Simple concept, Difficult Question

[hqi123]

For cash flow statement, why the direct method and indirect method would agree?


E.G.
A company buys some equipment and will pay later (i.e. Equipment increases, Account Payable increases)

In this transaction, CFO does not change according to Direct Method.

However, CFO actually increases under Indirect Method (since Account Payable increases)


So....why would these 2 methods always agree?

 

[Triest123]

For cash flow statement, why the direct method and indirect method would agree?


E.G.
A company buys some equipment and will pay later (i.e. Equipment increases, Account Payable increases)

In this transaction, CFO does not change according to Direct Method.

However, CFO actually increases under Indirect Method (since Account Payable increases)


So....why would these 2 methods always agree?

why would these 2 methods always agree
=> Both can indicate the change in the company's "CASH" balance.

Under Direct Method;
There is no cash payment for the equipment.

Under Indirect Method.
The increase (or decrease) in "current asset & current liabilities" are considered.

The purchase of equipment is grouped as '"Investing activities"

Investing Activities
Cash paid for the purchase of equipment :
Equipment at costs (say $10,000) : $10,000
Less : Increase in other payable ($10,000)
----------
Net Cash paid $ 0

Under the Indirect Method, the cash paid for the equipment is also "zero",

 

[hqi123]

I agree with you about the Direct Method.

However, for Indirect Method, when we calculate CFO, we would adjust for the "current asset & current liability"

As the purchase of equipment is backed by Account Payable (current liability), when we calculate CFO, the increase in Account Payable($10,000) actually indicates that there is an increase of Cash ($10,000).

In this sense, Direct method and Indirect Method do not agree (considering CFO)??

Of course, when we consider Investing Activity, we would consider the increase in equipment. So, the net change in cash is zero.

 

[Triest123]

I agree with you about the Direct Method.

However, for Indirect Method, when we calculate CFO, we would adjust for the "current asset & current liability"

As the purchase of equipment is backed by Account Payable (current liability), when we calculate CFO, the increase in Account Payable($10,000) actually indicates that there is an increase of Cash ($10,000).

In this sense, Direct method and Indirect Method do not agree (considering CFO)??

Of course, when we consider Investing Activity, we would consider the increase in equipment. So, the net change in cash is zero.

=> Under the Indirect method, the cash inflow/outflow from the operation activities is
derived from the "Operating proft before Tax" and excluding any non-cash items.

Using the purchasing of equipment is not a good example to explain the indirect method
as it is a capital expenditure (i.e. no impact on the operating income)

Assumed the company pay later for an expense of $10,000, and there is no other
transaction. The company's will record an loss of $10,000 in the income statement.

Under Indirect Method

Operating (Loss) from operation : (10,000)
Add : Increase in account payable 10,000
Cash inflow/ (outflow) from operating activities 0


It is equal to the indirect method, the cash payment for expenses is 0

 

[hqi123]

=> Under the Indirect method, the cash inflow/outflow from the operation activities is
derived from the "Operating proft before Tax" and excluding any non-cash items.

Using the purchasing of equipment is not a good example to explain the indirect method
as it is a capital expenditure (i.e. no impact on the operating income)

Assumed the company pay later for an expense of $10,000, and there is no other
transaction. The company's will record an loss of $10,000 in the income statement.

Under Indirect Method

Operating (Loss) from operation : (10,000)
Add : Increase in account payable 10,000
Cash inflow/ (outflow) from operating activities 0


It is equal to the indirect method, the cash payment for expenses is 0

I understand your example. However, for my example (Buy $10,000 equipment, Account Payable increases $10,000), there is no change in operating income nor net income.
When we calculate Operating Cash Flow using Indirect Method, the OCF would be +$10,000 right?

I just want to know is +$10,000 OCF is correct under my example.

 

[Triest123]

I understand your example. However, for my example (Buy $10,000 equipment, Account Payable increases $10,000), there is no change in operating income nor net income.
When we calculate Operating Cash Flow using Indirect Method, the OCF would be +$10,000 right?

I just want to know is +$10,000 OCF is correct under my example.

=> You need to open a "Account Payable A/C" for the Equipment
to find out how much cash is actually paid for the Equipment.


Account Payable A/C
Cash (balancing figure) $0 Equipment $10,000 Balance c/f $10,000
----------- ----------
$10,000 $10,000

 

[hqi123]

=> You need to open a "Account Payable A/C" for the Equipment
to find out how much cash is actually paid for the Equipment.


Account Payable A/C
Cash (balancing figure) $0 Equipment $10,000 Balance c/f $10,000
----------- ----------
$10,000 $10,000

Do we have this kind of account in real life?

I only see 1 account called "Account Payable" on usual financial statements. They do not distinguish "Account Payable A/C for Equipment" from "Account Payable"

 

[mike99]

However, CFO actually increases under Indirect Method (since Account Payable increases)

This would not fall under CFO. It should fall under investing activities.

However, if we use, say, inventory as an example, which should fall under CFO, it becomes easier to understand. Under the indirect method, the increase in inventory in CFO would cancel out the increase in accounts payable in your working capital adjustments, thus giving zero.

Direct or indirect would not concern us if it fell under investing activities.

[Edit: Typically one would separate the current liabilities from operations (rent, telephone, inventory, etc.) with the current liabilities from buying PPE, etc., on credit (investing) either within the same accounts payable, or by using a separate account, say, "assets payable" for the latter. If we use other operations bought on credit, say, rent, this would result in an increase in A/P but a decrease in net operating income, thus cancelling it out. Simply saying A/P increases does not mean it increases because of an operating activity.]