Statement of Cash Flow - Direct or Indirect Method

Statement of Cash Flow - Direct or Indirect Method

When taking over a forensic accounting engagement, the accountant must be certain he or she knows how to provide information about cash receipts and cash disbursements of an entity during a period. The statement of cash flows is one of the main financial statements. Its link to the other financial statements sheds light to investors, creditors, employees, governmental agencies about the ability of an organization to generate positive future cash flows, to meet its obligations when they become due, to pay dividends, and its need for external financing.

In preparing a statement of cash flows the forensic accountant must identify the major classifications of cash flows, know the difference between net cash flows from operating activities and net income, and be able to identify the contrast between the direct and indirect method of calculating net cash flow from operating activities.

Classification of Cash Flows

This statement classifies cash receipts and cash disbursements by operating, investing, and financing activities. The operating activities take into consideration the cash effects of transactions that enter into the determination of net income: cash receipts from sales, payments to vendors, employees, advertising services, costs of goods sold, etc. Investing activities are related to long-term assets such as making and collecting loans and acquiring and disposing of investments, example, and available-for-sale securities. Within the financing activities are included liabilities and stockholders’ equity items. Examples are borrowing money, repaying loans, obtaining loans from stockholders and paying them a return on their investment.

Sources of Information for the Statement of Cash Flows

Mainly three sources: 1) Comparative balance sheets. It gives the forensic accountant a quick look to the variances and changes in assets, liabilities, and equity. The percentages are compared to the percentages in which the client operates to see if it makes sense. 2) Current period income statement, which reflects the cash provided by operations during the period. 3) Selected transaction data from the general ledger, useful in determining how cash was provided and used during the period. Keep in mind forensic accountants see beyond the numbers and I add to it, forensic accountants search beyond financial records.

Preparing the Statement of Cash Flows

It involves three major steps: 1) Determining the change in cash. This is crucial in every forensic investigation because it leads the investigator to rationalize and understand the potential for under reported income with the purpose of evading taxes, hid assets, etc. The change is determined by establishing the difference between the beginning and the ending cash balance shown on the comparative balance sheets. 2) The second step, determining the cash flow from operating activities, involves analyzing the current year’s income statement and, in addition, the comparative balance sheets, and the selected transactions data. 3) Determining the cash flows from investing and financing activities.

Arriving at the net cash from operating activities it is necessary to disregard those transactions that did not have an effect on cash changes, which means that we must eliminate non-cash revenues and non-cash expenses from the calculation.

Direct Method

Also called income statement method, reports cash receipts and cash disbursements from operating activities and the difference between these two amounts represents the net cash flow from operating activities. This is the equivalent of cash-basis net income. An additional schedule that reconciles net income to net cash provided by operating activities should be attached to the statement of cash flows when using the direct method.

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