Hey friends. I pray the Lord protect you from this new COVID strain that is circulating now. These are different times from what we’ve all known for many years. God is still on His throne and is able to provide what we need when we put our trust in Him.
This post continues the cash flow from operations theme. Note the title of the post today describes the terminology “cash flow from operations” as a wrong or inaccurate expression. Indeed, the latter portion of my prior blog post pointed out that there are no actual operating cash flows shown on the face of the Statement of Cash Flows (SCF) as presented according to the “indirect” approach. Also, recall the prior post’s comment that virtually all companies report operating cash flow using the indirect method. So, when you and I look at the SCF for the inflows and outflows of cash from doing business (operations), we don’t actually see those flows.
Let me explain further. Recall there are 3 major financial reports, namely the balance sheet, the income statement, and the SCF. The income statement reports inflows and outflows from operations but does so by measuring accrual flows, not cash flows. For instance, “sales revenue,” as seen on the income report isn’t an amount that denotes cash collected for the period from selling goods and services. That’s because companies often sell their wares on account. Under accrual measurement, credit sales are reported as revenue based on the period during which the goods or services were sold, not based on the period when the cash on account is collected. The period of sale and the period of cash collection of that sale may be the same period, but not necessarily. Sales on account made late in the accounting period usually are not collected until the subsequent period(s). So, again, when you read the line item “sales revenue” on the company’s income report, you aren’t reading a line that denotes “cash collected from sales.” We could therefore use a report (i.e. SCF) that would show us that cash collected from sales number.
Yes, because the income report measures operating inflows and outflows based on an accrual system (basis), the SCF is needed to reveal the cash inflows and outflows from those same operations. The direct method, which was encouraged by the Financial Accounting Standards Board (FASB), would indeed show the cash inflows and outflows from operations. However, since the FASB didn’t “require” the direct approach in presenting the SCF, almost all companies have followed the indirect approach and this indirect presentation does not show operating cash inflows and cash outflows.
What I’m saying is that since companies don’t use the direct method to report operating cash flows, we are really left without any clear revelation of cash flows that occurred from operating. Remember an earlier blog post where I used the analogy of a check register. The SCF is intended to show the full checkbook register of the company and breaks the register into 3 sections, operating, investing and financing. Yet, while 2 of the sections, namely investing and financing, reveal actual investing and financing cash flows when the SCF indirect method is used, the main section, namely operating, doesn’t show any actual operating cash flows.
Then, what does the SCF do in order to arrive at net cash flow from operations when the indirect method is used — since the “line item” cash flows aren’t actually shown? Well, instead of starting from scratch at the top and producing a cash flow income report (that would be the direct approach), the indirect method starts at the bottom, taking the accrual “net income” figure from the income statement and then makes all adjustments needed to convert that accrual bottom line into a cash bottom line. These adjustments aren’t cash flows themselves so that’s why we don’t see any actual cash flows under this approach.
Unfortunately, when you say something in a less than straightforward manner, it sounds like you’re talking in circles. Well, the direct method of presenting operating cash flow on the SCF is a straightforward presentation of cash flows. The indirect method is not. The direct method can be explained in a straightforward manner. Since the indirect method is not really a presentation of operating cash flow, trying to explain how you can end up with the same bottom line “net cash” number (as the direct method would yield) is akin to sounding like talking in circles.
A visual is almost always helpful. Thus, I’ll close by linking a brief youtube video I found that hopefully helps make better sense out of it all. Go here to watch.
See you next time.
Paul,
Thanks a million for explaining this. Something about the indirect method has always concerned me but I never could figure it out. This is because I didn’t know the difference in direct and indirect.
Blessings and best wishes.
David
Hey David,
I’m glad this helped some. After spending a career in the academic world of accounting, it became clear that there’s really no arena of life where politics aren’t played. If you research why reporting companies prefer the indirect approach, you’ll find they contend it is easier and less time consuming to gather data and prepare. Yet, the indirect approach actually involves more steps in its final preparation than does the direct method. If the argument is that the net income and balance sheet are all that’s really needed to produce the operating net cash flow number using the indirect approach — an argument that implies that identifying and gathering the actual cash flow data during the period that would be needed under the direct approach is too burdensome —
well, my own reaction to that argument: Poppycock!
SEC companies are indeed bookkeeping according to accrual accounting, but can you imagine any company today not also maintaining careful internal records of cash flows from doing business?
In fact, the indirect presentation can be converted to a direct presentation by just using the balance sheet and income statement figures but companies leave that to the investors and creditors to accomplish. Yet it requires some depth of accounting knowledge that shouldn’t be expected from the lending and shareholder communities.
The indirect method sort of pulls a veil over the cash flow picture relative to operations (for the user community). Management (the agent) has a responsibility to its principal (owners) to always act in the owners’ best interest. I believe the direct approach is in the owners’ best interest.
Paul