 This audio lecture is brought to you by the YouTube channel Farhat Accounting Lectures. On my YouTube channel you can find over 1500 free accounting, auditing and tax lectures to prepare for your CPA exam. Those audio lectures are designed for people on the go, for busy people, people who are commuting on the plane, on the train or if you are spending some time in the gym or walking in the park or even trying to go to sleep. So they are designed to review the material for the exam. If you really want to learn the material in depth, please visit my YouTube channel and if you happen to visit my YouTube channel, please consider making a donation to support the channel. I'm here to help you, let's get started. This audio file can be downloaded from my website, farhatlectures.com. In this audio lecture we would look at the operating cash flow statement using the direct method. In the prior session I looked at the indirect method, this is going to be the direct method. Remember the indirect method is a reconciliation process, it starts with net income and it works backward. Now we are going to look at the direct method. The direct method is a little bit different. The direct method is directly converting each line on the income statement to cash. So rather than starting with net income and going backward, so rather than starting from the bottom and adjusting, we are going to start from the top, we are going to start from revenues and going down, converting each line into cash. Converting each line into cash. Now if you happen to prepare, if a company happened to prepare the cash flow statement using the direct method, they still have to prepare the indirect method in the notes. Therefore the reconciliation process will have to be done regardless whether you prepare the direct or the indirect because with the direct method you still have to prepare the reconciliation. Let's start with the direct method. As I said, the direct method is going through each line and converting each line into cash. So the best way to do it is kind of close your eyes and think about the income statement. What's the first line on the income statement? Sales or sales revenue. Some sort of revenue. Now I'm going to go over the concept for revenues and they apply to all revenues, whether you have sales revenue, dividend revenue, interest revenue, rental revenue, they all apply the same concept. So you're starting with sales revenue. Let's for the sake of illustration, let's assume your sales revenue is $780,000. That's an accrual figure. What I want to do now, I want to take the sales revenue and convert the sales revenue into cash received from customers. So this is a positive number, cash received from customers. So think about what could explain beside the sales revenue revenue? What could explain sales revenue is account receivable. So I have to look at the change in my account receivable. And for the sake of illustration, let's assume my account receivable went up. My account receivable went up by $15,000 from the prior year. It was zero, the prior year and now it's $15,000. What do I need to do if my account receivable went up? And what does that mean if my account receivable went up? It means I'm selling $15,000 more on credit than I collected the prior year. It means if my receivable went up, it means I'm not collecting the cash. It means in my sales revenue, there is a $15,000 of sales on credit. Well, sales on credit are not cash sales. I'm only interested in cash receipts from customers. Well, the rule is I will start with sales. If my receivable went up, guess what? I will deduct it from sales. So if my sales was $780,000 and my receivable went up by $15,000, therefore my cash receipt from customer is $765,000. The opposite would have been true. If my account receivable went down, went down by $15,000, it means compared to the prior year, I collected more cash. Then I will take $780,000 plus $15,000. Therefore I received from customers $795,000. One more time, I'll start with sales. If receivable went up, I will deduct from my sales. If receivable went down, I add to my sales. Because if receivable went down, I'm receiving more cash. And what I'm concerned about is converting sales, a cruel to cash receipts from customers. Sales is done and this concept would apply to all your revenues. Let's look at the second line on the income statement and usually that's cost of goods sold. Cost of goods sold is basically an expense account. And simply put what you are doing with cash of goods sold is you are spending money, spending money on your, not spending money, basically spending money to your supplier, your writing checks to your suppliers. Cost of goods sold is in a cruel figure. So I need to convert cost of goods sold into cash paid to suppliers. Think of this number as a negative number. So we're starting with cost of goods sold, which is an outflow of cash and we're gonna make certain, we're gonna make certain adjustments. And how do you, how do we convert cost of goods sold into cash paid to suppliers? We're gonna start with cash of goods sold, then analyze two accounts. Inventory, which is a current asset and account spable, which is a current liability. So we'll start with cost of goods sold, which is an outflow of cash. Then we looked at our inventory. If our inventory went up, think about it, inventory went up, it means we bought more inventory. But if inventory went up, it means we have to increase cost of goods sold, increase it in a way negative. So of cost of goods sold for to use numbers, let's assume cost of goods sold was $450,000. And my inventory went up $100,000. Well, then my cash paid to customers and cash paid to suppliers is 550 because my inventory went up, I'm buying more inventory. So if inventory went up, I increase cash paid to suppliers. Then I will analyze my accounts spable. I look at my accounts spable and if my accounts spable went down, what does that mean? It means I am paying down what I owe my suppliers. It means that's gonna increase. Let's assume my accounts spable went down $50,000. Now, I started with, when I started with cost of goods sold, it was $450,000. My inventory went up, that's an additional $100,000 of outflow. Then my payable went down by $50,000, that's an additional $50,000 of outflow as well. Well, what end up happening, cash paid to suppliers is $600,000. Why? $450,000 was my cost of goods sold. I bought more inventory, $100,000 more and my payable went down. Now, the opposite would have been true. If I started with $450,000, my inventory went down. If my inventory went down, let's assume my inventory went down $100,000, it means my outflow was $450,000, then I add $100,000, now it becomes $350,000. Cash paid to suppliers is $350,000 because I'm using inventory that I bought in prior years. I'm not adding to my inventory. And the same thing with payable, if my payable went up, if my payable went up by an additional $50,000, it means I am buying inventory and not even paying for it because my payable went up. So I go from $350,000, then my outflow will be $300,000. Simply put, I'm gonna give you the rule. We start with cost of goods sold. If there's an increase in inventory, we increase that cost of goods sold because we're converting to cash paid to suppliers. If there was a decrease in inventory, that's good news. It means we paid less to suppliers because we bought less from them. Then from an accounts payable perspective, if the payable went up, we reduce cash paid to supplier because we're not paying them. If the payable went down, we'll take that decrease and add it to cost of goods sold to increase cash paid to suppliers. From cost of goods sold, we have other expenses. Let's assume we are looking at depreciation expense. You're looking at the income statement and you said convert depreciation expense. Well, what should be your answer? It's a non-cash expense. So what do I do with depreciation expense? Nada, nothing, I ignore. It's already non-cash because I'm converting everything to cash. You are giving bad debt expense. I don't have to do anything. I'm giving losses. I don't have to do anything. I'm giving gains. I don't have to do anything. So those you ignore because those are non-cash activities. What I'm doing is taking my expenses and converting them into cash, cash basis. Let's take a look at income taxes payable. Let's assume you are giving income tax expense on the income statement for $48,000. Well, what do I have to do? I have to look at my balance sheet to see if I have any income taxes payable and any change in income taxes payable. Well, let's assume, let's assume no change. Well, if my income taxes 48,000 and there was no change, in other words, I look at my income taxes payable from year to year. It's either zero or it was 10,000. It stayed at 10,000. What does that mean? It means I pay to the IRS $48,000. Let's assume I reported $48,000 on the income statement but my income taxes payable went up by 10,000. What does that mean? It means my liabilities, my income taxes liabilities are going up but I'm not paying them. It means although I'm booking $48,000 on the income statement, 10,000 of it was an increase in my liabilities. It means I did not pay 10,000. It means cash paid to the Uncle Sam is only 38,000 because my liability went up, my liability went up. If my liability went down, if my income taxes payable went down by 10,000, now the opposite. Well, I reported $48,000 on the income statement then on the balance sheet my liabilities went down and my income tax liability went down $10,000. Well, guess what? It means I debited expense $48,000, credited cash $48,000, then I debited income taxes payable $10,000 and credited cash $10,000. It means in total I paid $58,000 to Uncle Sam. Why? $48,000 on my income statement and my income tax liability went down. It means I paid an additional 10,000. Therefore it's $58,000. Also, some expenses they have a related liability like income taxes payable, but sometimes they might have a related current asset like a prepaid taxes. Sometimes the company might pay their prepaid taxes. Then I have to analyze their prepaid taxes. If I'm starting with the income statement for $48,000 and I see my prepaid taxes went up by $10,000. So now it's an asset and it went up. What does that mean? It means I paid $48,000 for the income statement then I happen to prepay my taxes by 10,000. Well, if that's the case then I paid $58,000 in my taxes. $48,000 I expense and 10,000 I prepaid. In cash, $58,000 cash paid to Uncle Sam. Same concept will be true if my prepaid went down by 10,000. If I notice my prepaid went down and I'm reporting $48,000 of expenses on the income statement it means of that $48,000, $10,000 was already prepaid from prior year. I just expense that now. It means $48,000 minus 10,000, the decrease in prepaid I only paid $38,000. Simply put, I started with my expense income taxes and I have to look at the related assets and the related liability. If the liability goes up it means I am paying less. If the liability goes down it means in addition to that expense I paid more. Then when I look at my assets I look at the expense and the related asset. If the related asset went up it means I expense $48,000 and I paid more in prepaid. It means my cash outflow is higher than my expense but if I look at my expense and the related account the prepaid went down it means I'm expensing my prepaid. It means I'm not paying them now. I bought them in another period. This period I'm only expensing them, I'm not paying them. And this concept that I illustrate for you for income tax expense it applies to all expenses whether it's income tax expense, rent expense, insurance expense. Okay and the tricky thing is when they have a related asset and the related liability. Just look at it separately. Take the expense, analyze the current asset then analyze the current liability and figure it out. It's just they're independent from each other. But remember all expenses are negative and sales revenue is positive. So when you are analyzing your expenses you're starting with a negative number because it's cash paid to suppliers, cash paid to the US government to taxes so on and so forth, okay? So remember the direct method is taking each line and converting into a cash expense. Remember depreciation, amortization, bet that expense, gains and losses. You simply ignore those, you don't convert them. They're non-cash and that's why in the indirect method we adjust them because we're starting with net income. I hope this review although you cannot see the numbers but you could always go to my website or my YouTube and view examples but this is a review for you if you are commuting, busy on the go. If you happen to visit my YouTube or my channel please consider donating to support the channel. Good luck and study hard for your CPA exam.