Use Sophia to knock out your gen-ed requirements quickly and affordably. Learn more
Become a Member Try for Free
×

Operating Activities: Direct Method

Author: Sophia
PDF Version

what's covered
In this lesson, we will discuss the direct method for preparing the operating activities section of the statement of cash flows. Specifically, we will discuss the following:

Table of Contents

1. Using the Direct Method

Using the direct method to compute the cash provided by operating activities requires us to rebuild the income statement. We start with sales and then make adjustments as we work our way down the income statement. Sales are adjusted for the changes in accounts receivable and expenses are adjusted to reflect the cash that was actually paid. The income statement is essentially converted to a cash basis, which records revenue and expenses when cash is exchanged, not when revenue is earned. The income statement is typically presented on an accrual basis, which recognizes revenue and expenses when they are generated, not when the cash is exchanged. Companies using the accrual basis of accounting record revenue when they have met their obligations by providing a good or service, not when cash is collected. Subsequently, expenses are recorded in the same period as related revenues are recognized as opposed to when the bill is actually paid.

The direct method uses a top-down approach in regard to the income statement to calculate the cash provided by operating activities.

formula to know
Cash flows from operating activities:
table attributes columnalign left end attributes row cell Cash space received space from space customers space end cell row cell negative space Cash space paid space for space inventory end cell row cell negative space Cash space paid space for space operating space expenses end cell row cell negative space Cash space paid space for space interest space expense end cell row cell negative space Cash space paid space for space income space taxes end cell row cell stack Net space cash space flows space from space operating space activities with bar on top end cell end table

terms to know
Cash Basis
An accounting method that records revenue and expenses when cash is exchanged instead of when revenue is earned.
Accrual Basis
An accounting method that recognizes revenue and expenses when they are generated instead of when cash is exchanged.

2. Preparing the Statement of Cash Flows Using the Direct Method 

 To make this calculation easier, we use the following process.

step by step
  1. Adjust sales to the cash basis.
  2. Adjust for cash payments made for inventory.
  3. Adjust for cash payments of operating expenses.
  4. Adjust for cash payments of interest expenses.
  5. Adjust for cash payments of income tax expenses.
  6. Calculate the net cash flow from operating activities.

2a. Adjust Sales to the Cash Basis—Step One

Begin with the revenue that was reported on the income statement. Total revenue will be adjusted for the increase or decrease of accounts receivable during the period. The change in accounts receivable balances will be found on the balance sheet.

The flow chart shows how to adjust the sale figure based on whether accounts receivable increased or decreased. If accounts receivable increased, decrease the sales figure by that amount. If accounts receivable decreased, increase the sales figure by that amount.

2b. Adjust for Cash Payments Made for Inventory—Step Two

Begin with the cost of goods sold figure that was reported on the income statement. The cost of goods sold will be adjusted for the increase or decrease in inventory and accounts payable during the period. The change in inventory and accounts payable balances will be found on the balance sheet.

The flow chart shows how to adjust the cost of goods sold by inventory. If inventory increases, increase the cost of goods sold by that amount. If inventory decreases, decrease the cost of goods sold by that amount. The flow chart then shows a step for accounts payable. If accounts payable increase, decrease the cost of goods sold by that amount. If it decreases, increase the cost of goods sold by that amount. The result is cash paid for inventory.

2c. Adjust for Cash Payments of Operating Expenses—Step Three

Begin with all operating expenses, except depreciation and amortization expenses which were reported on the income statement. Depreciation and amortization expenses are not adjusted for or reported on the statement of cash flows because they do not involve a cash outflow. The operating expenses will be adjusted for the increase or decrease in accrued expenses payable and the increase or decrease in prepaid expenses during the period. The change in accrued expenses payable and prepaid expense balances will be found on the balance sheet.

The flow chart shows how to adjust the cash paid for operating expenses. If accrued expenses payable increase, decrease the operating expenses figure by that amount. If accrued expenses payable decrease, increase the operating expenses figure by that amount. The flow chart then shows a step for prepaid expenses. If prepaid expenses increase, increase the operating expenses figure by that amount. If prepaid expenses decrease, decrease the operating expenses figure by that amount. The result is cash paid for operating expenses. 







2d. Adjust for Cash Payments of Interest Expenses—Step Four





Begin with the interest expense that was reported on the income statement. The interest expense will be adjusted for the increase or decrease in interest payable during the period. The change in interest payable balances will be found on the balance sheet.



The flow chart shows how to adjust the cash paid for interest expense. If interest payable increases, decrease the interest expenses figure by that amount. If interest payable decreases, increase the interest expenses figure by that amount. The result is cash paid for interest expenses.





2e. Adjust for Cash Payments of Income Tax Expenses—Step Five





Begin with the income tax expense that was reported on the income statement. The income tax expense will be adjusted for the increase or decrease in income tax payable during the period. The change in income tax payable balances will be found on the balance sheet.



The flow chart shows how to adjust for cash payments of income tax expense. If income tax payable increases, decrease the income tax expenses figure by that amount. If income tax payable decreases, increase the income tax expenses figure by that amount. The result is cash paid for income tax expenses. 





2f. Calculate the Net Cash Flow From Operating Activities—Step Six





Finally, we can now put together the results of each of these steps to find the net cash flows from operating activities.


table attributes columnalign left end attributes row cell Cash space received space from space customers space space left parenthesis step space 1 right parenthesis end cell row cell negative space Cash space paid space for space inventory space space left parenthesis step space 2 right parenthesis end cell row cell negative space Cash space paid space for space operating space expenses space left parenthesis step space 3 right parenthesis end cell row cell negative space Cash space paid space for space interest space expense space space left parenthesis step space 4 right parenthesis end cell row cell negative space Cash space paid space for space income space taxes space space left parenthesis step space 5 right parenthesis end cell row cell stack Net space cash space flows space from space operating space activities with bar on top end cell end table








3. Example Preparation of the Statement of Cash Flows Using the Direct Method





Allentown Hydraulics Inc. is a midsized producer of hydraulic parts used in many industries and has customers all over the world. We will use their most recent income statement for 2022 and a comparative balance sheet for 2022 and 2021 to demonstrate the process for preparing the operating activities section of the statement of cash flows using the direct method.







EXAMPLE

First, let’s take a look at Allentown Hydraulics’s income statement for 2022.



View this spreadsheet in Google Sheets
 



And their balance sheet for 2021 and 2022:



View this spreadsheet in Google Sheets







Now, we will walk through the steps of the direct method using the information from the Allentown income statement and balance sheet.




  • Step One: Adjust for cash payments made for inventory.




EXAMPLE

Cash received from customers = Revenues + decrease in accounts receivable

$2,025,200 = $2,000,000 + (215,300 – 190,100)








  • Step Two: Adjust for cash payments made for inventory.




EXAMPLE

Cash paid for inventory = Cost of goods sold + decrease in accounts payable + increase in inventory

$1,417,400 = $1,400,000 + $4,600 + $12,800








  • Step Three: Adjust for cash payments of operating expenses.




EXAMPLE

Cash paid for operating expenses = Selling and administrative expenses + other operating expenses + increase in prepaid expenses – increase in accrued expenses payable

$172,100 = $165,000 + $15,000 + $900 – $8,800








  • Step Four: Adjust for cash payments of interest expenses.




EXAMPLE

Cash paid for interest expense = Interest expense (There is currently no interest payable on the balance sheet

$52,000 = $52,000 + $0








  • Step Five: Adjust for cash payments of income tax expenses.




EXAMPLE

Cash paid for income tax expense = Income tax expense + decrease in income tax payable

 $66,200 = $64,000 + $2,200








  • Step Six: Calculate the net cash flow from operating activities.




EXAMPLE


View this spreadsheet in Google Sheets





















try it





Now, let’s try to prepare the operating activities section for the statement of cash flows using the direct method on your own. The 2020 income statement for D.R. Winslow Inc. is provided below along with select information from their balance sheet.



View this spreadsheet in Google Sheets
 




Begin by calculating the cash received from customers
Cash received from customers = Revenues - increase in accounts receivable

$495,000=$500,000 – (37,000 – 32,000)










Calculate the cash paid for inventory
Cash paid for inventory = Cost of goods sold – increase in accounts payable + increase in inventory

$167,000 = $160,000 + ($94,000 – $82,000) – ($68,000 - $63,000)










Calculate the cash paid for operating expenses
Cash paid for operating expenses = Operating expenses – decrease in prepaid rent + decrease in salaries and wages payable

$120,000 = $120,000 – $2,000 + $2,000










Calculate the cash paid for income tax expense
Cash paid for income tax expense = Income tax expense – increase in income tax payable

$37,000 = $38,000 – $1,000










Finally, calculate the net cash flow from operating activities
table attributes columnalign left end attributes row cell Cash space received space from space customers end cell row cell negative space Cash space paid space for space inventory end cell row cell negative space Cash space paid space for space operating space expenses end cell row cell negative space Cash space paid space for space income space taxes end cell row cell stack Net space cash space flows space from space operating space activities with bar on top end cell row cell $ 495 comma 000 end cell row cell – space 167 comma 000 end cell row cell negative space 120 comma 000 end cell row cell – space 37 comma 000 end cell row cell equals space $ 171 comma 000 end cell end table





















summary






In this lesson, we discussed the basis and general structure for using the direct method with a particular focus on preparing the statement of cash flows using the direct method. While using the direct method, adjustments are made directly to sales by calculating the cash received by customers and deducting cash payments for inventory, operating expenses, interest, and income tax.


We also used a step-by-step process to calculate the net cash flow from operating expenses. This model requires you to evaluate changes in balance sheet accounts and either increase or decrease the cash inflows and outflows by these changes. Finally, we walked through an example preparation of the statement of cash flows using the direct method.













Source: THIS TUTORIAL HAS BEEN ADAPTED FROM “ACCOUNTING PRINCIPLES: A BUSINESS PERSPECTIVE” BY hermanson, edwards, and maher. ACCESS FOR FREE AT www.solr.bccampus.ca. LICENSE: CREATIVE COMMONS ATTRIBUTION 3.0 UNPORTED.




















Terms to Know









Accrual Basis





An accounting method that recognizes revenue and expenses when they are generated instead of when cash is exchanged.





Cash Basis





An accounting method that records revenue and expenses when cash is exchanged instead of when revenue is earned.



















Formulas to Know









Cash flows from operating activities





table attributes columnalign left end attributes row cell Cash space received space from space customers space end cell row cell negative space Cash space paid space for space inventory end cell row cell negative space Cash space paid space for space operating space expenses end cell row cell negative space Cash space paid space for space interest space expense end cell row cell negative space Cash space paid space for space income space taxes end cell row cell stack Net space cash space flows space from space operating space activities with bar on top end cell end table
































© 2025 SOPHIA Learning, LLC. SOPHIA is a registered trademark of SOPHIA Learning, LLC.