 Hello and welcome to this session in which we would look at a statement of cash flow exercise that deals with the Direct method. So in this session, I'm going to illustrate the direct method for preparing the operating section of the cash flow statement We have two methods. We have the direct method and we have the indirect method for the for preparing the operating section So today I'm going to show you the direct method and what's neat about the direct method is it will help you understand converting, simply put the direct method is an illustration for converting accrual to cash. Now sometime you might have to convert cash to accrual, but understanding how accrual to cash works will help you in understanding cash to accrual. So that's the neat thing about the direct method. So what is the direct method? For one thing it only applies to the operating section of the statement of cash flows What is the operating section of the statement of cash flows? Simply put the operating section is taking the income statement, the regular income statement that you have and converting the income statement into, I'm gonna put it in quote cash flow income statement. So this is this is what the operating section is in my opinion. It's taking the income statement and showing you on a cash flow basis Are you making a profit? Now, what do you have to do? Well? For the direct method, what you do is you examine each line on the income statement, each line separately and you convert each line and you convert each line into cash flow starting with sales, you would say, okay, this is my accrual sales 186,000. You would say, okay, this is my accrual sales But what is my cash sales? Well, what is your cash sales? How do you convert? accrual to cash? Well, what you have to do is you have to examine the account on the balance sheet That's related to sales. Well, Which account on the balance sheet is related to sales and the answer is account receivable So you are giving the balance sheet account and you notice that account receivable went from 74 to 79 So you are starting a cruel sales 186 then your account receivable overall went up by 5,000 Now, what does it mean? What does it mean when your account receivable increases? When your account receivable increases It means you are selling more on credit. You are selling more on credit So embedded in this 186,000 an additional $5,000 of credit sales Because here's what happened from a t account perspective If you're looking at it account receivable and you're analyzing account receivable, this is what we have We have the beginning balance is 74. We have the ending balance is 79 We also know That we have cash. I'm sorry sales in total of 186. So sales will increase 186 Now you want to know how much account receivable was credited Simply put to go from 74 74 plus 186 Minus something equal to 79. This is how we end up with 79. Well, let's see what that number is So if I took 74, let me just make this a little smaller If I take 74,000, which is my beginning balance plus 186 Equal to 260. So if I minus 79,000 I will find out that my credit should be should be 181. So my credit should be 181 What does that mean? It means I received in cash. This is cash Received from sales. It means although my sales is showing 186 But really I have to do what I have to I have to report it at 181 and what is 181? Simply put 181 represent the increase So I have to deduct the increase and account receivable because account receivable overall went up by 5000 It means I have to reduce my sales To 181 simply put my sales on cash basis is 181 1,000 however on an accrual basis is 186 before we proceed any further I have a public announcement about my company farhat lectures.com Farhat accounting lectures is a supplemental educational tool That's going to help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as becker, roger, wily, gleam, miles My accounting courses are aligned with your accounting courses broken down by chapter and topics My resources consist of Lectures multiple choice questions through false questions as well as exercises Go ahead start your free trial today. No obligation. No credit card required I'm done with sales. I will move on to cost of sales 102 Well, this is my cost of sales 102 What accounts on the balance sheet influence cost of sales? Well, two things influence cost of sales accounts Accounts payable when I buy stuff on account and inventory Because my inventory turns into cost of goods sold now. I have to analyze their effect on my cost of sales What's their effect on cost of sales? Let's look at inventory first inventory went from 1 1 18 to 124 if I take 124 minus 118 I will find out that my inventory went up My inventory went up by 6,000 Well, what does that mean if my inventory went up by 6,000? Well, it means that I am buying more inventory that I am selling overall. I have plus 6,000 of inventory and you can see this it went from 118 to 124 Well, if I am if I am buying more inventory and by the way cost of sales is negative as a cash outflow because it's cost Well, what I'm going to do is this if I bought an additional 6,000 of inventory from a cash basis I spent an additional 6,000 On inventory That's exactly what I did and the opposite would have been true if my inventory went if my inventory went down Now, let's take a look at my accounts payable. My accounts payable went from 41 to 53. Let's find the difference 53 minus 41 my Accounts payable went up by 12,000. Well, if accounts payable went up By 12,000 What does that mean? It means I am buying stuff But I am buying it on account. It means I am not using cash It means I have to add back 12,000 to my cash Because I am not using the cash. Why I am not using the cash. How do I know this? My accounts payable go up now. I'm ready to net them. So if I take the difference between 102 plus 6 minus 12 I will find out that I paid overall for cost of sales of 96,000 So this is what my cash paid For suppliers 96,000. I started with 102 102 then my inventory went up. It means I bought more inventory But my accounts payable went up even further by 12,000 and when my accounts payable go up It means I'm not paying cash. I am buying stuff on account. It's going to save me cash That's why the plus here. Therefore cash paid to supplier will be 96,000. So I'm done with sales. I'm done with cost of sales Gross profit is a is a computational figure operating expenses is 59,000 Now I need to analyze my operating expenses of 59,000 to analyze my operating expenses I have to know which account Are part of the operating expenses. Well, most likely not most likely prepaid expense is based on my operating expense So I'm going to start by saying 59,000 And my prepaid went up if my prepaid went up. It means remember 59 is an expense. That's a negative cash outflow If my 59,000 is my accrual and I purchase an additional 1000 of prepaid. So notice here I have 1000 additional of prepaid. That means I purchased another 1000 of prepaid. Therefore, I have to Consider it as a cash outflow Also, if you notice here I have accumulated depreciation and I have Franchise and those account changed So I need to know if I have any additional information If I look at my additional information, I will find out that a fully depreciated plant asset which originally cost 20,000 It's fully depreciated with no salvage value was sold for a thousand And I see here that normal depreciation expense was recorded during the year And the franchise was amortized. So I have to be careful here I have to be careful because I am told There's depreciation expense and there's amortization and since they are not listed as a separate line They must be part of this 59,000. So part of this 59,000 is depreciation expense And part of this 59,000 is amortization expense I am not given those as a separate line if I'm giving the depreciation expense and the amortization expense It's easy. All what I have to do is ignore them, but I am not they are embedded in the 59,000. Therefore, I have to back them out Let's take a look at the franchise. The franchise went from 32 to 24 The franchise was amortized for 8,000 It means with this within this 59,000 I have to back out 8,000 because this is a not not a cash expense. Therefore, I add 8,000 of franchise because it's not a cash expense Yes, I did took the expense, but it's not cash. If it was listed separately, I would have just simply ignore it But since it's part of the 59, I have to back it out Again, I'm starting with 59 as negative. If I started with 59 as positive I would do the opposite, but I'm saying just to kind of let you know 59 is cash paid This is the expense. Let's convert it into how much cash paid for operation So the franchise is done Now I have to deal with This depreciation, which is a little bit unusual Because accumulated depreciation went down. So if I look at my accumulated depreciation Account for this exercise, it's a little bit unusual. It's not unusual, but I went from 80,000. I'm sorry. It went from 86,000 To 80,000. This is what I have the beginning and ending. It means overall the account went down Well, the reason why is because I'm told I sold a plant asset That's fully depreciated. If that's the case. It was a $20,000 plant asset. That's fully depreciated Well, if you sold an asset, you have to remove its accumulated depreciation. Therefore, I went from 86 I reduced 86 by 20. So let's let me get my calculator so I reduced my 86,000 86,000 I started with that I reduced it by 20,000 minus 20,000 And I should end up with 66. I end up with 80. Therefore, I am looking here for another credit So if I find the difference between 66 and 80 I will find out that the depreciation that I took was 14,000 So this is basically I found this is I find basically a plug. This was given Where is where was it given? It was giving here. It was giving that the asset was sold. It was fully depreciated Well, what does that mean? It means my depreciation was 14,000 It means embedded in this number again another 14,000. That's not not a cash expense. So I will add back This 14,000 as a non-cash expense When I net them I will find out that cash paid for operation is only 38,000 therefore cash paid for operation is 38,000. So what I did is I took I took each line starting with sales converted sales To cash sales converted cost of goods sold to cash paid to customers and converted operating expenses into cash paid for operation Now gain on sale of plant asset is a thousand. I ignore this I ignore this because the gain is not a cash Amount the gain will be accounted for in the financing section. I ignore gains. I ignore losses I ignore depreciation expense. I ignore amortization expense Then you just said you ignore them. Why did you so why did why did you Why did you added 8,000 and added 14,000? I had to add them because they were included in the 59 If they were listed separately, I would ignore them since they were included. I have to take them out That's why I that's why I included them overall What I did is now I Prepare my statement of cash flow cash received from customers 181,000 computed here Cash paid the suppliers 96,000 and cash paid for operation for operating the asset 38 if I net them out cash paid for operating expense Net cash provided by operating expenses 47,000 Simply put notice my net income was 26 my accrual net income But cash provided from operating is 47 which is more And the reason is we explained it because we expense 102, but we only paid 96. We expend 59 We only paid 38, but from the cash perspective we received less cash from sales But overall it was more than net income. So this is how you would prepare an operating net Operating section using the direct method of the statement of cash flows now the next session I would I would look at the indirect method using the same example Using the same example. I would also complete the complete Cash flow statement using the indirect method because the only difference between direct method and indirect method Is only the operating section. What should you do now go to farhat lectures and work mcq's? Exercises through false questions. That's going to help you this important topic. Good luck study hard and stay safe