 Hello and welcome to the session. This is Professor Farhad. In this session, we would look at the operating section using the direct method for the statement of cash flow. This topic is covered in introductory accounting, intermediate accounting. I have more explanation in intermediate accounting and 100% sure on the CPA FAR section. The direct method, it's not only a method that you will need to know. Once you know the direct method which I will cover, you'll be able to go from cash to accrual or if you want to accrual to cash. So you would learn how to convert your financial statements and this is basically what we're doing. We're gonna take the income statement using the accrual method and convert to the cash method. That's basically what we're doing. 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 and tax lectures. This is a list of all the courses that I cover, including many CPA questions. If you like my lectures, please like them, share them. Subscribe to the channel. If it benefits you, it might benefit other people. So share the wealth, connect with me on Instagram. On my website, farhatlectures.com, I have additional resources for the CPA exam, the EA exam, the CMA exam and many accounting courses if you'd like to supplement your accounting education or if you'd like to pass the CPA exam and move on with your life. So if you would like to see the prerequisite, basically, if you don't know how the indirect method work, if you don't know what the cash flow statement is, please check the description for the link for those lessons, but simply put, I'm gonna be assuming here, you know what the state of cash flow looks like and you know how to prepare the indirect method, otherwise go to the description. So to work with the direct method, you need an income statement because this is what we're gonna be converting and you need a balance sheet, two-year balance sheet. So what are we really doing? Here's what we're doing. We're taking the income statement and this income statement is prepared using the accrual method and you will see by the end of this recording, I'm gonna convert this accrual method to the cash method, convert everything to cash. That's basically what I'm gonna be doing. So what am I doing? I'm taking sales, starting with sales, starting with each number. Each number on this list, I'm gonna go over each number and take it from accrual to cash. I'm gonna convert it to cash, starting with sales. Now, to convert, you have to have a related account on the balance sheet. So you have to understand the relationship between accounts and believe it or not, the direct method relies on your knowledge, relies on your T-account techniques, relies on your T-account skills on your basic accounting knowledge to understand what's happening. So you will notice, you're gonna go back to basic accounting to see how you analyze accounts. So starting with sales, this is what the company reported in sales. They reported in sales, 590,000. Well, that's great, but that's accrual. That's sales accrual. Now we need to convert sales into cash received from customers. So this is not really what we're looking for. Is cash received from customers. Because, okay, we know sales is accrual. So sales include cash sales and sales on account. Well, I want to only find out how much cash that I received from my customers. How do I convert? Well, what account is related to sales on the balance sheet? Well, I'm gonna be analyzing account receivable. And here's the account receivable. The account receivable was 40,000 and it went from 40,000 to 60,000. So account receivable increased by 20,000. Well, let me interpret this in a T account setting. How do I interpret this in a T account setting? So if I have my T account, account receivable, I have the beginning balance is 40,000. The beginning balance is 40. The ending balance is 60,000. And this is right from the balance sheet. I know that the net change, I can say the net change equal to 20,000. That's all what I know. Okay. The net change equal to 20,000. What does that mean? Well, I need to find out how much, the net change is 20,000. I need to find out how much that I actually received from customers. Well, I know that my sales was 590. And what happened when you make a sale? Every time you make a sale, you debit the account receivable, you credit sales. So we're going to assume that you're going to sell on credit first. In total, we know that we have 590,000, or at least that much, 590,000. Why? Because sales is 590,000. So let's fill out the T account. Now sales, so we debited account receivable, 590,000. Now, if I take $40,000 as the beginning balance, plus 590,000, okay? That's going to give me 630,000. If my math is right, that's going to give me 630,000. I end up with 60,000. So I can conclude that I must have received in cash, 570,000. For this to balance, I need 570 balance. Why? Because every time I receive from the customer, I debit cash, credit account receivable. So I must have debited cash, 570, credited account receivable, 570. So notice, debit to receivable, 590, credit to receivable, 570, the net change is 20,000. So notice, I only received cash from customers, cash from customers, only 50,000 cash from customers. What does that mean? It means what you do is you start with your sales, you start with your sales, and what you do. If account receivable went up, which it did go up, so you start with sales, and if your account receivable went up, so if AR went up, and this is what happened here, you deduct the difference. The difference is 20,000. If your account receivable went down, you would have add to 590, why? If your account receivable went down, it means your customers are paying their account, they're paying their account. So in addition to the sales that you made, the customer paid off their account, which is good for you. It means you received more cash, you received more cash. Here, you received less cash. So let me show you what we did. So this is what we did. We started with 40,000, the beginning balance, the ending balance, and sales was 590, and this was basically a plug. Basically, this is what happened throughout the year. Throughout the year, this is basically the net transaction. Throughout the year, we credited sales 590, we debited cash 570, and we debited the account receivable 20. So overall, receivable went up by 20,000. After all said and done, when we net everything, this is basically what at net down to. And the formula would look something like this. You start with sales, and to convert from sales to cash received from customers, you take your sales revenue, and you add any decrease to account receivable. This is not what happened here. Here, you deduct increase in account receivable. So this example illustrates an increase in account receivable. Therefore, we took 570. So basically what ended up happening is we took 570 minus 20. I'm sorry, 590, not 570. 590 minus 20, we end up with 570. What we say, we say this is our cash flow statement. Cash received from customers, cash received from customers, 570. So what we did, now we are rebuilding our income statement using the cash method. Starting with sales, we converted our sales from the cruel sales to cash sales. Now, this applies, this same concept applies to interest revenue, dividend revenue, rental revenue. What you do is you start with the revenue, then you examine the related account receivable. If account receivable goes up, you have less cash. If account receivable goes down, you take the decrease and you add it to the revenue that you reported on the income statement. So this is how you analyze account revenue. Now, let me just make one assumption here. Hopefully this will make it easier for you to understand. Let's assume for the sake of illustration, my account receivable started at 40 and remained at 40. What does that mean? Well, if it started at 40 and remained at 40, it doesn't matter how much sales I made. If I made one zillion of sales, I must have also received one zillion of cash because the sales and the cash cancel each other out and this is 40 equal to 40. So again, if the 2019 receivable was 40,000, so whatever sales I received, it must have been all in cash because my receivable did not change. Hopefully this will help you understand what we just did. Let's move on now to, so we're done with sales. What's next on our list? Next on our list is cost of goods sold. Now we are looking at cost of goods sold. This is in a cruel figure. Now we want to convert cost of goods sold to cash paid to suppliers. Because of goods sold, basically how much did we incur in cost? Well, how do you know how much you paid for your customers? Well, we know from an accrual, we incurred 300,000. That's fine. That's fine. From an accrual perspective, we did debit at cost of goods sold 300,000. Now, however, to convert to cash, we have to examine the related account. What account are related to cost of goods sold? Well, we have, hopefully you know this, inventory. Because inventory turned into cost of goods sold. And when you buy inventory, sometime you buy them on account. So to convert cost of goods sold to cash paid to suppliers, we have to analyze two accounts. First, we have to determine how much did we purchase? And the second thing we have to find out, how much cash did we pay for those purchases? So we have to analyze two accounts. Starting with inventory. Let's analyze inventory. What do I mean by analyzing? It's like taking a T account. This is the inventory. You have a beginning balance of 70,000. You have an ending balance of 84,000. What do we know here? What do we know from this picture? We know that inventory is increased by 14,000. This is all what we know from this. That the net increase is 14,000. Now, we also know that, remember from your basic accounting, when the account, when we have inventory, let me just kind of show you, when we have inventory, when the inventory is sold, when we sell inventory, oh, let's go back to the journal entry. Here's the journal entry when we sell. We debit account receivable, credit sales, $100. I'm just making up this number. Then what we do is we debit cost of goods sold, then we credit inventory. So this is the entry that we make. Let's assume this is $80 and this is $80. What I'm trying to say is every time you reduce inventory, every time you reduce inventory, it goes on to cost of goods sold. So simply put, it seems we reduced inventory by, let me change the color here, it seems we reduced inventory by 300,000. How did I know 300,000? Well, I see here, 300,000. So I know the credit to inventory was 300,000. Now, let me do this. If I take 70,000 minus, no, 70,000 minus 300,000, that doesn't make any sense. We must have made some purchases, right? Because if I take 70,000, credit the account 300,000, it's not equal to 84. So I must have made purchases because every time I purchased inventory, I debit inventory and I credit accounts payable. So I must have bought some inventory. How much inventory did I buy? Well, what number do I need to make this account equal to 84? Well, I must have purchased. So notice what I did. I'm looking for my purchases, 314,000. Well, if I take 70,000 plus 314 minus 300, it will give me 84. So I must have purchased 314,000 of inventory. But that's not my answer. This is how much I purchased. What I need to find out is how much did I purchase pay in cash? So the first thing, so the 314,000 is my purchase. First, you find your purchase. How much did you purchase of inventory? I know I purchased 314,000 because I'm giving the beginning, I'm giving the ending, I'm giving the credit to inventory, which is the cost of goods sold. So I was able to find out 314. Well, that's good. Now I need to analyze. So I'm done with analyzing inventory. I need to analyze my accounts payable to find out how much cash that I pay. Now, every time I pay my accounts payable, I debit AP. This is AP accounts payable and I credit cash. Every time I pay my accounts payable, I debit AP and I credit cash. Let's analyze accounts payable because analyzing accounts payable, it's gonna tell us how much we pay for inventory. So let's analyze it. Accounts, I keep writing AR, AP accounts payable. We started with 40, we end up with 35. So our accounts payable went down. And we know that we purchased 314. So throughout the year, we know that we debited inventory 314, we credited accounts payable 314. Why? I already told you, we find out how much we purchased. So this account, I'm sorry, this should be credit not debit accounts payable. So the beginning was 40. The ending was 35. And I know now that I purchased 314. Therefore I have a debit inventory credited AP. So I know from my prior computation, I increase my AP with 314. Well, now this is a plug now. This is the plug. So if I started with 40, added 314 of inventory, end up with 35. It means I paid, I paid for all of this inventory 314 and I paid an extra 5,000. It means I paid 319,000. Hold on a second, how did you do this? Well, I know I purchased 314 worth of inventory. However, my accounts payable end up being lower by 5,000. It means I paid for all the inventory and I paid off an additional 5,000 for my payable. So my payable went down. Therefore I paid for inventory 319. So how much cash did, was it paid to suppliers? 319,000. Let me show it to you in a T account, what I just did. So first you analyze inventory and we find out we purchased 314 worth of inventory. Then you have to find out how much you paid on account. Well, you analyze your accounts payable and you find out you paid 319. Now let's take a look at the formula. So first you have to find your purchases. You will take your cost of goods sold. If inventory goes up, you add because if you're in, it means if your inventory goes up it means you bought more inventory than last year. So your balance went up. You add it. Then after you find your purchases you have to find out if you paid more on credit or less on credit, you will take your purchases and if there is any decrease in accounts payable, any decrease, which what happened here it's a subtraction, you basically paid. Okay, if there's any increase it's a deduction. You paid less. So simply put, now we are completing our statement of cash flow using the indirect method. We started with cash received from customers. Now we are, we computed cash paid for inventory which is 319. So simply put this is our sales, cash sales and this is our cost of goods sold cash wise, cash wise 319. Why 319? Two reasons, why that 19? Because cost of goods sold was 300,000 and what happened since our inventory went up by 14 it means we purchased the inventory and since our accounts payable went down it means we paid plus five and all of those are negative because they're all paid out, okay? So that's why it's 319. So 300 was cost of goods sold, 14,000 for the additional inventory and 5,000 for the additional reduction in accounts payable. Now if inventory was going down would have deducted, would have less paid. If accounts payable went up there will be a deduction too. In the sense it's a positive cash for us, okay? Positive cash. So simply put if I want to summarize this in a journal entry everything that we did well we know that we debited cost of goods sold 300,000 you can't argue with that it's right here. We know that inventory went up the net inventory went up 14,000. Why? Because look after all said and done inventory went up by 14,000 accounts payable went down by 5,000 AP went down by 5,000 how did I know this look? Accounts payable decreased by 5,000 so the cash must have been 319. Cash must have been 319. For this entry to balance cash I'm just showing it to you from a journal entry. Once again if you know the journal entry you are really really in good shape, okay? Now let's take a look at this now we're done with sales we'll done with cost of goods sold. Now we're gonna look at wages and other operating expenses. Now what accounts are related to wages and other operating expenses? Well we have to find a related account. Well not account receivable not inventory prepaid. Prepaid is related to wages and other operating expenses. Let's analyze our wages and other operating I'm sorry let's analyze our prepaid I apologize. So prepaid is PP prepaid. We started the account with 4,000 we ended up with 6,000. So what do we know? We know the net increase was 2,000. So throughout the year we debited this we credited this but the net increase was 2,000. That much I keep switching my balances. Prepaid is an asset 4,000 and 6,000. Okay so this is what happened to the prepaid account. Now what else do we know? We know, we know that wages and operating expenses was 216. Well what does that mean? It means at some point when we were operating the business we credited the account. We credited prepaid to 16. Why am I saying this? Because what's gonna happen is this. We're gonna assume every time you debited an expense you credited the prepaid. Why? Because you either paid for it now which is expense cash. You either paid for it now or it was already paid for because you credited the prepaid. It means the prepaid was credited in total to 16. It doesn't have to be true but we could make this assumption to get to our cash. Well if we have 4,000 we credited the prepaid to 16. Well what does that mean? Well if 4,000 minus to 16 is not 4,000 minus to 16 credited is not equal to 6,000. So we must have purchased prepaid of 218. Either we purchased prepaid or where we paid them in cash because we're converting everything to cash. It means cash paid is 218. Cash payment for operating the business for wages and operating the business is 218. Simply put all what you have to do is state your expense from the income statement which is 216 and look at your prepaid. If your prepaid went up you add to your expense. Why? Because it means you have 216 of accrual then you also acquired more prepaid. Well acquiring prepaid means you are paying for the prepaid. You are paying cash. Therefore you add the increase. It means you paid in total 218,000. Now if your accrual is 216 and your prepaid went down in value. When down in value means what does that mean? Well let's start with 216 and 216. Let's start with 4,000 and 4,000. Assuming the beginning prepaid is 4,000 the ending prepaid 4,000 and we know the wages and accrual is 216. It means you purchase 216 because 216 and 216 with cancel and 4,000 is left. Okay, I just want to make sure you're aware. You can see this. Now what happened is you have 4,000 and let's assume now prepaid is 2,000. Prepaid is 2,000. Well from accrual, from accrual you know that you credited prepaid 214. It means you only need 214,000. The cash paid why? Because 4,000 plus 214 minus 216 equal to 2,000. It means 216 minus 2,000. It means you paid in total to 14. So you'll take your expense and you look at your prepaid. If your prepaid went up, you had more cash payment. So it's your expense plus your cash payment. You look at your expense. If your prepaid went down, it means you operated the business by expensing the prepaid. Expensing the prepaid means you have, you use more prepaid this year than you purchase which is it means you consumed less cash. So let's take a look at this example one more time. So what you did is you started with four and up with six. Your prepaid went up. Your expenses on the accrual basis were to 16, but you paid for an additional $2,000 in prepaid. That means your cash was more than to 16. Your cash was to 18. Your cash was to 18. Simply put you'll take your wages and other operating expenses. You increase, you add to them any increase in prepaid which is what happened in this situation. If there's any related liability, if there's any related liability, you add the decrease in related liability. So if your liabilities went down, it means you paid more. If your liabilities went up, it means you're not spending on your expenses. Because remember for expenses, you could also have a related liability. Like you, for example, for wages, you could have wages payable, but we don't have wages payable. Here we're gonna deal with liabilities. So what does the journal looks like overall? Well, here's what happened. You debited. Wages expense, 216. You can't argue with this. It's right there on your income statement, okay? Your prepaid went up by 2,000. You can't argue with that. It went from four to six. Therefore your cash equal to to 18. And this is why I said your cash is to 18. So this is what it looks like. So cash received from customers 570. Cash paid for inventory 319. Cash paid for wages. And other operating expenses, 318. So simply put, you will take your accrual. If there's any increase in the prepaid, you paid more. If there's any decrease in the prepaid, you paid less. If there's any decrease in the liability, you paid more. If there's any increase in the liabilities, you paid less, okay? Let's take a look at. So we're done with sales. Done with cost of goods sold. Done with this. We converted all of those. Now interest expense 7,000. The first thing you look at your balance sheet. If there is no interest payable or prepaid interest, you're good. We do have interest payable. It seems interest payable went from 4,000 to 3,000. Let's see if we can do this real quick. On the income statement, it shows that you have 7,000 of expenses. Your balance sheet shows that your interest payable went down. So in addition to the 7,000, it means you paid down the interest from prior period. That means you're gonna add 1,000 to your expense and you paid 8,000 for interest expenses. Let's take a look at it from a journal entry perspective. So we are looking at a liability. This is interest payable and your beginning balance was 4. Your ending balance is 3. It means overall it went down. Overall it went down. It went down by 1,000. But we know that you, from the income statement, we know that interest payable was credited 7,000. It means it was debited 8,000. Why it was debited 8,000? Because you need to go from 4 to 3. So the difference has to be a reduction of 1,000. It means cash paid for interest, cash paid equal to 8,000. Cash paid equal to 8,000. So simply put, what you do is this. You will take your expense and if you have a related liability, if the liability went down, you paid more. If the liability went up, you paid less. If the liability went up, it means you debited the expense and you credited the liability. You did not pay cash. You did not pay cash. You debited the expense and you credited the liability. So this is what it looks like, 4,000 at the beginning, 3,000 at the ending. And the interest payable went down. It means you paid. How did I know you paid? Because it went down. It means 7,000 was recorded. So let's take a look at it from a journal entry also. So basically what happened, you debited interest expense 7,000. You can't argue with this. It's right here. And you debited interest payable 1,000. How do you know this? Your payable went down by 1,000. It means your cash must have been for interest 8,000. You recorded 7,000 for this year and you paid 1,000 for prior year. So basically here's the formula. Now remember, sometimes you could have a prepaid interest. If you have the prepaid interest, you have to go a little bit further. If your prepaid interest went up, if you prepaid your interest, that's minus cash. It means you paid more. If your prepaid interest went down, it means positive to cash. It means you are using your prepaid to expense it. But usually you will not have payable and prepaid at the same time, but in case you do. Who knows? On the CPA exam, they may throw something like that at you. Now we're done with sales. We converted sales to 570. We converted cost of goods sold to 319. We converted wages and other operating expenses to 218. We just converted 7,000 of interest to 8,000 cash paid for interest. Now the next is depreciation expense. Now we need to convert depreciation expense to cash paid. And the answer is nada, nothing. Depreciation expense is a non-cash expense. Well, if it's non-cash expense, how can you convert something that's non-cash to cash? It's already non-cash. So guess what? We're done with this. So what do we need to move on to losses? Losses on plant asset. Oh, hold on a second. Losses, that's also a non-cash expense. Why? Well, if you sold the land for a loss, you're gonna debit cash, 10,000. You're gonna debit the loss, 2,000, and you're gonna credit the land 12,000. So if you have a piece of land for 12,000, you sold it for 10, you have a loss of two. The loss is not cash. You did not really lose any cash. The loss is an accounting number. So there's no cash, okay? That's why loss is a non-cash. And if you're not sure why non-cash, look in the description when we explain this for the indirect section. So we're done with loss. We don't have to worry about this. Same thing with gains. Gains are non-cash. Bravin, why? Well, let's go back to this land example. Let's assume I sold this land for 15,000. So I received cash of 15,000, credit land 12. Now I credit the gain 3,000. Well, this gain, I did not really receive 3,000 of cash. I received 15,000, and this 15,000 will be accounted for in the investing section. Therefore, I don't have to do anything with the gain. Gain is done. So technically what's left for me is income tax. Now let's take a look at income taxes. Income tax is showing 15,000 on the income statement. Do we have a prepaid tax? We don't. We don't have to worry about prepaid tax. We have income taxes payable, and it went up by 10,000. Wow, that's good. It means I recorded 15,000 of income tax expense. The cruel, the cruel then, but I did not pay it. How did I know I did not pay it? Because my liability, my related liability went up. So what would the T account looks like? I started with 12 on my liability and that put 22. Well, my liabilities went up by 10, okay? But I, I recorded 15,000 of income taxes payable. So I must have only paid 5,000. So simply put, you take the expense, which is 15,000, and you look at the related liability. If the liability went up, it means I paid less. How much I paid less? I paid less than 10,000 less. It means I only paid 5,000 in cash. So from it, let's look at it from a T account. From a T account, you're gonna debit income tax expense 15,000, you can't argue with this. It's right here, income tax expense of 15,000. You're gonna debit, I'm sorry, you're gonna credit. Income taxes payable, 10,000. You can't argue with that because your income taxes payable increased by 10,000. It went up by 10,000. Well, if that's the case, the only cash that you paid is 5,000. So you record the fifth, so simply put, let me show it to you one more time. You record that 15,000 of expenses of which 10,000 was on account and 5,000 cash. So of the 15,000, sorry, of the 15,000, of expenses, of the 15,000 of expenses, you only paid five in cash and the 10 was on account. So let's look at the formula. You'll look at your expense. If there was any decrease, decrease in income taxes payable, it's an additional outflow. If there's any increase, it's a reduction in your outflow. So simply put, and basically once we're done with income tax expense, we're done with all of them. So we kind of complete all of them. So now this is your statement of cash flows using the direct method for this income statement. So this income statement has a net income of 38,000, but what we did is we converted everything to cash and you received cash of 20,000, 20,000. That's the difference. Now, this is a summary of all the formulas that I just showed you. You have to understand these formulas. You have to understand them. Once you understand them, you are good to go. Now, this is in a comparison, the indirect method, which is in the description, and this is what we did in the indirect method using the five steps, which is 20,000, versus the direct method, also 20,000. Obviously they have to give you the same number and only the operating section uses the direct and the indirect method. So basically the direct method, it's like you are building an income statement, revenues 570 minus the expenses. Why people like it? Because it's revenues minus expenses based on a cash basis. And indirect method, on the contrary, you are starting with net income and you are adjusting it back to cash received. So I like this end product because this looks like an income statement to me. Just it's on a cash basis. That's why I like it. That's why I like it. Now, if you like this recording, talking about this recording, please like it, share it, put it in playlist. If you want additional resources, visit my website, farhatlectures.com, especially if you're studying for your CPA exam. If you're looking for those seven to 10 points or if you're looking to supplement your accounting education with additional practices and exercises and lectures, my website is the key. I cover many courses, study, stay safe during those coronavirus days and good luck.