Direct Method with T Accounts | Cash Flow Statement
In this video you’ll learn how to
prepare a cash flow statement using a direct method example
with the help of the income statement
and the balance sheet, along with some T Accounts. [Music] Hey viewers, i’m James and welcome to
Accounting Stuff. This is a place where i
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pick up from where we left off last time with preparing a cash flow statement using
a direct method example. Previously, i showed you a
cash flow statement for the Chudley Cannons Quidditch team,
along with its corresponding income statement and balance sheet.
But if you missed part one there’s a link to that over here as well.
In this video we’re going to rewind a bit and prepare that same
cash flow statement using T Accounts, and both of these reports.
We’re going to use the direct method as we work out each number
as we piece it together. We’re going to start off with the
easy ones and move on to the harder calculations
as we progress, so recommend watching this video
through until the end to get a clear picture of the whole process.
Let’s begin… So here we have the
cash flow statement for the Chudley Cannons and the plan is
we’re going to recalculate all of these numbers directly from
the income statement and balance sheet for the same period…
the 31st of December. We will start at the top with
cash flow from operating activities and work our way down through
all three sections to cash flow from financing activities.
We’re using the direct method today, so cash flow from operating activities
mirrors the layout of an income statement prepared under
the cash basis. So we have cash receipts
from customers at the top which reflect our sales,
and below that we have cash paid to suppliers, employees,
and the rest of the expense types. Operating activities are the
principle revenue generating activities of a business.
So this section shows the cash that we receive or pay out during the
course of our regular business. The first line item that we’re going
to calculate is cash receipts from customers,
and to do this we’re going to need to look at the movement in our
accounts receivable balance. I said in the intro that we’ll need
some T Accounts so let’s draw those out. Accounts receivable is an asset, which is the A in DEALER,
so it’s a normal debit account. That means our opening balance
or our balance brought forward goes on the left side of the T Account because
debits always go on the left. The accounts receivable balance
increases as we make revenue because when we credit sales
we debit accounts receivable so sales go on the left side as well.
And finally, the closing balance or the
balance carried forward also goes on the left
because it’s a normal debit account. Opening and closing balances
for normal debit and credit accounts should always be on the
same side as each other. On the credit side of the T Account
which is on the right, we have cash receipts from customers.
Cash received from customers reduces our accounts receivable
and this is what we’re looking to solve for because cash receipts
from customers ties back to our cash flow statement.
Now we’ve laid out our T Account let’s enter some numbers…
We get our opening balance from the balance sheet for the previous year.
In this case accounts receivable were $98,000 as at 31st of December
for the prior year, so we can write this down
in the T Account. Sales come straight from
the income statement. This year the Cannons made sales
of two hundred and fifty thousand dollars, so we need to debit
accounts receivable by 250. And finally,
our closing balance comes from the balance sheet,
this time from the current year. Accounts receivable at the end
of the current year were one hundred and twenty thousand dollars
so that goes on the Left at the bottom of the T Account.
Now we only have one missing value… cash receipts from customers
and we can work this out using some basic maths.
Our closing balance of a hundred and twenty
less our sales of 250 less our opening balance of
ninety eight gives us minus
two hundred and twenty eight. The negative sign signifies
that this is a credit so we write this down
on the credit side of our T Account. As you can see
this ties back to the two two eight that we have
in our cash flow statement. All as well.
Next, I’m going to skip over cash paid to suppliers
and return back to a later in this video because it’s
actually one of the harder balances to calculate.
So instead we move on to cash paid to employees.
The balance sheet account that we’re going to need for this one is
salaries payable. Salaries payable is a
form of liability, the L in DEALER.
So it’s a normal credit account. That means our opening balance
goes on the right hand side of the T Account because
credits always go on the right. The balance on this account
increases as the salaries expense goes up because when we
debit to the salaries expense and credit salaries payable
so these go on the right. And lastly,
the closing balance joins the opening balance on the
right hand side because we have a normal
credit account. We are looking to solve the
cash paid employees which will show as a debit on the left hand side
of this T Account, because when we pay out
cash to employees, we reduce salaries payable.
This is the only unknown value for us at this stage
because we can easily pull the opening and closing balances from
the prior and current year balance sheet and we can get the salaries expense from
the current year income statement. So let’s do that…
the prior year balance sheet shows a closing balance in salaries payable
of 30. The current year income statement
shows a salaries expense of 80, and the current year balance sheet
shows a closing balance in salaries payable of 42. Let’s write these down
in the T Account to work out cash paid to employees. Our closing
balance of -42, less the salaries expense of 80,
less the opening balance of 30 gives us cash paid to employees of 68.
This number is positive so we debit the T Account by 68.
And does it tie back to our cash flow statement? Yes it does
perfect. Next up we need to work out
interest paid. We’re going to run through
this one a bit quicker because the balance sheet account that we use to
work this out is interest payable which is also a liability.
So the process is very similar to cash paid to employees.
That means that the opening balance, the interest expense
and the closing balance all go on the right-hand side
of the T Account, because interest payable is a
normal credit account. On the left side,
the debit side, we are looking to solve
for interest paid, which should tie back to
the cash flow statement. We are again going to look for the
opening and closing balances in the respective balance sheets
and for the interest expense in the income statement.
So here we go… The prior-year balance sheet shows a
closing balance in interest payable of 2,
the current year balance sheet shows a closing balance
in interest payable of 3, and the current year
income statement shows an interest expense of 8. So let’s enter these
into our T Account to work out interest paid.
Our closing balance of -3 less the interest expense of 8
less the opening balance of 2 gives us interest paid of 7.
It’s positive so we debit the T Account by 7,000.
When we check back against the cash flow statement,
we can also see interest paid of 7,000 so it matches.
The last line in cash flow from operating activities
is income taxes paid which we will work out now.
The balance sheet account we’re going to need for this one
is income tax payable and since that’s also a liability,
the process is going to be very similar to the previous
two examples.The opening balance, the income tax expense,
and the closing balance go on the right-hand side
of the T Account because we are dealing with
a normal credit account. On the debit side we have
income tax paid which we’re solving for.
The opening and closing balances will again come from the balance sheet
and we will get the income tax expense from the income statement.
The prior-year balance sheet shows a closing balance
in income tax payable of 4, the current year balance sheet
shows closing balance of 6 and the income statement shows an
income tax expense of 9. We enter these into the T Account
to work out income tax paid. Our closing balance of -6
less the income tax expense of 9 less the opening balance of 4
gives us income taxes paid of 7. So we debit the T Account by 7,000
and this ties back to income taxes paid in the cash flow statement.
Phew How did you find that? Brace yourselves because
we’re about to take on something a bit more challenging. We’re going to head
back to cash paid to suppliers which we
left out earlier and I’ll show you how to calculate it.
The balance sheet account that we need here is accounts payable,
which is a liability. Now you might be thinking… But James,
we just did three liability accounts… isn’t the process going to be
exactly the same? Bear with me for a moment and I’ll explain why it’s different. We lay
out the accounts payable T Account as we’ve done before…
the opening balance, inventory purchased
and closing balance go on the credit side
and cash paid which we’re solving for
again goes on the debit side. We can easily pull the opening and closing
balances from the prior and current year balance sheet.
In this case we have an opening balance of 95
and a closing balance of 105. So all we need now is
inventory purchased and we’re on our way!
But how do we find inventory purchased? There isn’t an inventory expense
in the income statement…All we have is cost of goods sold.
Bummer. What we have to remember here
is that we’re accounting using the accrual basis.
And under the accrual basis, we apply the matching principle
which states that revenue and all expenses incurred in order to
generate that revenue, need to be recognised
in the same accounting period. Now what that means for us in the
context of this example is that when we purchase goods from suppliers that we
intend to sell we can’t immediately
recognise an inventory expense in the income statement.
That’s because our intention is to sell our inventory in order
to generate sales, and if we’re generating sales,
then the matching principle is telling us that we need to
recognise those sales, and their related expenses
in the same accounting period. In order to do that we need the help of
another account… Inventory. Having an inventory account
means that we can store the costs of all goods that are intended
to be sold as a debit balance in the balance sheet
and when they are sold we decrease inventory in the
balance sheet and increase cost of goods sold in the
income statement. Let me explain this using an inventory T Account. Inventory is a form
of asset which makes it a normal debit account
so the opening balance, inventory purchases
and the closing balance go in the debit side.
On the credit side we have cost of goods sold. We can easily find
the opening and closing balances by
referring to the prior and current year balance sheet.
Here we have an opening balance of 68
and a closing balance of 94 which we will write down
in our T Account. And we can find cost of goods sold
in the income statement which in this case is 60. So we write 60 on the credit side of the T Account because
when we sell inventory we debit the income statement to
recognise the expense and we credit
inventory in the balance sheet to reduce our assets. That leaves us with inventory purchases, which we can work out using
the other numbers. A closing balance of 94
less the opening balance of 68 and adding back cost of goods sold of 60
gives us inventory purchases of 86. So we debit the T Account by 86. You might have noticed already that it was inventory purchases
that we were looking for in our accounts payable T Account. So we can copy the 86 over to the credit side of accounts payable
because when we purchase inventory we debit inventory to increase it
and credit accounts payable to increase the amount that
we owe to suppliers. Now that we’ve worked out that number.
We’re on the home straight calculating cash paid to suppliers. Our closing balance of -105 less inventory purchases of 86
less our opening balance of 95 gives us cash paid to suppliers of 76. Which goes on the debit side of the accounts payable T Account
and ties back to our cash flow statement.
Ouch! Did you survive that?
Cash paid to suppliers is definitely one of the hardest numbers to calculate on the
cash flow from operating activities. If you’d like to learn more about
accrual accounting then I’ll throw a link up here to a video
that I made about it previously. So that was
cash flow from operating activities and when we subtotal all of these numbers
that we worked out we can see that the Cannons
have generated $70,000 of cash inflow from their core operations. But hold your horses
we’re not done yet. Next up we have cash flow from investing activities.
Investing activities most commonly relate to the sale or purchase of
non current assets or investments in stocks and shares
that sit outside of a business’s core operations.
In this cash flow statement we have cash flowing out of the business from
the purchase of Plant Property and Equipment
or PPE for short, and cash flowing back in from the sale of
PPE. You might have guessed it already,
but the balance sheet account that we need to calculate these numbers
is plant property and equipment. This account is an asset
which is the A in DEALER. So it’s a normal debit account
and therefore our opening and closing balances go on the left hand side.
On the credit side we have the depreciation expense because
the value of non current assets reduce as they depreciate. Credit non current
assets in the balance sheet Debit depreciation expense in
the income statement. Now I don’t want to over complicate things
in this tutorial so we’re going to keep PPE simple and make
a few assumptions at this point. We’re going to
ignore accumulated depreciation assume no gain or loss on disposal
and that all cash related to these transactions has changed hands
and finally that the Cannon’s spent seventy thousand dollars
purchasing PPE this year. I know that’s a lot of assumptions,
but we don’t have a fixed asset register for this example
so we’ll leave it at that. I’ll probably do a whole video
in the future covering fixed assets and depreciation. Now that we’ve cleared that up, all that’s left to include are
cash paid to purchase PPE and cash receipts on sale of PPE. The prior year balance sheet shows a closing balance in PPE of 202.
The current year balance sheet shows closing balance of 234
and we can see that the depreciation expense in the
income statement was 23. I just said that we can assume
that the Cannon’s spent 70,000 on the purchase of PPE and that
all their cash has changed hands. So we would credit cash by 70 to decrease it
and debit PPE by 70 to increase it. That leaves us with
cash receipts from the sale of PPE on the credit side which we
now need to solve for. A closing balance of 234
less cash paid of 70 less an opening balance of 202
and adding back the depreciation expense of 23
gives us cash receipts on the sale of PPE of 15.
So cash would be debited by 15 to increase it and PPE would be
credited by 15 to decrease it. Both cash paid to purchase PPE
and cash receipts on the sale of PPE tie back to our cash flow statement
and when we subtotal all of these we see a cash outflow of 55,000
from investing activities. Cash flow from investing activities
is an important section of the cash flow statement because it can
significantly offset the cash flow generated from operating activities. Last up we have cash flow from financing activities
and don’t worry we’ve got all that hard work out of the way. This section is going to be quick. Financing activities relate to transactions
involving a businesses owners or lenders. In this case we’re dealing with lenders
because we have proceeds from long term borrowings of 20,000.
And the number is very simple to calculate. We take the closing balance
of long term borrowings in the current year balance sheet of 100
and we take away the closing balance from the previous year of 80.
100 less 80 is 20. So we have a net cash inflow of 20,000 from financing activities. Now let’s take the total of all these
cash inflows and outflows that we have worked out. We can see that the Cannons have a net cash increase of $35,000
for the current year. Which ties to the movement
in the cash balance which we can see below
and which we can get from the balance sheet. The closing cash balance
for the current year of 185 less the closing balance from
the prior year of 150 gives us a $35,000 increase in cash.
So there we have prepared the Chudley Cannons
cash flow statement using the direct method. Working out all of the numbers manually
in the income statement and balance sheet. Woah That was hard work wasn’t it? And this is only
a simple example. You can imagine that this whole process is more complicated for larger companies with more
complex transactions. Which is why most of them actually
avoid this process altogether because it can be too expensive
and time-consuming for their accountants to work out
cash flow using the direct method. The majority of large corporations
tend to opt for the indirect method instead. Which is the subject
of our next video. The indirect method has the benefit
of being much easier to prepare. However it’s less useful to investors
and I’ll explain why next time. Thanks for watching today’s video
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