This is the second blog on IFRS Accounting with
Using the more common method in the U.S.—GAAP-compliant financial statements prepared with the Indirect Method—you start with accrued net income per the Profit and Loss statement. Then reverse out non-cash entries and segregate changes to cash based on financial and investment activities. The basic areas of a Statement of Cash Flow using the Indirect Method:
- Net income per the Profit and Loss statement
- Less non-cash entries (primarily depreciation and amortization)
- Results in: cash supplied by operations
- Then analyze changes to cash based on financial activities
- Increases in current liabilities (provides cash)
- Decreases in current liabilities (use cash)
- Increases in current assets (use cash)
- Decreases in current assets (provide cash)
- Then analyze changes based on investment activities
- Increases in long-term liabilities (provides cash)
- Increases in equity instruments (additional paid-in cash, sale of stock, etc.)
- Decreases in long-term liabilities (use cash)
- Decreases in equity instructions (purchase of stock, for example)
- Increases in long-term assets (new contracts, for example)
- Decreases in long-term assets (sale of assets, for example)
- The net effect of the above results in the net change to cash.
- It is customary to also do a very brief Direct Method calculation of the change to the cash to “prove” the Indirect Method change to cash.
When preparing a Statement of Cash Flow using the Indirect Method, non-accounting professionals frequently confuse whether the change increases or decreases cash. Test the change by thinking, “If I collect AR (Accounts Receivable), that increases cash; therefore, a decrease to AR provides cash and an increase to AR uses cash. If I pay AP (Accounts Payable), I use cash; therefore, a decrease to AP uses cash and an increase to AP provides cash.
It is noteworthy from a technical standpoint when preparing your Statement of Cash Flow, to set up your chart of accounts to facilitate reporting of the changes to cash based on investment activities in greater detail than you report the financial activities.
The section of the Cash Flow Statement interpreting financial activities deals with current assets and liabilities. It seeks only the net change to those accounts. The report Designers can easily be directed to provide the net change to those accounts during the accounting period.
However, the changes based on investment activities are typically shown on the Statement of Cash Flow in more detail. As an example, your company may have bought stock from one stockholder for $10,000 and sold the same stock to a new stockholder for $12,000. Looking at the simple net change, you might incorrectly report an increase in equity providing $2,000 in cash. The two separate transactions are appropriately reported on the Statement of Cash Flow.
The same example holds on the long-term asset section. You may have disposed of a $1,000 asset and purchased a $2,000 asset. Using a simple net change calculation, you would report the use of cash with a $1,000 asset acquisition. Standards on the State of Cash Flow require that you report two transactions: the sale of assets and the purchase of assets.
Within a correctly configured chart of accounts, the design can perform a near-perfect analysis of the transactions. You simply create one asset account for acquisitions and another for dispositions. Similarly, you create one account for long-term liability increases—a new contract payable—and one account for payment or decreases of long-term liabilities.
Benefit of Direct Over Indirect Method
In a more straightforward manner, the Statement of Cash Flow prepared using the Direct Method provides a clearer scenario showing you how you used your cash and where it’s hiding. Either method, honestly and accurately prepared, provides good information. But when you prepare a Cash Flow Statement over several years using the Direct Method, you get an extremely accurate idea of trends and how that’s affecting your ability to pay your bills and acquire assets—really nice things to do in a growing business.
A change to a long-term asset or liability is grossly affected by accounting standards. GAAP tells you to recognize revenue from a long-term contract with one method and IFRS requires a different method. GAAP tells you to match expense to that revenue with one method and IFRS requires different expense recognition.
By using the Direct Method of preparing a Statement of Cash Flow, you reduce the changes down to what caused your bank account balance to go up or down. It’s harder to hide changes to cash.
I once struggled to show a company owner why he had less cash than he did the year before, after a 20% growth in sales and no change to the percent of cost of sales. He was stockpiling inventory to meet the increasing demand. He refused to push on accounts receivable collection from his new, wonderful customers. He was faithfully paying every bill as it came in the mail rather than paying according to terms; he even refused negotiate or take payment terms because he thought that would make his vendors nervous. Up to a point, his actions made sense as he was protecting his credit rating (a change in payment methods can wreak havoc even though you’re still within terms), and courting his new customers kindly. With a Statement of Cash Flow prepared using the Direct Method, the cash situation became brilliantly clear.
It is this type of clarity we can all hope to attain if we are required to transition our accounting methods from GAAP to IFRS.
This completes this IFRS Accounting with Microsoft Dynamics® GP series. The posts in this series are also available in the white paper,
©2011, Computeration®, Inc.
By Gloria Braunschweig, The IFRS Implementation Expert for Dynamics GP, with Computeration, a Pacific Northwest Microsoft Dynamics GP Partner.