Operating Activities: Direct Method

Alright now let's discuss the direct method for the operating cash flows. So the direct method, it's gonna directly find the operating activities by summing all relevant cash flows instead of starting with net income and then adjusting it, we're just gonna say, okay, how much cash did we collect from customers? How much cash did we pay to our suppliers? How much cash did we pay for interest? How much cash did we pay for all the different operating activities? Okay. And I want to note that whether we're using the indirect or the direct method, we're only dealing with operating activities. When we talk about indirect or direct, when we get to investing activities and financing activities, they're their own separate beast. We only talk about indirect or direct when we're talking about the operating activity section. Okay? So when we do direct method, a lot of times these questions can be simple and they'll just tell you you collected so much cash from customers. You paid so much to your suppliers and you just have to sum up all those numbers. But sometimes they make you use your T. Accounts to figure out what those numbers are. Okay? So let's go through the most relevant t accounts that you would see in the direct method. Okay, So the first one here is cash received from customers. Okay? So this is a cash flow, right? When we receive cash from customers, this is an operating cash flow. We we our operations to sell things to customers and will receive cash from them. But sometimes we sell things on credit. So how do we know what is the cash received from customers? We need to look at our accounts receivable t account. Okay? So if I make our T. Account right here for accounts receivable, we can think about what happens here. We're gonna have our beginning balance in the account. And then whenever we make a sale a lot of times in these questions, they're just gonna assume that all sales are on credit and we'll have all our sales going into our accounts receivable. Right? We would be making a journal entry, a sales journal entry. That would look something like this debit accounts receivable. Credit sales. Right? So we would have our revenue and it would increase our accounts receivable and what would decrease our accounts receivable. It's when we collect from our customers, right? They owe us money. And when they don't know us anymore by paying us. So if we have any cash collected, that would decrease our accounts receivable. So cash. And this is what we're this is what we're concerned about. Right in the direct method we're concerned about that cash. So we would debit cash and we would credit accounts receivable to get the account off of our books. So in this case this is what's important to us, this cash amount this cash collected in our accounts receivable, journal or T account here. So what's left after all of that is our ending balance in the account. We have our beginning balance. And this goes back to our base equation as well, right? We have our beginning balance plus the additions which are sales, minus the subtractions which are the cash we collect leaves us with our ending balance. Okay, so that's the cash received from customers. Let's go ahead and pause here, and then we'll talk about the cash paid to suppliers.

So when we talk about cash paid to suppliers it can be a little trickier. There's gonna be two relevant T accounts. We're gonna have to think about inventory as well as accounts payable. Ap. Okay so let's make t accounts for both inventory and accounts payable. Give it more space. Okay inventory and accounts payable. So we're gonna have some beginning balance in inventory. And then we're gonna be making purchases right? We're gonna purchase more inventory and then that would increase our inventory balance when we purchase some. What would decrease our inventory balance when we sell the inventory. Right? And it goes to cost of goods sold. So that would get rid of some of our inventory. And we would be left with our ending balance in inventory. Now what about the accounts payable side? We would have some beginning balance and it says a credit right? Because this is a liability. And what would increase our accounts payable when we purchase stuff? Right. So we can assume in this lesson that we're gonna purchase everything on credit and pay them later. So we'll have our purchases here and that's gonna increase our accounts payable. Right? We're gonna purchase uh more inventory. We're making a couple assumptions first that we're just purchasing inventory in Ap and we're also assuming that we're putting all our purchase none of our purchases are in cash. Now you can make that assumption anyways even if we pay in cash immediately. Well maybe for a millisecond. Right we owe them an account payable and then we pay them in cash. Right So it can it can all flow here through accounts payable. All our purchases can be increases to our accounts payable. And how do we decrease our accounts payable with that cash paid? Right when we pay them in cash, that's going to decrease our accounts payable and then where we left with our ending balance. So notice the cash paid to our suppliers is the important part of this journal entry right here. Now. Why would we need to use both of these balances? Well they could make the question really tricky by talking about inventory. They could give you the beginning balance of inventory. The ending balance of inventory. They could tell you cogs and you'd have to figure out purchases and then with that purchases number you would have to bring that purchases number over into your ap because those are gonna be the same number and then you'd have to use your beginning and ending balances from ap as well as the purchases to figure out the cash paid. Okay so it can be a little trickier here but they would have to give you all that information if they're talking about the direct method and they're giving you inventory numbers, accounts payable numbers, chances are you're gonna have to figure out these purchases to back into the cash paid to suppliers. Alright let's go ahead and in the next video we'll talk about cash paid for operating

So the last big category in our direct method is the cash paid for operating expenses. Now we don't have like this synergy of T. Accounts as we did with the cash paid to suppliers. We're just gonna talk about two main ones which is our interest payable as well as our income tax payable. These are the main ones that you see when you talk about operating expenses and you have to figure figure them out with a T. Account. So interest payable. Let's start there because these don't go hand in hand. They're two different topics. So interest payable. Well it's gonna have some beginning balance as a credit right? This is interest that we already owe. And how are we going to increase our interest payable by having interest expense right? If we take some interest expense and we're gonna pay it later. So notice in all of these examples, we're just assuming that things are gonna be paid later. So we have interest expense increasing our interest payable. And what's gonna decrease our interest payable when we pay the cash right? The cash paid for the interest is going to decrease our interest payable and we'll be left with an ending balance. So notice in all these cases they're gonna have to give you some of these numbers and you solve for the cash paid sometimes they'll just tell you what the cash paid is and you don't have to go through this trouble. Okay. But a lot of times it takes familiarity with the T. Accounts to be able to back into what the cash paid amount was. They could easily tell you. Beginning balance in in interest payable was 5000. The ending balance was 10,000 interest expense. Was 40,000. What was cash paid? Well, you would just use this formula right? You would use your T. Account and you would figure out what the cash paid is based on the information they gave you. So same thing with income taxes payable, they would have to give you the information. So income tax payable right? We have to pay income taxes and we would have some beginning balance in our income tax payable. And that would be a credit there. And what would increase our income tax payable? Having income tax expense. Right? If we have an expense, what we're due to pay it at some point. So we have the income tax expense increasing the payable. What would decrease the payable would be the cash we paid for the income taxes, right? Just like with interest and that would leave us with our ending balance in the income tax payable. So notice those lessons on the base formula and learning how to use T. Accounts. They're gonna come back to haunt you If you need to use the direct method right? You need to be very familiar with the T. Accounts and being able to find the missing pieces of the puzzle when we use the direct method. Okay, let's go ahead and use an example on the next page to explain these concepts. Alright, let's do that now.

Alright, let's try this example here. Abc company is preparing its statement of cash flows using its direct method. Okay, so notice we're doing the direct method in this example, the accountant gathered the following information purchases totaled 200,000 accounts payable increased by 6000 during the year. Cash received from customers was 440,000 depreciation expense. Was 25,000 cash paid for operating expenses excluding interest totaled 140,000. Interest expense was 35,000 interest payable increased by 5000 and a loss on the disposal of plant assets equaled 6000. What is cash flow provided by operating activities? Wow. That was a lot of information. Right? There's tons of numbers here, but we need to focus on the direct method. Right? We're focused on operating cash flows. So we need to see is there any information that was extraneous here from the direct method? What I noticed was this depreciation expense, Right. The depreciation expense. We don't use that. That was in the indirect method that we added that back in. So let's just get that out of mind. And how about this loss? The loss on the disposal plan assets. We don't deal with that in the direct method either. Okay, that was only in the indirect method that we used, we added those back in. Right, so we don't have to deal with that information. Now, what I like to do is did they give us any information straight up? Did they give us any of the cash information straight up. And I noticed that they told us the cash paid. Excuse me. The cash received from customers was 440,000. And the cash paid for operating expenses excluding interest totalled 140,000. So now we've got some information directly given to us here. Right? So we know that the cash received which was obviously from operations, right? We sold things to customers And we received it. Well that was 440,000. So that will increase our cash flows from operations. And we had the cash paid for operating expenses and this was excluding interest That came out to 140,000. So we know that's a decrease here To our operating cash flows, right? These operating expenses, we paid cash for them. Well, that was an outflow in our operating cash flows. Okay. So we've gotten some of them down. But now I think we're gonna have to get into our t accounts. The first thing they told us was purchases totaled 200,000 and accounts payable increased by 6000. Okay. So they didn't mention anything about inventory and they told us to purchase amount already. So let's go into our accounts payable t account and find out what was the amount we paid to suppliers for our inventory. So remember our T account is gonna have some beginning balance as a credit. It's going to increase by the purchases that we make, right because we're gonna owe money for those purchases and it's gonna decrease by that cash paid. And this is what we're looking for in this example is the cash we paid to the suppliers and that will get us to our ending balance, Our ending balance in the account. So what did they tell us about? Beginning balance and ending balance? They told us accounts payable increased by 6000. That means there was a difference between the beginning and ending balance of 6000. Now I don't know about you. They didn't give us any direct numbers. They didn't tell us the beginning and ending balance. So we have to make up numbers here that satisfy this condition of $6,000. Right? The 6000 increase. Now I think the easiest way to do this is to say that we started with a balance of zero and ended with a balance of 6000. Right? This is an increase of 6000 to the account. Now you could use any two numbers. As long as there's an increase of 6000 you could have used $1 beginning balance and $6001 for the ending balance. You could have used 100,000 for the beginning balance, 106,000 for the ending balance. It doesn't matter. I think this is the easiest way to do it because it simplifies the math. So we've got the zero and the 6000 that is our increase. So that's our increase in accounts payable during the year. And now we need to deal with these purchases purchases totaled $200,000. So those purchases would have increased our accounts payable because we were due to pay these to our suppliers. So how could we have ended up with a 6000 balance in the ending balance? Well, we could just do our based formula from here, right? We're gonna have, our beginning balance was zero plus the additions of 200,000 minus the ending minus the cash paid. Right? What we're searching for, the cash paid is gonna equal 6000. Our ending balance right? We started with zero, we added 200,000 minus the X. Is gonna give us the 6000. So if we rearrange our formula here a little bit, if we got our X. To the other side, do it in a different color. We're gonna add X. To both sides. Subtract 6000 from both sides. And we'll be left with 194,000 is equal to X. Right? So our cash paid to our suppliers is 100 and 94,000. That's how we could have got into this decrease. Um In in the excuse me, this increase in the accounts payable account of 6000. So the cash paid for our purchases Is going to be 194,000. So this is another decrease in our direct method, cash paid uh to suppliers. I'm gonna say cash paid to suppliers And that's gonna be the 194,000. That we just solved. Pretty tricky right? We had to use our t. Account to find the cash amount they gave us information about the T. Account and we had to figure it out. We're not done yet though, right? We still have interest expense. And we have to do a similar calculation for interest expense. So let's do that over here on this side, interest payable, right? We want to deal with the balance sheet account interest table. Let me get out of the way here. And it's gonna be the same thing. We're gonna have a beginning balance as a credit and it's going to increase by the interest expense. Right? If we have interest expense in the period, we are liable to pay it and it's gonna decrease by the cash paid. Mhm. For interest, Right? So the cash paid for interest, that's what we're searching for here. And that will get us to our ending balance in the interest payable account. So we had some information about that given to us as well, We had interest expense And we had interest payable increasing during the period by 5000. Okay, so we can use the same logic, if interest payable increased by 5000, that means we can have a beginning balance of zero and an ending balance of 5000, right? That is going to be an increase of 5000 during the period. And we had interest expense of 35,000. Right? So based on the same logic, we could calculate that we would have zero as our beginning balance plus the additions of 35,000 minus the cash paid. What we're solving for Is gonna equal our ending balance right? Our ending balance of 5000. Oops. So if we rearrange the formula, just like we did before add X to both sides, subtract 5000 from both sides And will be left with our cash paid for interest, which is gonna be 30,000, right? 30,000 is equal to X, which is our cash paid for interest, 30,000. And that's what we're searching for here. So we're just about done with this problem. I'm gonna box this section up off here because this is where we're solving the actual problem and we're gonna have our cash paid for interest. So now we've used all the information in the problem And we found out that that was 30,000. So that's a decrease here of 30,000 and we can find our operating cash flow using the direct method. Okay, so we're just about done here. All we need to do is calculate this operating cash flow. So let's find out what that is here. Open up the calculator and we've got 440,000 minus the 140,000 paid for operating expenses minus 194,000 paid to suppliers minus 30,000 paid in cash. We are left with 76,000 as our operating cash flow. So our final answer here is 76,000. The answer is a pretty tough right. We have a mixture of figuring out what they've told us and using T accounts to find the remaining numbers. Okay, so this is a pretty tough method. Let's go ahead and see if you can figure it out in the practice problem below.