The direct and indirect approach
A cash flow statement is important in the organization because it shows the movement of cash. It outlines where a company receives money from and how the money is used. That is cash receipts and payments. The statement is divided into three distinct parts. Each section reports the cash generated and used in various activities in a company. There are two main approaches to preparing a cash flow statement. These are direct and indirect approaches. These approaches yield the same result. However, there are differences in how a cash flow statement appears when the two methods are used (Warren, Reeve, & Duchac, 2013). These differences are discussed below.
The main difference in the two approaches is in the first section of the cash flow statement, which reports cash flow generated from operating activities. Under the direct method, the cash generated from operating activities is arrived at by deducting cash paid to suppliers, employees, lenders, and taxing authorities from the cash received. Therefore, only cash received and payments made are recorded under cash generated from operating activities.
On the other hand, under the indirect approach, the cash flow generated from operating activities begins with reported net income for the year. Adjustments are then made to the net income to change revenues to cash received while the expenses are changed to cash payments. This entails altering the net income for revenues and expenses that do not involve the movement of cash. Examples of the adjustments that are often made are depreciation, gains or losses on fixed assets, and changes in operating liabilities and assets. Basically, these changes convert the net income (accrual basis) to cash flow (cash basis) (Stickney, Weil, Schipper, & Francis, 2008).
Further, companies that chose to use the direct method are required to show reconciliation between the net income and cash flow from operating activities, while companies that use indirect methods are not required to show reconciliation. Therefore, the use of the direct approach is quite involving. It is worth mentioning that both the IFRS and GAAP permits the use of both approaches. However, most companies often use the accrual basis of accounting. Therefore, they find it easier to use the indirect method. Statistics show that over 90% of entities across the globe use the indirect approach (Benedicto & Elliott, 2008).
Cash flow from operating and investing activities
Cash flow from operating activities focuses on the regular activities of the company. Some of these activities include the manufacturing and sale of goods and services. It also includes cash payments to various suppliers. It excludes amounts spent on investments and long term assets. This section measures the ability of the company to generate money from the main business activities. This gives information on the amount of cash that is available for daily use.
It does not evaluate the ability of the company to raise capital or purchase assets. On the other hand, investing activities include the sale and purchase of assets. Examples of these assets are marketable securities and capital assets (building, equipment, and land, among others). It also includes cash transactions that are related to mergers, acquisitions, and dividends received. Therefore, cash transactions on these investments are recorded under cash flow from investing activities (Benedicto & Elliott, 2008). In most companies, cash is often used in investing activities. Therefore, the total value of this section is often negative.
Cash flow and income statement
The cash flow and income statement are two significant financial reports. The income statement shows the profit or loss that a company makes at the end of the financial year. It looks at the revenues and expenses for a specific period. On the other hand, cash flow shows the movement of cash in and out of the company. A review of these two financial statements gives a broad understanding of an entity. The information in the two statements is related but different. The result that is generated from a cash flow statement is the cash balance at the end of the year, while the outcome of an income statement is net income or loss. These two items are different. It is worth mentioning that the cash at the end of the year can also be obtained from the statement of financial position (Madegowda, 2007).
The income statement provides a bigger and better picture than a statement of cash flow. This is based on the fact that the income statement gives information on factors that are beyond the movement of cash, such as the non-cash income and expenses. This information permits a broader and long term look at the patterns of revenue and expenditure. The information on the income statement allows the management and analysts to compare the performance of the entity over time and with other companies and to make decisions that can lead to proper management of revenue and expenses, among others. On the other hand, a cash flow statement only gives information that can assist the management in knowing the availability of cash to make payment (Madegowda, 2007).
Differences in cash flow for Apple Inc. and Samsung Electronics Co. Ltd.
A review of the cash flow statements for the two companies for the financial year 2015 shows that they both use the indirect approach to prepare the cash flow statements. However, there is a slight difference in the manner in which cash flow from operating activities is presented. In the case of Apple Inc., there is the line by line items for adjustments that reconcile the net income to cash and the changes in the operating assets and liabilities (Apple Inc., 2015).
For instance, under adjustments, the items that are recorded are depreciation and amortization, share-based compensation expense, and deferred income tax expense. Under changes in operating assets and liabilities, some of the items recorded are accounts receivables, inventory, and accounts payables, among others. In the case of Samsung Electronics Co. Ltd., the adjustments and changes in operating assets and liabilities are made separately under the notes to the financial statements (Samsung Electronics Co. Ltd., 2014). There is no line by line entries for the adjustments as observed in the case of Apple Inc.
Therefore, a summary of the adjustments is shown in the statement of cash flow. Further, entries of interest received, interest paid, dividend received, and income tax paid is made to arrive at the value of net cash generated from operating activities. Therefore, there are fewer entries for cash flow generated from operating activities in the statement for Samsung Ltd. than that of Apple Inc. Finally, there are no differences in the sections for cash generated from investing and financing activities (Samsung Electronics Co. Ltd., 2014; Apple Inc., 2015).
Apple Inc. (2015). Form 10-k (annual report). Web.
Benedicto, A., & Elliott, B. (2008). Financial accounting: an introduction. New York, NY: Prentice-Hall/Financial Times.
Madegowda, J. (2007). Management accounting. Mumbai: Himalaya Publishing House
Samsung Electronics Co. Ltd. (2014). 2014 Samsung electronics annual report. Web.
Stickney, C., Weil, R., Schipper, K., & Francis, J. (2008). Financial accounting: an introduction to concepts, methods, and uses. Boston, MA: Cengage Learning.
Warren, C., Reeve, J., & Duchac, J. (2013). Financial and management accounting. Boston, MA: Cengage Learning.