 Hello, and welcome to the session. This is Professor Fahad and the session we're going to keep looking with the statement of cash flows operating sections as well. However, we're going to be using the direct method. This topic is covered in intermediate accounting and it's heavily covered on the CPA FAR exam section. Also, this session would help you tremendously converting from cash to accrual or accrual to cash. As always, I would like to remind you to connect with me only then YouTube or where you need to subscribe. I have 1500 plus accounting, auditing, finance and tax lectures. This is a list of all the courses and the number of lectures I cover for each course. And I do also have CPA questions. On my website, I have, you have access to additional resources such as notes, PowerPoint slides through false multiple choice quasi CPA simulations and 2000 plus CPA practice questions. So to illustrate the direct method, we will work an example. But before we work an example, let's take a look at the indirect method as a review. So you'll be given an income statement. This is an income statement. You'll be giving two years of balance sheet. So this is the two year of balance sheet. Okay. For this example, and basically I'm going to scroll down and show you the indirect method statement completed. So this is the indirect method. We start with net income. Then we make the appropriate adjustments such as adding back depreciation expense. There was an increase in receivable. We subtracted it. There was an increase in inventory. We subtracted it. There was an increase in prepaid asset. We subtracted it. Those three are assets. Then we had an increase in liability, which we add. We had an increase in another liability, which we add. Then those are all operating assets and operating liabilities. So that income was 112. We net all the increases and decreases. Net cash provided by operating is 19,000. And this is using the indirect method. So what we did in the indirect method, we basically did a reconciliation between net income and cash flow. Basically, we explain the difference between net income, which is 112, and net cash flow from operating activity. Net cash flow from operating. So that's basically the indirect method. This is what it showed us. Okay. And this is the people that advocate the indirect method. They say it shows both net income, then it shows how much your income would have been if it was, if it was used, if you were using the cash basis. Now we're going to go back to the same example. And, which is this is this income statement here, which is for this company and the balance sheet for two year balance sheet, which is we need to two year balance sheet January 1st and December 31st, beginning and ending. And we have the income statement. Now we're going to prepare the direct method. The direct method is a little bit different. The direct method, you're going to take the income statement items and each item starting with sales revenue. You're going to take the sales revenue and convert into cash received from customers. So the sales revenue is 718,000. That's, that's good. Now what we need to do, we need to take this number and convert the sales revenue into how much actually cash you received. This is what matter because we want to turn sales revenue into cash received. So what do we do? We need to examine the accounts that affect sales revenue and that's account receivable. So we noticed that account receivable started with zero increased by 15,000. So the net increase is 15,000. So let's go back and convert the first number. But before, before we convert, let's just take a look at what do we mean by operating cash, operating cash flow, basically taking cash receipts from operation, which is sales as well as dividend and interest received minus cash payments, such as cash paid to suppliers, employees, operating expenses, interest and taxes. We subtract those two, we'll get net cash provided by operating activities. So let's go to this example and let's convert sales into cash receipts from customers. So this is how you always convert sales revenue to cash receipts from customers. So you want to know how much cash was received. So what you do is you start with sales revenue, which is an accrual number, 780, 780, 780,000 coming from the income statement. Then you would do the following. You will add any decrease in account receivable. So if account receivable went down, you would add the cash flow. If account receivable went up, you will subtract from cash flow. If account receivable went up, it means you are selling more on account than receiving cash from customers. And what happened here? AR went, so if we look at AR, it went from zero to 15,000. So there was an increase of 15,000. We look at this increase, we say, well, 718, it was an increase. Therefore we subtract 15,000. So cash receipts from customers is 765. And this is what I just said. Sales revenue minus an increase in receivable because your receivable went up, it means your cash went down. It means you are selling more on credit. So part of this, another way to look at it of the 780,000, 15,000 is on account and 765 is cash sales. This is the cash sales. And this is all what I care about. And this was on account. And this is basically the analysis of the account receivable. You start with the balance of zero. This is the T account. Sales revenue was increased by 780. How do I know this? Total sales was 780, but I end up with 15. It means I received 765, which is the same thing as this one here. So always make sure you know this formula to convert sales revenue to cash receipts from customers. You take sales revenue plus any decrease minus any increase in receivable. Okay. And we're done with this. We're done with this. Therefore, on the statement of cash flow, you would say, okay, this is another way to see the sales revenue 780 minus the increase in receivable. On a cash basis, you received 765,000. And what you do, this is your cash flow and cash received from customers, 765 were done with the first figure. Now we're going to convert the second item, which is cost of goods sold. Cost of goods sold is an expense, 450,000. So we're going to start with 450,000 as a negative, as a cash payment. Then we're going to determine how much actually we paid for the cost of goods sold. We know on a cruel basis, it's 450. So to convert cost of goods sold into cash payment, you need to examine two accounts, and those are inventory, because you buy inventory that turns into cost of goods sold. And they told us accounts payable deals with cost of goods sold. So you need to examine those two accounts. So you will start with, let me first get you the formula. Let's just do the same thing as we did with the receivable. See if we can capture everything. Yes. So the formula is the following. So for cost of goods sold, you have to do two things. You have to start with your cost of goods sold as a negative. It's an expense. Remember, cost of goods sold is an expense. And what we started with is 450, which is already an expense. And you add to it any increase in inventory. So you add more cash outflow. So if inventory went up, that's a negative cash. Okay. If inventory went down, that's a positive cash. It means you have less cash expenses because your inventory went down. It means you sold the inventory. Also, after you examine your inventory, you have to examine your accounts payable. If your accounts payable went up, that's positive cash. If your accounts payable went down, that's negative cash. It means you paid cash to bring down your payable. Now, let's start with our examples. We started with cost of goods sold of 450. Then inventory increased by 160 because we started at zero. Inventory started at zero and up at 160. So this was the inventory account. Therefore, inventory went up. If inventory went up, that's an increase to the expenses. It's been negative cash. It means we spent cash. Therefore, minus 160 were down to 610. And this is going to give us how much we purchased. We expensed 450 and we still have an inventory 160 more. It means we purchased 610. Why? Because inventory went up. Inventory went up. It means we spent cash. We spent cash. Now, we know our purchases is 610. So we're done with this part of cost of goods sold. Now, the opposite would have been true if inventory went down. If inventory went down, it would have less of an expense. Because it means we sold the inventory more than we bought it. Okay. Now, we'll start with purchases, which is 610. Then we need to determine what happened to our accounts payable. Again, accounts payable, just like inventory went up by 60,000. It went from zero to 60,000. It went up. It means I bought more stuff on account. I bought 60,000 of the 610 on account. If I bought 60,000 on account from the 610, it means I only paid cash 550. So notice my accounts payable went up. It means I did not spend cash. I spent less cash. If my accounts payable would have went down, then it will be in addition, then I will add that decrease. Okay. So I ended up paying 510,000. And what I did, I went from cost of goods sold to cash paid, cash payment to suppliers. You need to analyze two accounts for cost of goods sold. And this is the T-account. You started with zero and up with 60. You purchased 610, so your accounts payable was increased by 610, but you end up with 60. It means you made payment of 550. Therefore, you still owe 60,000 because you paid 610. You purchased, not you paid, you purchased 610, but you end up with 60,000 unpaid balance. That means you paid 550. Okay. It means you paid 550. And let's look at another. Okay. So we start with cost of goods sold at the increase in inventory, deduct the decrease in payable. You end up with a cash basis 550. Now you start with cash payments to suppliers. You paid 550, done with this item. Okay. Sales were done with sales, done with cost of goods sold, gross profit, sales minus cost of goods sold. We don't need to do anything with that. Okay. Let's look at operating expenses. Operating expenses are 160. And we are told here that prepaid expenses, which is an asset and accrued expenses, which is a liability, relate to our operating expenses. It means we have to convert operating expenses into how much cash paid for operating expenses. And we are told two accounts relate to this. Those two accounts are prepaid and accrued, and they both went up, prepaid and up, went up by 8. Accrued expenses went up by 20. So let's see if we could do this. So I'm going to start with 160, basically as a negative because that's an expense. It's a cash payment. Then I'm going to say, well, prepaid expenses went up. Remember, if asset went up, it means negative cash. How did I acquire my prepaid expenses? I had to pay for them. So it's negative 8,000 because my prepaid went up. So prepaid went from zero to 8,000. That's a negative. Now I'm up to negative 168. Now I'm also told that accrued expenses relate to this account. Well, accrued expenses is a liability. So this is a liability account went from zero to 20. It went up. Well, if I'm not paying, my expenses will go up. If I'm not paying, it means I am paying less 20,000 in my operating expenses. Therefore, I end up only paying 148,000. And this is how I converted the 160. To 148,000 in cash paid. So I started with 160, added the 8,000, subtracted the 20. And here's the formula. Cash payment for operating expenses equal to operating expenses at any increase in prepaid or subtract any decrease for liabilities at any decrease, subtract any increase. And here's what we did. We took 110 plus 8 minus 20, get the cash basis 148. Cash paid for operating expenses 148. We're done with operating expenses. Let's take a look at the next expense. The next expense is depreciation expense. Let me highlight this. So we need to convert depreciation expense to a cash expense. Well, this is already a non-cash. So what do we do? We ignore. Also, we ignore any losses. We ignore any gain. Remember what we learned about those gains and losses? They are non-cash. So any non-cash expense, depreciation, amortization, but that expense, losses, gains. Okay. Any, anything that you can take out that's non-cash already, you cannot convert it into cash. Okay. So we don't do anything from indirect method. We ignore this. We ignore any non-cash expenses or revenues for that matter, any non-cash expenses or revenues. Okay. So we're done with depreciation. Income before taxes is 330 minus 170 income tax expense. Income tax expense is 48. Now we need to know if we need to convert income tax expense. Well, we need to take a look at the balance sheet. And what do we need to do? We need to see if there's anything on the balance sheet that relate to income tax expense. So let's look at the balance sheet that we are given in this example. Okay. We are giving cash, receivable, inventory, prepaid expenses, property, accrued, payable, accrued expenses. Well, guess what? There's nothing. It doesn't tell us anything about any income taxes, payable or prepaid taxes. So guess what? If income tax expense is 48, it means we paid cash 48. That's it. Because there's nothing to analyze. Now, if we had a liability, let's assume we had, let's assume we had income taxes, payable, and we starting with zero and went up to $10,000. If it went up $10,000, it means we paid less than $10,000. It means our cash paid will be $38, because we expense $10,000 on account, because our income taxes payable went up. And the opposite would have been true. If accounts payable went down, we would have added, it means we paid more taxes than we expense on the income statement. And that's basically it. So there's no reason to convert income tax expense because there's no adjustments. We don't have any taxes payable, income taxes payable or income taxes, yes, income taxes payable or prepaid expenses. Sometime you prepay your expenses, which is an asset. You analyze it as if it's an asset. So also, let me mention this, for this account, you could have a prepaid taxes, which is some companies. Do I remember owners in practice? I still do it when you prepay your taxes. So basically, if you have a prepaid taxes and your prepaid taxes went up, that will be a negative that you will add the negative to the 48,000. If your prepaid expenses went down, it means you are using your prepaid, then it will be a positive. And if it went down, it will be a positive adjustment. If we are dealing with a prepaid taxes, we do have prepaid here, but it says prepaid expenses. And they told us already, those prepaid expenses has to do with the operating expenses. So we don't have to worry about the taxes. Then let's look at the complete cash flow. The indirect method, the direct method, income tax is 48. So cash receipt from customers 468, paid to supplier 550, paid to supplier 148, income tax expense 48, total cash payment for 746, total cash receipts 468, net cash provided as 19. This is no surprise because under the notice, under the under the indirect method, what did we get? We also got 19,000. So notice those are side by side. Both the indirect method, which is 19,000 and the direct method, 19,000. Again, people that prefer the indirect method, they say it reconciled. It shows you what is your net income. It shows you the difference between net income and cash approval. Here, the people that the proponent of this method, they said, it's like, it's more like the income statement. So it's more like it's showing you net income on cash basis. So it's showing you where the company bringing their cash. Where are they spending their cash? So you can clearly see what's going on. Now, if you're a prudent investor or you're a prudent analyst, you would look at both. But the point is they're both acceptable. Both give you the same answer. Now, it comes to financing and investing. There's no direct and indirect. There's only one method for those. OK. And this is, I'm going to show you a summary. And this is the summary of all the adjustments for the direct method. For the direct method, these are all the adjustments. Whoops, one more time. OK. So this is if you want to convert from the sales revenue, which is cash receipts, receipts from rent, you go from rent revenue, then your payments, how you convert your payments. So pretty much you would have everything that you need on the slide for the direct method. OK. So again, the major component of the direct method that need to be separately showing, cash collected from customers, interest and dividend, other operating cash receipts. Those are the positives, the receipts. Also, for the payments, you need to show what cash paid to employees and suppliers, interest paid income taxes, and other operating cash payment. Those are also need to be shown separately at minimum when you are preparing the direct method. OK. And that's about it for the direct method. If you take the formulas that I showed you on this screen and follow them, and hopefully you understand them, you understand how they work, if you don't understand them, fully go back to the direct method. I explain the changes. And I explain, for example, if an asset, we are dealing here with current assets. But generally speaking, it doesn't have to be a current asset. When an asset goes up, it means you are spending cash. When an asset goes down, it means you are spending the asset and not spending cash. It's a positive cash. It means you paid for the asset before. For liabilities, kind of the opposite. For liabilities, when a liability goes up, it means you are bringing cash. When a liability goes down, it means you're paying down the liability negative cash flow. So hopefully you remember those that we covered in the prior session, which is they apply here in one way or another. If you have any questions, any concerns about this recording, please let me know. In the next topic, we're gonna keep looking with the statement of cash flows. I'm gonna be looking at special problems. There are nothing really special about them, but the point is there are special circumstances where we have to deal with them. And I would like to remind you to connect with me and visit my website. And I strongly encourage you to subscribe. It's an investment in your career. Good luck and study hard for your CPA exam.