 Hello, and welcome to this session. This is Professor Farhad. In this session, we would look at the operating section of the cash flow statement using the direct method. This topic is covered in intermediate accounting, the CPA exam section. And this exercise could be used as a CPA simulation. And I will explain why as we work the problem. As always, I would like to remind you to connect with me on LinkedIn. If you haven't done so, YouTube is where you would need to subscribe. I have 1,700 plus accounting, auditing, finance, tax, and Excel lectures. If you like my lectures, please like them, share them, put them in playlists. If they benefit you, it means they might benefit other people. So share the wealth, subscribe, connect with me on Instagram. On my website, farhadlectures.com, you will find additional resources to supplement your accounting education and or pass your CPA exam. I have plenty of resources. So if you're looking for those seven to 10 points or 15 points, I will be happy to help you get over your CPA exam. The prerequisite for this session is in the description. If you'd like to learn about the direct method, although as I'm working this exercise, I will explain the concept as well. So to work this exercise, I'm gonna have a balance sheet to your comparative balance sheet. Although it's not complete because I'm only working the operating section, I'm gonna have an income statement. I'm gonna have the credit balances for the allowance, the depreciation for the equipment and the building, and the account spable as well as additional data. This is what I'm gonna be working with. And the question that could be asked on the CPA exam is, or on the CPA simulation is compute the operating section of the cash flow statement using the direct method. So what is the direct method? Simply put, the direct method is taking the income statement, which is the accrual income statement, and converting the accrual income statement into a cash income statement. So here's the accrual income statement, and I need to convert this into cash. Now, on the exam to make this as a simulation, rather than just giving you the figures, they can give you exhibits. And I will tell you in a moment, what do I mean by exhibit? Because when it comes to CPA simulations, the CPA simulations are the same information as an exercise, except that this exercise is given to you, is presented to you in a real-world situation. And I will tell you how and when we look at this. So to start this process, we need to look at sales revenue, which is 950,000, and we need to convert sales revenue into, we need to convert sales revenue into cash received from customers. Well, how do I know how much cash did I receive from customers? I know my sales revenue is 950, but that's an accrual number. Because remember, the income statement is accrual. How do I know what's my sales revenue? Well, to know my sales revenue, I have to examine my account receivable, to see what happened to my account receivable overall, as far as the year is concerned. So let's examine account receivable and see what happened. Our account receivable throughout the year went up from 130,000 to 155. Notice, the balance was 130, now it's 155. Now throughout the year, we did collect a lot of money, we did sold a lot on account, but the net change, as we see the net change is 25,000. It means overall, we sold more on account than we collected cash. Well, how is that gonna affect the 950? Well, if we're saying we're reporting 950 in sales, but our account receivable went up, it means part of that 950 is on account. How much of it on account is 25,000? How did I know 25,000 is on account? Because my account receivable went up. My account receivable went up. It means my cash sales is only 925,000. So the first thing I'm gonna do, I'm gonna convert sales into cash received from customers. So cash received from customers is 925,000, although my accrual sales is 950. The reason it's less, because my account receivable went up. If my account receivable went down, it means I collected more cash from customers. If I collected more cash from customers, then I would have added this number to the 950, but since my account receivable went up, it means overall I sold more on credit than I collected in cash. So practically I'm done with sales. I can cross this number out. I can cross account receivable. Let's work with cost of good sold. Cost of good sold is basically payments you made to suppliers. Now the number here is positive, but technically it's a negative, negative 600,000, but since we are converting this to cash. So basically now I'm gonna record my cash payments. And part of my cash payments is to suppliers. And from the income statement, it shows that I recorded 600,000. It means I spent 600,000. Technically this is negative. Technically this is negative. So 600,000. So now I need to convert this number 600,000 to how much I actually paid. Well, in order to do so, you have to examine two accounts. And the two accounts are inventory. You have to examine inventory. And you have to examine accounts payable. Because what happened is this. Your suppliers, you bought inventory from them and you might have bought it on account or you might have paid cash for it. So to examine how much what happened is, you have to examine those two account. So you started with 600,000. Your inventory went up from 61,000, 61,000 to 75,000. Well, if your inventory went up, it means overall the net change was positive, positive 14. The net change positive 14. Positive 14 means you are purchasing. Well, if you are purchasing, it means you are paying more. Now you might say, what if I bought it on account? Don't worry, I'm gonna make the adjustment for accounts payable in a moment. But all what I know for now, since my inventory went up, that's an additional disbursements of cash because I have more inventory, okay? So inventory went up, I dispersed more cash. Well, let's see how much if I dispersed more cash or if I bought them on account. I look at my accounts payable. I look at my AP and it went from 60,000 to 66. What does that mean? It means the net change was positive 6,000. It means although I bought inventory, I also used my credit because my accounts payable went up overall. My accounts payable went up. It means of the 14,000, 6,000 of it was on account. It means I did not pay cash for it. I did not disperse cash for it. Therefore, if I take negative 600, cost of goods sold starting with, examine my inventory, which it increased my cash disbursement, then when I examine my accounts payable, it means I did not pay for it in cash. Overall, I have negative 608,000 that I paid to suppliers. So for suppliers, it's cash payment to suppliers 608. Basically I'm done with cost of goods sold and I'm done with analyzing inventory, done with analyzing accounts payable. Gross profit is basically a total, a computation. I don't have to worry about this. Operating expenses include depreciation expense and that expense of 250. Now, what do we know about depreciation and bad debt? What we know about those two account, they are non-cash. It means we expense them from an accrual perspective, but they don't involve cash. Well, what do I have to do? It means cash paid to operate the business is not really 250. Accrual is 250, but the cash paid to operate the business should be less than 250 because what's included in this account is two numbers that are non-cash. Now, how do I know how much depreciation I took? How much do I know how much bad debt expense I took? I have to look at the related balance sheet account. The related balance sheet account to bad debt expense is allowance. And what do I see in my allowance? I see my allowance went from 8,000 to 10,000. Now what happened is this? Allowance, every time allowance is increased, you debit bad debt expense, you credit allowance, you debit, so the entry was bad debt expense, the total of 2,000 allowance, 2,000. In other words, I recorded 2,000 of bad debt expense. What does that mean? It means of the 250, I'm starting with 250, then 2,000 of it was non-cash. I have to reduce it. Now I'm down to 248. Now I have to back out the depreciation. And this is where I can start to turn this into an actual simulation. Why? Because I'm given additional information. I'm told that equipment costing $10,000 and what 60% depreciated was sold in 2007. Now what I can do, rather than give you this information, I can give you two things, actually three things if I want to. I can give you the purchase paperwork. So I can tell you when we purchase this equipment, I can give you a contract. I can show you that we purchase this equipment for 10,000, but you have to read this contract to determine how much we paid for it. Then for the 60% depreciation, I don't tell you it was 60% depreciated. I can give you an exhibit that's a depreciation schedule and you have to figure out that was sold in 2017, 60% was depreciated. So rather than give you the statement, I can give you two different exhibits that are pretty scary, but they're nothing. Just if you know what you're doing, it's just, okay, I purchased it for 10,000. That's my cost. When I sold it, it was 60% depreciated. Now why this is important? Why do I have to examine this? Because now I have to determine how much depreciation I took. So this was for the equipment. So here I have depreciation for the equipment and depreciated for the building. The building, I didn't do anything with the building. My depreciation of the building went from 28,000 to 37,000. It means for the building, I booked depreciation of 9,000. So simply put, I can just say, I'm gonna reduce 9,000 for the depreciation of the building. Why? Because this is for this account only. I'm breaking down the depreciation into two components just to show you step by step. So basically what I'm gonna do, I'm gonna take, let me get my calculator here and start to look at this. So we have 248 minus 9,000. So now we're down to 239. Now I have to determine what happened to this account, the equipment. Why the equipment is important? It's because I sold a piece of equipment. So let's examine the depreciation for the equipment. Accumulated depreciation. What we are told for the accumulated depreciation, we started at 14 and we end up with 21. Now, the classic mistake is to say, well, it's 7,000 increase, therefore I took 7,000 of depreciation. Not really, why? Because what happened in this account, the net change was 7,000, but what really happened, I removed one of the assets and as a result, when you remove the asset, you remove its accumulated depreciation. So what happened is 6,000 was debited to accumulated depreciation dash equipment, this account, because I sold the equipment. So now to find out how much depreciation I took, I have to start with 14,000, add to it, I'm sorry, deduct from it 6,000, because this is basically a debit, is a deduction for the depreciation, I have to deduct from it 6,000, then to find out the difference, the difference to bring me to 21,000. So if I took 14,000, 14 not 17, 14,000 and I deducted 6,000, that's gonna give me 8,000, but somehow my accumulated depreciation is 21. It means what's the difference between 21 and 8? That's 13,000, it means I booked depreciation expense of 13,000, what does that mean? It means there's an additional depreciation expense of 13,000, it means here I have to deduct, I have to deduct 13,000 for the equipment, the equipment account depreciation and this was for the building was easy, there was nothing, no changes in the building. Now I'm gonna take 239 minus 13,000 and that's gonna give me 226,000 and I believe that's all what I need to do to convert my operating expenses into cash. I started at 250 and I backed out first the bad debt, that was easy, then I backed out the building, that was easy and for the equipment I had to be very careful because I sold one of the equipment. So this is how they can trick you. So to operate the business, I paid 226,000. So notice I could have, I turned this into a simulation just to tell you how easy you can make it more complicated. So income from operation, I don't have to worry about this. Gain on the sale of investment, remember gains are non-cash revenue, therefore you cannot confer something non-cash to cash. Losses, they are like non-cash expenses, like non-cash expenses, they are non-cash, you don't have to worry about them. So when you're doing the direct method, gains and losses, they don't need any adjustments. Remember the indirect method, you deduct the gain and you add the loss and if you want to know why, view my indirect method, but we're looking here at the direct method. So income before losses, that's a number, that's a computation, income taxes. I'm told my income taxes on the income statement is 45,000. Now what I have to do, I have to examine my income tax expense. I'm sorry, this is income tax expense. I have to look at my income taxes payable. And I'm just gonna make up this number to tell you what happened to income taxes payable. So income taxes payable, again, this is, I'm gonna add this information and I'm gonna tell you that income taxes payable went from, so we have year 2017 and 2016. I'm gonna tell you that it went from 10,000 to 12,000. Income taxes payable, this is income taxes. So this account is income taxes payable. It went from 10 to 12. What does that mean? It means my income taxes payable increased by 2,000. Well, what does that mean? It means of the 45,000, here's what happened to this 45,000. I have 45,000 of income tax expense. Here's what happened. I debited income tax expense 43,000, credited cash 43,000. I debited income tax expense too. And I credited income tax payable 2,000. So this income tax expense 43, this income tax expense of two, those two gave me the 45,000 on my income statement. How did I know that an additional 2,000 was not paid because my income taxes payable went up? So it must have been a net change of 2,000. And this is how I came up with the second entry because my income taxes payable went up. What does that mean? It means although I recorded 45,000 on my income statement, so 45,000 on my income statement, how much did I really pay? I only paid 43. I only paid 43. How did I know I only paid 43 because my income taxes payable went up by 2,000? So the third component to kind of to convert, to convert so we converted what we paid the suppliers, we converted what we paid to operate the business. The third component is income taxes paid to, I'm just gonna call it IRS, 43,000. It doesn't have to be the IRS. It could be the state, the local government, it doesn't matter. Now I can compute my net cash either provided or used but it's provided, it's more. So 925, so basically I'm gonna take 925,000 minus 226 minus 43 and my net cash provided from business, I'm sorry, minus 608, I didn't do that. 925 minus 608 minus 226 minus 43 and net cash provided is 48,000. So this is net cash provided, 48,000 which is positive. But notice here the net income was 67, net income was 67, cash provided is 48. So this is the direct method of preparing the statement of cash flow. Why is this important? Why is this example is important? Because it helped you convert from accrual to cash. Sometime you have to go from cash to accrual, make sure you are familiar with this. As always I would like to remind you to like the lecture, visit my website. If you're looking for those 10 to 15 points on the CPA exam by all means, check out my website for the additional resources. Good luck, study hard and stay safe, especially during those coronavirus days.