are converting each line to cash accounting, well, this is already not cash. So we don't touch it. It's not cash. You don't touch it. Loss on sale of plant asset. Loss. Remember loss, what we talked about in the prior session, this is not a cash expense. Ignore it. It's already not cash. Gain. Same thing. Gains and losses. We ignore them. Why? Because there are no cash gains and no cash losses because whatever we received in cash, it's going to be accounted for somewhere else, but not in the gain or in the loss. So we ignore gain, ignore losses, ignore depreciation, ignore amortization, ignore bad debt expense, any expense or any revenue that's non-cash, it's already non-cash. So you don't convert something that's not cash into cash. What we are left with is income taxes of 17,000. So on the income statement, we show income taxes of 17,000 and this is basically an expense and we analyze the related liability. So it went from 14 to 24. Our liabilities went up. If liabilities went up, reduce the difference. So simply put, we paid 7,000 in income taxes, although we recorded 17, but of that 17. So simply put, let me show you in a complete journal entry, income tax expense for the year was 17,000 of which cash was 10,000. Cash was 10,000. I'm sorry, cash was 7,000 and income taxes payable was 10,000. Let me see if I did this right. So we went from 10 to 24. That means our liabilities went up by 10. I did it right and we recorded 17,000 of expenses. It means we only paid 7,000. So overall, we did debit income tax expense of 17. We credit cash only seven and the remainder was income taxes payable. It means we only pay seven out of the 17. What's going to happen next period? We're going to have to pay our taxes, but for this period on a cash basis, we only paid 7,000. Now let's take a look at the income statement again and look at what we did. In other words, what we did means converting everything to cash. We converted sales to cash. Sales went from 620 to 602, cost of goods sold went from 320 to 339. That was a huge increase because we bought in more inventory and we paid then our liabilities. Our wages and operating expenses was 218, but for cash basis 220 because we paid an additional 2,000 for the prepaid. Our interest expense was 10,000, 9,000 from a cruel basis, but we paid an additional 1,000. Therefore, it's negative 10. Our income taxes were 17,000 on an accrual basis, but from a cash basis, we only pay seven. So notice our net income is 40, our cash net income is 26. So from a cash perspective, we spent a little bit more cash and mainly it was to do with the inventory. The inventory was a huge increase. We paid much more and remember also, we lost 18,000 here, 18,000 in cash. In other words, we cannot count as cash, so that's the main difference between the two. But this is basically what do we mean by the direct method, converting the income statement into a cash income statement. What should you do now? Go to farhatlectures.com, start to work MCQs through faults and exercises, invest in yourself, subscribe. Good luck, study hard and of course, stay safe.