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Direct Method in Accounting: Definition & Example

Instructor: Martin Gibbs

Martin has 16 years experience in Human Resources Information Systems and has a PhD in Information Technology Management. He is an adjunct professor of computer science and computer programming.

In accounting, we need to report our net cash. This is cash we actually have free to use. The direct method is a means to prepare our statements in regards to cash. This lesson will define the method and provide an example.

Be More Direct!

In accounting, there are a couple of ways to prepare a statement of cash flows. A cash flow statement is a financial statement. It is a summary of how changes to balance sheet accounts impact the cash account. This reporting is done for a given period (month, quarter) and shows how cash is being used to fuel operations.

The direct method of creating the statement of cash flow calculates a NET cash amount, by subtracting operating cash from total cash receipts. When using the direct method, you need to list both the sources of cash and the uses for the cash. These items include cash paid to suppliers, wages, and cash payments from customers. The direct method looks at both the Balance Sheet and Income Statement from period to period (say Quarter 3 to Quarter 4) to determine changes in cash flow.

Let's take a look at how each piece is evaluated.

Accounts Receivable

Recall from accounting that credits to accounts receivable (AR) result from cash transactions, debits to AR are a result of sales. Not all sales are paid in cash! Think of it this way. If you had Accounts Receivable of $100 one month, then only $50 the next month, it means that the $50 was converted to cash. We'll ignore bad debt and all that for now.

In terms of building the statement of cash flows, the following is true of cash received:

Cash received = beginning accounts receivable + credit sales - ending accounts receivable.

Accounts Payable and Inventory

We also have to factor in the cash that we spent. However, since a lot of transactions are purchases on account, we have to look at the accounts payable side of the ledger also! We also need to look at inventory, since we may have purchased inventory during the period, either on credit or with cash. In order to get the costs paid for the cash flow statement, we look at both the Balance Sheet and Income statement.

First, from the Income Statement, we gather the cost of goods sold. We then ADD this amount to the CHANGE in inventory from period to period. However, a lot of inventory is purchased on credit. Therefore, we then SUBTRACT the change in Accounts Payable over the period. Therefore:

Payments = (Cost of Goods Sold + Change in Inventory) - Change in Accounts Payable

Why is this? We will assume the Accounts Payable went down from period to period. The difference is indicative of the cash we spent to pay off our debts.

Rent

Rent can factor into this also. We need to make sure we account for the prepaid rents from period to period and ADD that to the current rent expense.

Salaries/Cash Paid to Employees

Salaries/Wages are more like Accounts Payable in this sense. We need to factor the wage expense (as we have to pay our employees), but SUBTRACT the change in accrued wages from period to period. Just like Accounts Payable, or Accounts Receivable, the change in accrued wages indicates the amount we doled out in cash.

This should make much more sense with an example.

Example

Let's look at an example. Really Good Bread, Inc. had the following Balance Sheet and Income Statement. In order to highlight the concepts in this lesson, we added a column for differences. In a real Balance Sheet or Income Statement, this column would not appear.

Account Quarter 4 Quarter 3 Difference
Cash $150,000 $175,000 -25,000
Accounts Receivable 250,000 300,000 -50,000
Inventory 700,000 600,000 +100,000
Prepaid Rent 50,000 20,000 +30,000
Property, Plant, and Equipment (PP&E) 950,000 1,000,000 -50,000
Total Assets 2,100,000 2,095,000
Accounts Payable 420,000 480,000 -60,000
Wages Payable 150,000 120,000 +30,000
Shareholder Equity 1,250,000 1,000,000 +250,000
Total Liability 1,820,000 1,600,000

And now the Income Statement:

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